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The vexed question of bonuses – is there a better way?

As shareholders are asked to get more involved with executive pay monitoring, the problem for many investors is how to judge what is reasonable – traditional bonus plans have resulted in plans which are not aligned with performance. Basing bonuses on stock prices exposes them to external factors, including irrational behaviour that can also influence stock prices. Traditional approaches to managing executive pay – bonus caps, shareholder votes nor regulation have, so far, fallen short on aligning shareholder and management interests. So, is there a better way?

According to Dr Hermann Stern and his team at Zurich-based research consultancy, Obermatt there is. Their approach has been to create a bonus index which calculates a “deserved bonus” based on indexed operating performance for public companies and their significant divisions.

Non-indexed bonus plans typically pay excessively high bonuses in up-cycles and bonuses that are too low in downturns. Indexed bonuses have the advantage that they pay appropriate bonuses that are neither too high nor too low. By assessing performance relative to peers, the index measures true operating performance only, not the economy’s performance (external factors such as business cycles, resource price changes, customer demand or market sentiment at the stock exchanges etc.)

Based on the management performance of FTSE 100 companies relative to their global peers, 30% of UK listed companies have underperformed their international competitors. This means that, from a shareholder point of view, performance bonuses may not be justified for a significant minority of top UK companies for 2009. “Our research indicates that FTSE 100 companies are far better than companies listed in Switzerland and Germany where we have conducted the same type of research”, says Obermatt CEO Hermann Stern. “70% of the SMI/SPI companies listed in Switzerland and of the DAX 100 companies listed in Germany underperformed their global peers”.

Because the bonus index is objectively and transparently defined by an independent third party, Manifest will be incorporating the Obermatt Bonus Index in its comparative remuneration analysis for UK and European Securities for the 2010 proxy season. “We’ve been very impressed with Dr Stern’s work” said Manifest CEO, Sarah Wilson, “Obermatt’s quantitative approach is both transparent and objective and puts shareholders and companies on a level playing field. Clearly companies need to attract and retain the best possible talent to generate shareholder returns. But by the same token, shareholders do not want to overpay or pay at the wrong point in the cycle.”

The Manifest and Obermatt teams are currently working on integrating data sets to produce the first reports for December 31st year-end companies at the end of Q1 2010.

Links

Obermatt Index Methodology >>

Financial News Coverage >>

Accounting’s Contribution to Executive Pay >>

What do you think?