Management incentive schemes are used to implement strategy, retain the best people, and improve financial performance. A well-designed scheme will induce managers to behave as though they were shareholders of the business.

The Enron and WorldCom debacles some years ago, and Wells Fargo in 2016, demonstrated that poorly designed and uncontrolled schemes can promote unethical behaviour. Incentive schemes need transparency and strong corporate governance.

Why incentives schemes can be considered a financial tool?

A study in the United States correlated the bonuses paid to 14,000 managers over a period of 5 years, with their organisation’s financial performance. This study showed that organisations with high bonus payouts performed much better financially than those who did not pay high bonuses.

This attracted the attention of finance people. Where previously the incentive schemes were designed and administered by the Human Resource function, incentives came to be seen as a financial tool to drive better performance, leading to higher ROE and higher share prices.

Types of management incentive schemes

Budget-beating schemes

In the previous century, many firms used simple profit-based schemes based either on a straight percentage of profits, or on beating the budget. These schemes are easily understood, familiar to senior management, and measurable through a firm’s accounting system.

In the 1980s and 1990s many companies used these budget-beating schemes. In recent years, they have become less popular, as budget targets have been invalidated due to factors outside managers’ control including commodity price fluctuations, interest rate changes, and global economic instability. 

Share option schemes

Many managing directors have benefited enormously from share option schemes. These schemes fail when global markets crash. It does not require too much insight to realise that management actions and share prices are often unrelated. 

Appraisal based schemes and subjective awards

Today some firms have chosen to rather focus internally using appraisal-based schemes based on peer assessment. In spite of accusations of nepotism, some very successful private companies still favour subjective awards based on judgement by each person’s superior officer. 

Return based (ROE) and Residual Income based schemes

Return based schemes are popular in many listed companies. Originally, these schemes rewarded a return on assets greater than a target percentage. Today most schemes require a firm to exceed an objective, externally determined cost of capital target. This method incorporates a growth target into the equation. You take real dollars, not percentages, to the bank. 

Twenty-five years ago Coca-Cola CEO Roberto Gouizetta described his company’s business "We raise capital to make concentrate, and sell it at an operating profit. Then we pay the cost of that capital. Shareholders pocket the difference." Source: Fortune Magazine, 1993. 

Two subjective decisions must be made after the residual income number has been finalised:

1. the portion of residual income that should be set aside as the management bonus pool for the year.
2. how to divide the bonus pool among individual managers.

Common-sense rules for management incentive schemes

• Management incentive schemes should be self-financing. The bonus should pay for itself out of the savings arising from the scheme. 
• Bonuses should only be paid if the financial objective in the firm’s strategic plan has been met or exceeded. Profit participation is a privilege, not a right. 
• The scheme should reward exceptional, not average, performance.
• Managers entering into the scheme will be required to share in both profits and losses. Thus, when the incentive targets are not met, the deficit must be made up before managers can be eligible for future bonuses.
• Managers must be able to exert significant influence on their targets through their actions and the reward should be a major and not a minor part of their total package. Participants should be shown how to optimise their rewards from the scheme during the implementation. 
• Incentives should be paid regularly; many companies spread the payment over a number of years to encourage long-term thinking. This practice can pose legal challenges when managers resign.

The article was first published in Unit 4 Prevero Blog