Bonus points: Setting targets for CFO compensation in times of crisis

The recession has caused all sorts of difficulties for CFOs: falling earnings, tumbling stock prices and, occasionally, knotty negotiations with lenders. For most of them, it has also brought tougher targets for earning their bonuses. Many companies, as part of their CFO bonus plans, adopted earnings targets of zero or just above zero during the recession, according to a study by Michal Matejka, an accounting professor at the W. P. Carey School of Business. Thus a CFO would have received no bonus if his firm reported a loss. An earnings target of zero sounds easy enough. But in a recession it can be difficult to achieve even that. So what is the best way for companies to provide incentives to their financial officers?

The recession has caused all sorts of difficulties for CFOs: falling earnings, tumbling stock prices and, occasionally, knotty negotiations with lenders. For most of them, it has also brought tougher targets for earning their bonuses.

Many companies, as part of their CFO bonus plans, also adopted earnings targets of zero or a number just above zero during the recession, according to a study by Michal Matejka, an accounting professor at the W. P. Carey School of Business. Thus a CFO would have received no bonus if his firm reported a loss.

What if less is actually more?

An earnings target of zero sounds easy enough — generous even. Who wouldn't want to get paid a bonus for producing no earnings? But in a time when many companies were losing money because of a faltering economy, the practical effect of the change was to make it harder for executives to earn their bonuses, Matejka says. Put differently, the change effectively punished some CFOs for events beyond their control.

Why would a firm want to do that? "I think the main explanation is that companies want to prevent paying bonuses for losses," he says. "The irony is that a small loss in a big recession is great performance. But it's hard politically to come out and say that. Even private companies have to justify executive compensation to their boards."

The move in 2008 to tougher earnings targets in bonus plans was the most striking finding in Matejka's report, published in cooperation with the American Institute of Certified Public Accountants (AICPA). The study — the second one that Matejka has done with the AICPA — touched on many aspects of the construction of CFO bonus plans.

Matejka surveyed about 1,500 executives, ranging from CEOs to controllers, asking a variety of questions about how their plans worked. His results provide a benchmark for corporate pay practices, especially those in private companies. More private-company executives responded to the survey than public-company ones did.

Matejka found that private-company CFOs took home a median salary of $130,000 and a median bonus of $10,000 in 2008. Public-company CFOs made more, with a median salary of $200,000 and a median bonus of $35,000. "On average, corporate CFOs in private companies earned 50 percent of their 2008 bonus for meeting financial performance targets, 9 percent for meeting objective nonfinancial targets, while the rest was awarded subjectively, without preset targets," he writes.

By the numbers

The importance of financial targets increased compared with 2006, the last year about which Matejka surveyed AICPA members. "Average 2006 bonus weights on financial targets in larger companies ranged 45-58 percent depending on size, while 2008 bonus weights ranged from 57-67 percent," he writes.

On its face, a bigger financial component in a CFO bonus formula makes sense. After all, hitting financial targets during a recession is more important than ever. However, companies that rely too heavily on financial measures in CFO evaluation risk encouraging scrambling today at the expense of planning for tomorrow.

"Financial measures can be very short term and even backward looking," Matejka points out. Making them the sole or even main standard for evaluating a CFO can force the executive "to focus on surviving and just tending to fires." Another concern is that the CFO, even more than a chief executive, controls financial tools like reserve accounts and depreciation schedules that can make the difference between a company just making or just missing its earnings.

If a CFO wants to goose up earnings, he may, say, pull money out of a reserve account or relax a depreciation schedule. And that's exactly the reason that Matejka cautions against companies putting too much weight on financial measures when setting CFO pay.

"If somebody should be evaluated subjectively to some extent, it should be the CFO, because you want to minimize the incentive for the CFO to push the numbers too far in the interest of his compensation," he says. "You can't just evaluate them solely on the numbers."

Different kinds of yardsticks

Among the nonfinancial measures that companies might include in their bonus formulas are metrics related to strategy implementation such as market share and various business development milestones, he says. A few of the companies that Matejka surveyed didn't increase the weight of financial measures in their CFO bonus formulas. Executives from these firms reported that worries about employee retention prevented them from doing so.

In theory, a tougher bonus formula might prompt a CFO to look elsewhere for work. In such a situation, the executive might decide that the new standard is unfair or impossible to meet. A bank CFO, for example, might have felt this way at the height of the financial crisis. Sure, several of the country's biggest banks made imprudent investments in mortgage securities and mortgage derivatives.

But plenty of smaller banks managed their businesses more sensibly and still ended up with losses on account of the nationwide collapse in real-estate prices. In a situation like that, with much of an industry ailing, an executive might justifiably object to seeing his bonus rely even more heavily on financial measures.

Still, Matejka says that strict financial standards — even one as tough as a provision for no bonus in the event of a loss — can benefit firms. "If everybody understands that you don't pay bonuses for losses, that creates strong incentives over time to prevent ending up in a loss-making situations," he explains. In contrast, if a company pays a bonus even when it loses money, "then you've insured the manager against the consequences of ending up there, and companies don't like insuring managers in that way."

Controlling the whipsaw

For years, critics have complained of excesses in executive pay. Too often, they argued, corporate chiefs got paid handsomely even when firm performance was helped along mightily by a soaring stock market or a booming economy. The situation that Matejka observed in 2008 was the opposite: some CFOs got punished, via the adoption of stricter bonus standards, on account of performance that stemmed, at least partly, from the shimmies and shakes of chance.

"It's probably no surprise to anybody that sometimes managers earn bonuses for sheer luck," he says. But the downside of that compensation arrangement often gets overlooked: "You may be getting more than you ought in good times, but you also may get less than you should in bad times."

A way to stem this whipsaw effect — too much reward in good times, too little in bad — is the adoption of "multi-period earnings targets" in compensation plans, Matejka says. Most companies have annual targets in their bonus plans, but longer-term ones might make more sense. "When you have volatile results, perhaps the way to go would be to make part of the bonus dependent on three years' worth of performance," he says.

He calls the arrangement "a bonus bank." Each year, a company could give an annual bonus, but it would deposit part of the bonus in the bank. The money in the bank would only be paid out if the executive met his longer-term target. Few firms have these sorts of plans now, especially among smaller companies, but according to Matejka: "It's an interesting way to go if you have the sophistication to manage a plan like that."