About one year ago, the German business press reported that a large German company, while struggling with corporate scandals and layoffs, paid 60.000 EUR for a new heating system of the koi carp pond in their CEO’s home (a company villa for which he paid a very low rent). Why do we perceive such a pay arrangement as disturbing?

It is not – or at least not only – because of the amount of money, which is rather low compared to the 1,5 million EUR that CEOs in large European companies earn on average. What disturbs us more is the signal the firm is sending by paying for such a luxury perk while its employees have to fear unemployment. This blog post details the signaling effects of managerial compensation and explains how and why firms can actively use it in a beneficial way.

Researchers and practitioners have invested money and effort in the design of managerial compensation arrangements in order to improve the interest alignment of managers and shareholders and to successfully attract and bind managers to the firm. Beyond this incentive effect and selection effect of compensation, compensation arrangements can do more – they can signal firms’ and shareholders’ values. I propose three compensation design parameters to consider:

1. Choose the appropriate payouts and goals to signal your values

Usually a manager’s compensation arrangement is structured in the following way: The manager will receive a certain payout – partly as fixed pay and partly as a variable bonus, meaning that the payout is connected to one or more goals that the manager has to achieve. The firm (more specifically the board and the shareholders) decides about the payouts and the goals. Possible payouts are cash, stocks, and so called perks – privileges such as access to a company jet or the company villa with the heated koi carp pond from the example above. These perks are increasingly interpreted as signals of excessive splendor and bad governance. The goals are usually tied to financial measures such as growth in sales or increase in productivity. Shareholders including such growth measures in compensation contracts signal managers their interest in growth strategies. Likewise, the managers’ compensation can be tied to social responsibility and sustainability goals (e.g., employee satisfaction, CO2 emissions, or corporate water consumption). For example, in the 2000s, about 10 percent of the compensation of Walt Disney’s CEO, Bob Iger, was dependent on implementing a social responsibility agenda and increasing the commitment to employee diversity. Linking the compensation to such social goals indicates the firms’ and shareholders’ appraisal of social concerns.

2.  Balance how explicitly you communicate your values

Explicitness in compensation arrangements is a double-edged sword. In this context, explicitness is the degree to which CEOs have ex-ante knowledge about the exact performance conditions of their compensation. Of course, explicitness helps firms and their shareholders precisely convey their values, especially if they are tied to specific measures or even specific target values. Managers can use explicit measures as a guiding system, as they perceive these explicit measures as goals that they have to achieve to receive the bonus. However, firms and their shareholders have to consider the drawbacks of explicit goals. The more explicit they set the goals for their CEOs, the more they pre-define and detail their firms’ overall strategy. As CEOs are typically more experienced in evaluating and choosing strategic alternatives, defining the firms strategy should, however, be a CEO task. In that way, over-explicit goals in CEO compensation arrangements finally reduces firm performance, as my coauthors’ and my latest empirical working paper shows.

3. Consider the time horizon in your value signals

The payment of bonuses can be connected to a vesting period. That means, goal fulfillment is measured over a certain time period, e.g., resulting in arrangements such as “the bonus is paid when employee satisfaction increases by 20% in 4 years”. Such vesting periods signal the shareholders’ long-term orientation. For instance, the Norwegian Government Pension Fund recommends to the firms of which they hold shares that “a substantial proportion of total annual remuneration should be provided as shares that are locked in for at least five and preferably ten years, regardless of resignation or retirement”. A longer time horizon is supposed to encourage management decisions with a long-term focus. In a research project on compensation time-horizons, my coauthors and I found empirical evidence that longer vesting periods significantly change managerial behavior and lead to higher corporate social performance (McGuire, J., Oehmichen, J., Wolff, M. et al. J Bus Ethics (2017). https://doi.org/10.1007/s10551-017-3601-8).

In summary, I recommend firms to consider the choice of payouts and goals, the explicitness of these measures, and the time horizon that they link to these measures when designing compensation arrangements. The values that these compensation arrangements signal can have a great internal and external impact. Internally, compensation arrangements serve as a guiding system and thus influence managers’ behavior. Externally, compensation arrangements shape the public opinion about the firm and the firm’s values. As compensation arrangements of managers of listed firms are publicly available, they are a favored topic of the business press. Therefore, the compensation arrangement is a nice instrument to communicate the firms’ values to their stakeholders, including society, major suppliers, customers, and employees. The German firm mentioned in the beginning has learnt how signals of rather disturbing firm values can backfire and cause bad publicity.

Want to know more? Don’t hesitate to contact the author of this post: Jana Oehmichen / j.d.r.oehmichen@rug.nl