Rethinking remuneration

Offering bonuses may not be an effective way to boost productivity. A 2010 University of Guelph study revealed that offering employee bonuses instead of other incentives has a high probability of encouraging workers to lie about their productivity.

The researchers wanted to test an argument made by Dr. Michael Jensen, an American economist, that paying bonuses for reaching a goal often tempts employees to inflate their performance. Jensen’s position on this matter is in sharp contrast with his best-known work, a co-authored paper in 1976 with William H. Meckling called “Theory of the firm: Managerial behaviour, agency costs and ownership structure,” in the Journal of Financial Economics. The Jensen-Meckling study laid the foundation for stock options as executive compensation tools.

Dr. Francis Tapon, economics professor at the University of Guelph and one of the researchers, notes:

“We are pursuing this line of research with a new paper where we refine our measure of attitude towards risk by keeping track of our subjects’ levels of testosterone and cortisol. We think that this is the beginning of the junction of biology and behavioural finance.”

As shareholders look more closely at key executives’ compensation arrangements, they are questioning the logic of executives receiving large bonuses or generous stock options. In many instances, these incentives do not always increase the long-term share value, and are not aligned with shareholders’ best interests.

But from an executive’s perspective, the shift away from bonuses to longer-term remuneration strategies, such as stock options, often has unintended consequences. Stock options were supposed to align long-term interests of employer and employee. However, they have not worked in many companies. Sometimes on the option date, the share price is unrealistic relative to future earnings. If the employee exercises and sells, there is no incentive moving forward.

If the stock option plan is supposed to supplement retirement income, employees are vulnerable to stock price drops. Companies like RIM and Manulife have seen their share price drop dramatically in as little as a six-month period. An employee at retirement may find options worthless. If option dates are long and share price does not follow an upward curve, employees do not see the value in options granted. If option dates are short and share price fluctuates with a wide spread, the options could be underwater at option date.

Pension/benefits consultants and financial advisors use this research to go beyond a standard group pension and benefits plan for their business owner clients. Working with compensation professionals, they have additional tools to ensure both employees’ loyalty and actions are aligned with the long-term interests of their company.

A compromise solution is a Supplemental Executive/Employee Retirement Plan (SERP). A SERP provides base retirement compensation (“living money”) with the combination of Registered Pension Plan (RPP) benefits. The SERP can be secured and funded with a Retirement Compensation Arrangement (RCA) provision under 248(1) of the Income Tax Act in years that profit guidelines have been met. With cash bonuses, the executives take their money and run, but RCA contributions are held to retirement, providing the executive stays with the company. RCA rules allow for delayed vesting, which enhances loyalty.

Since the CRA limits the amount that can go into a funded SERP, the RPP and SERP might not provide the desired retirement income. Coupling the SERP with a stock option plan can achieve that desired post-retirement income. If the stock is underwater at time of retirement, the SERP provides a guaranteed income and there is time to wait for recovery.

A health and welfare trust can also address other healthcare benefits not covered under the group benefits plan. Given the increased post-retirement travel and longer life-expectancy rates, these benefits are becoming increasingly attractive. Finally, the employer can add flexible hours, telecommuting and onsite daycare. These benefits create a real incentive for employees to be productive at their jobs.

Pierre Ghorbanian is the managing partner of Retirement Compensation Funding Inc.