Executive bonus and firm performance in the UK

Annual bonus is a controversial but under-researched dimension of executive pay. Bonus packages have the chameleon-like ability to suit CEOs, shareholders or both. In other words, they may be consistent with executive power theory and the notion of “fat cats” and/or agency theory. As with many other components of executive pay, the “devil may be in the detail”, and trends in the particular architecture of schemes may prove to be at least as important as aggregate relationships. This paper presents new results on executive bonuses in the UK’s large firms. The agency perspective on the role of executive bonus is supported by the significant, aggregate, positive relation between CEO bonus pay and a firm’s financial performance. Results for the UK during a unique period of slack capital markets produces measures of bonus pay-performance responsiveness that are broadly in line with earlier studies. Transparency in bonus schemes (in the sense of simplicity in targets) is positively associated with firm performance, as agency theorists would predict. This all suggests that CEO bonuses offer a strong and consistent basis for the alignment of principals’ and agents’ interests. However, this apparent support for agency theory should be viewed with caution. While bonus simplicity is associated positively with performance, it would appear that detailed bonus scheme characteristics are generally insensitive to this relationship. Bonus schemes in the UK are becoming more complex in terms of the use of multiple targets. There appears to be a trend towards the abandonment of simple schemes with unpublished targets, in favour of schemes with more targets, and unpublished ones at that. Of course “Individual Performance Evaluation”, where Boards have some discretion over the amount of bonus paid against unpublished or undisclosed targets, may succeed in theory, especially where the nature of the business makes it advisable to keep CEO targets confidential. Nevertheless, the implication of this paper is that, on balance, transparency in the form of simplicity (and associated published targets) is positively associated with firm performance.