ERIM Research Clinic: Incentives and Time Orientation


Speaker


Abstract

The current economic and financial crisis has enhanced the attention in practice and academia in the effects that pay-for-performance systems may have on the risk inclination of decentralized managers in (financial) firms. Practice has developed several remuneration codes of conduct for designing pay-for-performance systems such that the behavior of financial managers under such systems is more aligned with the rational analysis of the relationship between risk and return. One prominent recommendation in these codes is the implementation of pay-for-performance mechanisms that reward managers for the long-term consequences of their decisions. An example of such a system is the so called ‘bonus bank’, which is a virtual bank to which bonuses are debited when they are earned and consolidated, and from which payments are made over time. Bonus banks work by smoothing out performance over time, thus correcting immediate profits with (potential) later losses. Although there are various techniques to design a bonus bank system, the smoothing effect it has of bonus pay-outs over time is essential. This smoothing effect is argued to reduce managers dysfunctional incentives to engage in financial transactions with good short-term prospects, at the cost of bad (long-term) outcomes. However bonus banks may not only have this positive effect, as the smoothing out of bonus pay-outs will have several distinct effects, that may enhance or reduce the positive effect that the codes expect of it. This research clinic discusses some of the research questions related to bonus-bank type incentive systems.

Reading:
Laverty, K.J. (2004). Managerial myopia or systemic short-termism?: The importance of managerial systems in valuing the long term. Management Decision, Vol. 42, No. 8, 949-962.

DOI: 10.1108/00251740410555443

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Contact information:
Miho Iizuka
Email