With the financial crisis in mind, Louis Velthuis is advocating changes to incentive schemes for business executives that would avoid future mismotivation
31.03.2010
The current financial and economic crisis is at least partly attributable to inappropriate payment and incentive structures at the executive level. These need to be urgently reviewed to prevent further poor quality management decision-making. According to Professor Dr. Louis Velthuis, Professor of Management Accounting at the Johannes Gutenberg University Mainz, current incentive systems tempt management executives, particularly those in the banking sector, to adopt high-risk strategies because this means that they can earn more. Velthuis explains, "I consider it completely appropriate for salaries to include variable components, the value of which is determined by company performance. However, incentive schemes must be designed so that they do not encourage investment in high-risk projects but in projects that add value at an acceptable risk level." In collaboration with Professor Dr. Thomas Pfeiffer of the University of Vienna, Professor Velthuis has developed a set of guidelines for management payment structures that provide for sensible incentives while maintaining responsible corporate governance. Central to these proposals is the reduction of return-on-investment objectives from the current level of 10% to a more reasonable 4-5% of equity capital and the introduction of loss-sharing schemes.
The origin of the financial and economic crisis was the subprime mortgage market in the US, which involved lending to borrowers with poor credit ratings. And it was because these mortgage debts had been repackaged as tradeable securities that the crisis was able to infect the whole of the world economy. Investment in these obscure high-risk transactions seemed at first to offer a chance of reaping massive yields. However, investment bankers worldwide made the mistake of simply going too far. Velthuis clarifies from the economic standpoint the extent to which established management payment structures contributed to the disaster.
"The wrong kind of incentive schemes have been in use for many years," Velthuis claims, going on to propose that the proportion of salary paid in the form of variable bonuses should be reduced. In the case of the 30 largest quoted German companies, executives receive 30% of their income as a fixed salary and 70% in the form of bonuses. This imbalance between fixed salary and variable incentives is even more marked in the USA. One of the main difficulties in this area is the fact that management teams devise their own incentive schemes and there is no effective way of monitoring them. Velthuis believes the government should intervene where necessary. "Managers do not need incentive schemes that encourage them to boost their own income. What they need are systems that help them make the right decisions on behalf of their companies."
Velthuis, an authority on business administration based in Mainz, sees three main causes of skewed executive incentivization. Overinvestment in high-risk projects is a direct corollary of the fact that loss-sharing concepts do not form part of executive payment schemes. Moreover, executive pay has for years been based on targets that assume cost of capital rates around the 10% mark - far too high, according to Velthuis, as this represents the return that investors and shareholders would like to see (hurdle rate). "In some cases, targets of 20% and 25% are even being set, making it even more probable that any projects initiated will be value-destroying rather than value-enhancing." Operating adjustments can also be employed in order to camouflage failing business sectors - another factor that goes some way to explaining the willingness of managers in the past to adopt extreme high-risk strategies.
Velthuis specifically proposes lowering the hurdle rate to some 4-5%: "Cost of capital should not contain a risk premium element; this means, in effect, that the value of equity capital needs to be marked down." The use of operating adjustments to tweak the figures used to calculate executive rewards (in some cases, results were modified by up to 50%) should be prohibited. Velthuis is also essentially in favor of making management accountable, to the extent that their income would also suffer if their company puts in a negative performance. At the same time, however, the basis used to determine executive level pay needs to be incentive-compatible - in line with proposals - if management accountability is introduced. Management executives would otherwise avoid risk and there would be the definite possibility of underinvestment.