Question

Agency theory suggests that a way to motivate managers to act in the best interests of the owners/shareholders is to link managerial compensation to performance measures such as net income or share prices. However, such linkage imposes some risk on the managers.
Required:
(a) What are the agency risks that are referred to in the above statement?
(b) How can the compensation risk imposed on corporate managers be controlled or reduced?
(c) Inclusion of shares and options in managerial compensation packages are designed to provide managers an incentive to adopt the policies that benefit the firm in the long-term. If this is true, what is the justification for having cash or bonus element in the compensation package?

Answer 1

(a) What are the agency risks that are referred to in the above statement?

- Major problem is that the full impact on the net income of current managers is not usually observable.

- Payoff observability problem is even greater if we recognise that manager effort is a set of activity rather than a single activity.

- Share price is affected by economy wide events such as interest rate changes, which imposes risks beyond those inherent in the firm.

- This management compensation plan may give excess pressure on managers and adversely affect their performance.

- There will be a fear of personal bankruptcy.

(b) How can the compensation risk imposed on corporate managers be controlled or reduced?

- An approach in reducing risk is to add a bogey to the plan. A bogey exempts managers from paying the firm if it should suffer a loss.

- Another approach is to filter manager's incentive pay through a compensation committee.

- Further risks can be reduced by the use of a Relative Performance Evaluation (RPE).

(c) Inclusion of shares and options in managerial compensation packages are designed to provide managers an incentive to adopt the policies that benefit the firm in the long-term. If this is true, what is the justification for having cash or bonus element in the compensation package?

Although inclusion of shares and options in managerial compensation motivates managers, there is a need for a better cash or bonus plan.

Bonuses have been studied to ascertain their effectiveness as an employee incentive to improve performance. Bonuses have served for a number of years as an incentive program to reinforce positive, efficient behaviour among employees. Some researchers shows that employees who recieves an additional bonus that is above their base salary shows more positive performance.

Cash or bonuses mostly helps to motivate employees in short-term, on the other side by giving shares and options to managers may result in improving performance of managers in long run, this will lead to benefit of the firm in long run. Both type of remuneration plans should co-exist for the benefit of the organisation.