New carrots, old yardsticks? Cash is back in incentive compensation, but companies are struggling to set the right performance targets

CFO: Magazine for Senior Financial Executives,  June, 2004  by Ronald Fink

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WITH STOCK OPTIONS INCREASINGLY out of favor, cash bonuses are making a comeback. [paragraph] A recent survey of 350 companies by Mercer Human Resource Consulting found that the percentage of overall CEO pay coming from bonuses grew from 13 percent in 2001 to 19 percent last year. At the same time, the contribution of long-term incentives such as options and restricted stock fell from 71 percent to 63 percent, while the proportion stemming from salary rose slightly (see "Cash, Please," page 80).

"The size of bonuses is increasing exponentially as stock options fall," says Paul Doff, managing director, of Compensation Resources, a consulting firm based in Upper Saddle River, New Jersey.

But if the form of incentive compensation is changing, the grounds for earning such pay may not be. And that could be a problem. Many critics of executive compensation complain that even after the end of the 1990s stock-market bubble, companies still cling to incentive schemes that encourage undesirable behavior-accounting shenanigans, earnings management, and value-destroying tactics.

"We've seen the ruination of many firms" as a result of compensation practices that encourage earnings management, says Michael Jensen, a renowned finance professor at Harvard Business School and a principal at Monitor Group, a consulting firm in Cambridge, Massachusetts. And while the incentive of choice during the market bubble was stock options, Jensen contends that few companies have responded by tailoring their bonus programs to discourage abuse. Doing so "takes a very deep understanding" of the pitfalls involved, he says, adding that such an understanding still escapes most CEOs and CFOs because of "the pressure they face from the capital markets and analysts."

For a spectacular example of what Jensen is talking about, consider the most-recent troubles at Nortel Networks, a Canadian telecom-equipment maker that in January reported its first full-year profit in six years. A little more than three months later, the company disclosed that its earnings for 2003 were in fact half as much as the $732 million it reported. Three top executives were fired as a result: Frank Dunn, who was CFO until he became CEO in 2001; CFO Douglas Beatty; and controller Michael Gollogly.

Sure enough, Nortel had instituted a questionable incentive program for top executives in 2003. While executives would receive bonuses if they oversaw a "return to profitability, they had great freedom to manipulate the results that qualified. "For the purposes of this program," says the company's proxy filing for 2003, "profitability is defined as positive pro forma earnings from continuing operations (which excludes acquisition-related costs and certain other items of a nonoperational nature)." That means the bonuses were to be paid for results that did not conform to U.S. generally accepted accounting principles.

Nor are problems with bonus targets limited to companies whose accounting practices have been called into question. Last February, for instance, Juniper Networks announced a $4 billion acquisition of NetSereen Technologies that critics claimed was driven by the company's short-term incentive plan for top executives. The plan specified that part of the incentive compensation for these executives in 2004 would be tied to their success in "expansion of the business into new growth areas," according to the company's proxy. And, of course, the easiest way to do that is through an acquisition--even if it turns out to be a bad fit, as critics predict NetScreen will be.

NOT WHAT, BUT HOW

Some experts on corporate pay contend that a company's choice of performance targets is less of an issue than how the targets are established. The fundamental problem, says Jensen, is that most companies base their bonus targets on internal budgets.

In an article entitled "Corporate Budgeting Is Broken--Let's Fix It, in the November 2001 issue of the Harvard Business Review, Jensen insisted that the standard practice of tying bonuses to the budgeting process "encourages managers to lie and cheat, low-bailing targets and inflating results. It penalizes them for telling the truth." He added that such an approach "turns business decisions into elaborate exercises in gaming.... And it distorts incentives, motivating people to act in ways that run counter to the best interests of their companies."

Jensen went so far as to suggest that incentive compensation should be divorced entirely from the budget-setting process. There's some evidence that companies were embracing Jensen's criticism even before it was offered. A recent survey of 237 companies by consulting firm Towers Perrin found that the percentage of companies that tied bonus compensation to budgets fell from 69 percent in 1996 to 60 percent in 2001, the latest year for which such data was available (see "Beating the Budget," facing page).