Cockpit
Statements
Bonus Bank
Due to the inherent volatility of financial markets and financial performance, the potential danger of managing for only short-term profits, and the practice of sandbagging year-end performance, bonuses are often withheld, retained, deferred or escrowed in a bonus bank, even after retirement. In each case, future negative performance can be credited against past and current "banked" bonus payments. The reverse can also occur.
There are two primary methods of instituting a bonus bank, each in the service of general value-based management attempts to align the financial interests of management with those of shareholders:
- Version A: bonus declarations below a certain threshold (e.g. a zero or minimum bonus), and part of bonus declarations above a certain threshold (e.g. target bonus level or a high bonus) are carried over to the next period
- Version B: the declared bonus is paid out over several periods (e.g. one third every year)
Innovations like the bonus bank generally do a good job of contending with one of the three problems of absolute bonus targets: the dangers of short-sighted management. But they still leave bonus systems open to inherent financial volatility and sandbagging, albeit perhaps only every three years instead of every year.
Only indexed operating performance, addressed in detail in the next and final knowledge section, actually separates the performance of operating managers from external and macro-economic factors, or the performance of the industry or economy as a whole. For this reason only indexed operating performance bonus targets truly motivate executives in alignment with shareholder interests, avoiding both sandbagging, and the the twin the dangers of overpaying undeserving managers in rising economies and losing the best of them through underpayment in falling economies.
Recommended Readings: EVA by Stephen F. O'Byrne, The Value Cockpit by Hermann J. Stern