Does your job offer a year-end bonus?
If so, what's it for? Maybe you get your bonus no matter what
happens in the year, or perhaps there's a formula or performance
review process that determines your payout.
You may never have thought about it this way, but the way your
salary is structured is almost certainly affecting your behavior.
If your bonus is guaranteed, for example, you're probably not
going out of your way to earn it. On the other hand, if it's
based on some other metric, like sales or performance, you might
find yourself pushing a little harder to make that sure you get
This illustrates a long-standing economic truth: Incentives
And that truth doesn't just impact your life at work -- it
should have a serious influence on your decisions as an
Why it matters
Take your annual bonus (or lack thereof) and now reimagine
yourself as the CEO of a major company. If your bonus makes a
difference in how you carry out your job today, what would happen
if it were scaled up to the corporate executive level?
In other words, if we were talking about $10 million instead
of $10,000, how would your bonus impact your behavior?
If we're honest, probably a lot.
That's why so much time and research effort has been spent on
studying executive compensation at large firms. The decisions
these executives make can not only impact their individual role,
but their company's risk exposure, growth prospects, and
Thus, it makes sense that boards of directors and shareholders
would want to encourage decision-making that's good for the
company -- not just the executive.
This is where "pay for performance" comes in. Executives often
have compensation packages that are tied to how well the company
does financially. So, for example, if earnings go up, the CEO's
pay package might go up, too.
It's a system that tries to ensure the executive has a
personal interest in the good of the company, but it can also
create some weird incentives.
For example, a
analyzing accounting rule changes related to transparency about
derivatives holdings found that strong performance-based pay can
actually be bad for the company by making it worth the
executive's time to take on unnecessary risks.
In this study, those risks took the form of financial
derivatives investments. They're the kinds of investments that
don't benefit the firm or contribute to productive activities,
but they can produce the kinds of returns that would make a CEO
look good -- and thus worthy of a bigger bonus.
And as you can imagine, this isn't exactly what an investor
would want to see.
Risk doesn't always bring rewards
Thankfully, bringing this kind of behavior to light forces
companies to rethink their compensation schemes and executives to
rethink their money-making methods.
But it doesn't change the fact that, sometimes, an executive
can get away with reaping huge benefits from taking unnecessary
risks -- and that those risks can come at the company's expense
rather than their own.
Keep tabs on executive compensation
This means that it is absolutely critical for you to have an
understanding of executive compensation.
We have all heard complaints that CEOs are paid too much, and
that might very well be true. But you really want to know is
your CEO is paid.
Is there a performance bonus? Is that bonus based on
short-term performance or long-term growth? Does it encourage
maximizing quarterly revenues, annual profits, or something
By knowing the answers to these questions you can uncover some
of the incentives a particular CEO or executive team is facing --
whether they might want to favor short-term gains, take excessive
risks, or build slowly for long-term stability.
So don't ignore executive compensation: it's more significant
than you probably ever could have imagined.
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The Reason You Can't Ignore Executive
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