ANALYSIS: Huge CEO bonuses don’t necessarily lead to bigger company profits

Australian CEOs at the b20 trade taskforce. Andrew Mackenzie, CEO BHP Billiton, speaking. Getty Images/Bradley Kanaris/Getty Images

Capping and regulating CEO payments, which run to as much as $10 million or more a year in Australia, could help make companies more profitable in the long term, according to analysis.

Traditional incentives, including short and long term schemes, shares and options to buy shares, don’t necessarily push a chief executive toward getting the best out of a business.

Reliance on performance bonuses can lead executives to pursue poor strategies, including being too focused on short term gains, according to research by Dr Peter Cebon at the University of Melbourne and Dr Benjamin Hermalin from the University of California, Berkeley.

In Australia, average pay for ASX top 100 CEOs is $4.84 million a year, or about about 63 times average earnings

Modelling by Cebon and Hermalin shows CEOs and boards will have an incentive to work together more closely if bonuses are restricted.

And this closer relationship can enable the CEO to pursue strategies more profitable in the long run.

“We’ve seen CEO salaries skyrocket in the last 30 years,” said Dr Cebon. “That is based on an assumption that these high incentives will create the most profitable environment for a company’s growth.

“In this research we’ve challenged that assumption and have found that relying on performance pay for CEOs doesn’t necessarily lead to higher profits. Strategies driven by bonus payments can get in the way of long-term growth.”

The academics argue that many organisations could perform more effectively and be increasingly profitable if CEO payments were regulated.

“Bonus payments based on results can create an inappropriately simple relationship between executives and boards,” said Dr Cebon.

“It encourages boards to hide behind measurable goals, rather than developing a deep understanding of what executives are doing, and why.

“This discourages CEOs from pursuing strategies where the results are harder to measure, such as building organisational capabilities, or pursuing high value, high risk innovations. Those strategies are often much more valuable in the long-run.”

The research is published in the journal Review of Financial Studies. The research was supported, in part, by the Australian Research Council.