Sustainability in bonus plans

Sustainability is required by law since August 2009 in Germany

The 2009 German Stock Corporation Act requires sustainable bonus plans. In publicly listed companies, the remuneration structure must be oriented towards sustainable business development. Variable remuneration components must, therefore, have a multi-year assessment basis (in section 87 of the Management Board Remuneration Act).

Companies also want long-term bonus plans

Even companies that are not subject to the Executive Board Remuneration Act, want more long-term and sustainable designed compensation plans. So a long-term perspective in bonus plans in Switzerland is currently the most important requirement for boards of directors and compensation committees. However, it is still largely unclear how sustainability can be realized in bonus plans.

Can share plans promote sustainability?

Siemens attempts to achieve sustainability by ensuring a level of stock ownership among executives (Siemens AG, 2009 remuneration report). The level of ownership for the President and CEO is three times the annual salary. For other Board members, it is double the annual salary. This ensures that deterioration in share price impacts directors. Non-sustainable performance will be penalized with devalued share packages. Sustainable performance is rewarded by a higher value of the share package.

Whether this equity participation promotes sustainable management is questionable. In the troubled financial sector, it was common for executives to have share and option-holdings held that were well beyond twice and three times the annual salary. These high investment levels have not prevented risks to sustainability in the financial sector.

In assessing the sustainability of public programs, there is another aspect to consider: how adequately does the share price really reflect a company’s sustainable development. A stock’s price is affected by movements in the capital markets. When an industry is favored, the average P/E ratios of companies in the industry rise. During the Internet boom, the IT-companies benefited from this phenomenon, today it is the alternative energy companies. The opposite is true for sectors that have fallen out of favor with investors. The average P/E of life science companies, once the darlings of the stock market have fallen, for example, in recent years incessantly. In both cases, the stock price is above the true, sustainable performance that belies a company. The share price can thus give the wrong market signals and to the management the wrong incentives.

Nevertheless, stock holdings have long been a part of standard compensation packages of many German directors. Even Siemens has introduced the stock program even before the new law. If share packages are sufficient to satisfy the legal requirement of sustainability, then it is also sufficient for companies to refer to their current stock plans. But this is certainly not the point of the legislation.

Polls are hardly sustainable

Volkswagen relies on surveys on sustainability and makes bonuses dependent on customer and employee satisfaction (The World, 12/17/09). However, surveys have several conceptual problems:

  1. First, objectivity is notoriously difficult to ensure in polls. Often respondents are influenced by the way questions are posed or framed.
  2. Second, customers can be satisfied even while a company is starting to go under. Photo enthusiasts were very satisfied with Kodak films until digital cameras came on the market. No survey could have recognized the negative consequences for Kodak at the time.
  3. Third, the employees can as a whole be satisfied, because a company compensates them generously, even though the money may be becoming increasingly scarce and insufficient for necessary investments.

To use surveys as a criterion for proof of sustainability, therefore, is highly doubtful.

Past profits are a poor benchmark

The German company Fraport and the energy giant E.ON measure sustainability on recent profits. For both companies, profit before tax and amortization (EBITDA, EBIT at E.ON rsp.) and return on investment (profit divided by invested capital) are measured and tested after a few years to see if the values could be sustained. If this is not the case, the bonus must be partially repaid (Company Press, 14.12.2009).

What seems reasonable at first glance, turns out in practice to be problematic. External influences, such as the business cycle, can have such a strong influence on a company’s performance that performance is hardly sustainable even without poor performance. If such evaluations of profits were introduced in DAX companies before 2008, then the majority of DAX companies would not be considered sustainable in 2009. But that was the main reason behind the poor results in 2009, not poor performance among management or lack of sustainability. At least outside of the financial sector, it was the involuntary economic downturn.

If board members are punished categorically in their bonus plans for the overall economy, then there is no way to separate the wheat from the chaff. Especially in times of crisis, one can see who really is a master in his or her field. If bonus plans don’t recognize above-average performance in times of crisis, then they are only of limited use in driving motivation.

In the long run, only the indexed performance measurement is sustainable

Just when bonus payments should be re-examined after several years, as is required by the new Corporation Act, then traditional performance measurement has failed. In practice, it’s not possible to define the level of performance that will be sustainable, especially several years in advance. As mentioned, this performance threshold is higher during an upswing and deeper during a downturn. In practice, the requirement of multi-annual assessment means that it has no effect in the upswing but that it punishes even good directors in a downturn. That can not be the meaning and purpose of the new legislation.

The only long-term valid criterion for evaluating sustainability is the market. In the long run, firms are more viable and therefore sustainable, the more competitors they beat in the market. If a bonus plan should reward sustainable management, then it must be defined relative to the market and run over a multi-year period. We call this indexed performance measurement. If the performance is defined only relative to internal goals, then bonuses may well be paid if the company is less and less competitive. This is in an indexed Bonus Plan, which is defined relative to the competition, not the case.

The sustainability of the Obermatt Bonus Index

Based on indexed performance measurement, the Obermatt Bonus Index couples the amount of remuneration paid to the number of competitors that a company outperformed. The more competitors are beaten - and not just in a given year, but over several years - the more sustainably a company has performed and the higher is the recommended bonus (methodology).

The Obematt Bonus Index is like an Olympics for management. It is also a publicly available ranking of sustainability. The VDI Nachrichten also calls the Bonus Index the Olympic method (link to article).