CEO Bonus Plans: And How to Fix Them

66 Pages Posted: 30 Sep 2011 Last revised: 20 Nov 2011

See all articles by Kevin J. Murphy

Kevin J. Murphy

University of Southern California - Marshall School of Business; USC Gould School of Law

Michael C. Jensen

Harvard Business School; SSRN; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Harvard University - Accounting & Control Unit

Date Written: November 19, 2011

Abstract

Almost all CEO and executive bonus plans have serious design flaws that limit their benefits dramatically. Such poorly designed executive bonus plans destroy value by providing incentives to manipulate the timing of earnings, mislead the board about organizational capabilities, take on excessive (or insufficient) risk, forgo profitable projects, and ignore the cost of capital. We describe the causes of the problems associated with widely prevalent executive bonus plans, and offer our recommendations for fixing them. We focus on choosing the right performance measure, determining how performance thresholds, targets, or benchmarks are set, and defining the pay-performance relation and how the relation changes over time. Finally we examine the role of banking bonuses in the recent financial crisis. While cultural and performance measurement issues certainly played a role in the recent crisis we find little or no evidence that banking bonuses per se were a major contributing factor.

Keywords: Executive Compensation, CEO Pay, Incentives, Governance, non-Equity Pay, Banking Bonus Plans

JEL Classification: G34, J33, M12, M52

Suggested Citation

Murphy, Kevin J. and Jensen, Michael C., CEO Bonus Plans: And How to Fix Them (November 19, 2011). Harvard Business School NOM Unit Working Paper 12-022, Marshall School of Business Working Paper No. FBE 02-11, Available at SSRN: https://ssrn.com/abstract=1935654 or http://dx.doi.org/10.2139/ssrn.1935654

Kevin J. Murphy

University of Southern California - Marshall School of Business ( email )

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USC Gould School of Law

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Michael C. Jensen (Contact Author)

Harvard Business School ( email )

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