The Reason You Can't Ignore Executive Compensation

By Markets Fool.com

Does your job offer a year-end bonus?

Continue Reading Below

If so, what's it for? Maybe you get your bonus no matter what happens in the year, or perhaps there's a formula or performance review process that determines your payout.

You may never have thought about it this way, but the way your salary is structured is almost certainly affecting your behavior. If your bonus is guaranteed, for example, you're probably not going out of your way to earn it. On the other hand, if it's based on some other metric, like sales or performance, you might find yourself pushing a little harder to make that sure you get it.

This illustrates a long-standing economic truth: Incentives matter.

And that truth doesn't just impact your life at work -- it should have a serious influence on your decisions as an investor.

Why it matters
Take your annual bonus (or lack thereof) and now reimagine yourself as the CEO of a major company. If your bonus makes a difference in how you carry out your job today, what would happen if it were scaled up to the corporate executive level?

Continue Reading Below

In other words, if we were talking about $10 million instead of $10,000, how would your bonus impact your behavior?

If we're honest, probably a lot.

That's why so much time and research effort has been spent on studying executive compensation at large firms. The decisions these executives make can not only impact their individual role, but their company's risk exposure, growth prospects, and reputation.

Thus, it makes sense that boards of directors and shareholders would want to encourage decision-making that's good for the company -- not just the executive.

Performance-based pay
This is where "pay for performance" comes in. Executives often have compensation packages that are tied to how well the company does financially. So, for example, if earnings go up, the CEO's pay package might go up, too.

It's a system that tries to ensure the executive has a personal interest in the good of the company, but it can also create some weird incentives.

For example, a study analyzing accounting rule changes related to transparency about derivatives holdings found that strong performance-based pay can actually be bad for the company by making it worth the executive's time to take on unnecessary risks.

In this study, those risks took the form of financial derivatives investments. They're the kinds of investments that don't benefit the firm or contribute to productive activities, but they can produce the kinds of returns that would make a CEO look good -- and thus worthy of a bigger bonus.

And as you can imagine, this isn't exactly what an investor would want to see.

Risk doesn't always bring rewards
Thankfully, bringing this kind of behavior to light forces companies to rethink their compensation schemes and executives to rethink their money-making methods.

But it doesn't change the fact that, sometimes, an executive can get away with reaping huge benefits from taking unnecessary risks -- and that those risks can come at the company's expense rather than their own.

Keep tabs on executive compensation
This means that it is absolutely critical for you to have an understanding of executive compensation.

We have all heard complaints that CEOs are paid too much, and that might very well be true. But you really want to know is how your CEO is paid.

Is there a performance bonus? Is that bonus based on short-term performance or long-term growth? Does it encourage maximizing quarterly revenues, annual profits, or something else?

By knowing the answers to these questions you can uncover some of the incentives a particular CEO or executive team is facing -- whether they might want to favor short-term gains, take excessive risks, or build slowly for long-term stability.

So don't ignore executive compensation: it's more significant than you probably ever could have imagined.

The article The Reason You Can't Ignore Executive Compensation originally appeared on Fool.com.

Anna Wroblewska has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Apple and Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.