©2009 Hay Group.
All rights reserved
Viewpoint
Unfortunately, bonus banking is far from a
complete answer to the issues surrounding
incentives in financial services. While they
can have many advantages, bonus banking
structures are known to be difficult to implement,
unpopular with employees, and ineffective at
driving performance. They were pioneered by
companies using economic profit (profit less
risk-adjusted cost of capital) as the primary
measure of corporate performance, and many
have since quietly abandoned them. Why?
In theory, an appealing idea
Bonus banking describes an incentive scheme
where part of the bonus earned is held back in
a bonus account, to be paid out in subsequent
years. It allows for the declaration of a negative
bonus (or ‘malus’) where performance drops,
or where the initial assessment of performance
turns out to be wrong. It is closely related to
a bonus clawback, but has the added benefit
of providing the company with some security
for repayment.
Bonus banking has an obvious appeal to
compensation committees searching for an
acceptable approach to incentivising their
people. It reduces the much-criticised reliance
on annual performance measures, creating
stronger alignment of incentives with medium
term or long term shareholder value creation.
Depending on the measures used, it can lessen
the opportunities for ‘gaming’ the scheme by
focusing exclusively on meeting bonus targets
at the expense of overall corporate performance.
And it reassures stakeholders – shareholders,
regulators and the wider community – that the
company has some comeback against those
who are seen to have caused current problems
by their actions in previous years.
It’s a cardinal rule
of reward that the
more remote the
payout becomes,
the weaker the
incentive.
Is bonus banking the answer
to banking bonuses?
Bonus banking is touted by some as the ‘holy grail’ of incentive
structures, allowing companies to balance short term and long term
value creation, satisfy their stakeholders’ demands for accountability
and succeed in attracting, motivating and retaining the talent they
need. Regulators are looking favourably on the idea, and some banks
have already announced their intention to adopt these structures.
©2009 Hay Group. All rights reserved
Viewpoint
But in practice, it’s harder
than it looks
The primary issue with bonus banking, in
our experience, is the greater difficulty of
managing and communicating the scheme
while maintaining its effectiveness as a
performance incentive. It’s a cardinal rule
of reward that the more remote the payout
becomes, the weaker the incentive. Employees
– quite correctly – feel their bonus payouts are
less secure, and are often unsure about the
conditions for vesting or clawback of future
payments. Complex multi-year performance
measures can dilute the focus on maximising
performance in the current year, without
setting clear long term performance goals.
What’s more, bonus banking schemes often have
an unintentionally punitive tone. Bonuses can
usually only be adjusted down, which can lead
employees to feel that failure will be punished,
but sustained success not rewarded. This has
led to them being highly unpopular, with the
consequent risks to retention and performance.
Even where the company leadership succeeds
in overcoming these issues, bonus banking is
still far from a complete solution. Depending
on how it is structured, the scheme can lead to
bonuses being paid out in years where overall
corporate performance is down, or to former
employees who have not contributed to this
year’s performance – unlikely to be a popular
result in the current environment. Performance
measures can be difficult to construct, and as
a consequence schemes are often based on
rolling annual targets, which are less effective
in driving a focus on long term performance.
What’s the alternative?
We recommend that our clients avoid the ‘me
too’ approach to incentives, and consider bonus
banking to be one of the many options available
to them. No one vehicle will ever provide a
complete solution, and financial companies
need to be clear about their goals and how
incentives fit within the larger strategic
programme before settling on a solution.
There are other options available which,
depending on the circumstances, may be
more effective than bonus banking. Deferring
a part of the annual bonus into time-restricted
shares ties the final value of the bonus to the
share price – useful for focusing top executive
attention on long term shareholder value,
though less effective for those employees
without a line of sight to the share price.
Basing some incentives on two or three
year timeframes – for example risk-adjusted
returns based on cash returns, rather than
profit estimates, can reduce the danger of
short term focus.
By no means are we saying that bonus banking
should never be adopted. Bonus banking can
work, but only as part of an overall strategy
that focuses the organisation on long term
value creation. It won’t by itself guarantee
the achievement of a responsible reward
programme.
For more information or to discuss any
of the issues raised in this Viewpoint, please contact:
Simon Garrett
|
UK executive reward leader
e
simon_garrett@haygroup.com
|
t
+44 (0)20 7856 7113
We recommend that
our clients avoid the
‘me too’ approach
to incentives, and
consider bonus
banking to be one
of the many options
available to them.