posted on 2006-08-08, 11:37authored byJay Fattorusso
Executive pay research has traditionally focused on salary, severance payments and longterm
incentives. A systematic rigorous empirical examination of short-term annual
bonuses is lacking. To address this omission, this research empirically examines the
relationship between short-term bonuses and firm performance (TSR and EPS), in the
UK. It also considers the association between form of bonus payment (i.e. cash/shares),
and type of performance target (i.e. hard/soft and simple/complex) with bonus and
performance. Furthermore, firm size and particular corporate governance factors are
included (i.e. NED ratio on remuneration committee, CEO presence on nominations
committee, CEO/Chair duality, tenure, and power) to examine their relationship with
bonus value.
From a sample of 299 firms listed in the FTSE-350 (1,542 executives including 300
CEOs), this study uses two competing theories (i.e. agency and power theory) to provide
a fuller explanation of the subtleties of the pay-performance relation. The main findings
support the agency view, since bonus is positively and significantly associated with
financial performance. As with previous studies on executive bonus pay this association
remains weak. By implication, power theory is not supported.
However, other findings indicate: (1) although firm size may change, the proportion of
bonus pay relative to salary does not vary. This suggests that large and small firms pay
out proportionally similar bonuses; (2) cash bonuses are not positively related with the
total value of bonus pay, suggesting that they are not any more open to abuse than other
methods of compensation, as agency theory would predict; (3) cash bonuses encourage
short-term achievement, as predicted by power theory; (4) consistent with agency theory,
share-based bonuses are positively related to bonus pay and performance (weak
association), suggesting that share-based bonuses (rather than cash bonuses) may be
more effective at aligning pay with performance; (5) in line with agency theory,
transparency (i.e. hard (external/published) and simple bonus conditions) is positively
associated with performance, providing support for the alignment between principals’
and agents’ interests; (6) detailed bonus scheme characteristics are generally insensitive
to performance and are becoming increasingly softer (i.e. more internal/unspecified
targets) and complex (i.e. multiple targets). On the power view, these may create
opportunities for executives to mask weak performance and extract greater rents; (7)
governance factors are insignificant, suggesting that efforts to improve this area may be
wasted, since they mainly leave pay-performance sensitivities unaffected. However,
based on power theory, weak governance may foster the rise of powerful executives and
widen the pay-performance gap. Therefore, it is suggested that close monitoring of
executive pay must continue and shareholders should remain vigilant.