Designing Performance Bonus Schemes
Performance bonuses give away billions of dollars each year based on methodologies where little thought has been applied. Who are the performance bonus experts? What qualifications do they possess to work in this important area, other than prior experience in creating the mayhem we currently have?
When one looks at the performance bonus experts’ skill base, one wonders how they got listened to in the first place. Which bright spark advised the hedge funds to pay a $1 billion bonus to one fund manager who created a paper gain that never turned into cash? These schemes were flawed from the start; super profits were being paid out, no allowance was made for the cost of capital, and the bonus scheme was only high-side focused.
There are a number of foundation stones that need to be laid down and never undermined when building a performance bonus scheme (PBS) that makes sense and will move the organization in the right direction.
Base the PBS on a Relative Measure
You should base the PBS on a relative measure rather than a fixed annual performance contract. Most bonuses fail at this first hurdle. Jeremy Hope and Robin Fraser1 have pointed out the trap of an annual fixed performance contract. If you set a target in the future, you will never know whether it was appropriate, given the particular conditions of that time. You often end up paying incentives to management when in fact you have lost market share. In other words, ...