Is Bonus Banking the Answer?

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Table of Contents

Abstract
Introduction
Theoretical framework
Issues arising
Alternatives
Conclusion
Works Cited

Abstract

After the recession in the US, the financial services sector was put to task over its role in bringing about the near collapse of the US economy. Most of those who felt that banks and other financial sector stakeholders were to blame for the economic crisis pointed out that most of the employees of these institutions, particularly the top executives, received hefty bonus packages that were unrealistic in terms of the economic situation.

Bonus banking was then touted as a possible route for those financial companies that wanted to stem the huge bonus payouts and make economic sense of the situation. While bonus banking provides some kind of security to the company, there is need to analyze the potential risks of using it as an incentive plan.

Introduction

Bonus banking is an incentive plan where some part of the bonus is put aside or banked in a reserve fund rather than paying out the entire bonus amount to the employee. Usually, these bonus plans come with a withdrawal clause though there are restrictions as to how much the employee can actually withdraw.

The rationale behind this kind of incentive plan is that it provides the financial company with some security whereby if it overstates the bonus or the employee’s performance dips in future, the company can recover its money. However, it is different from a bonus ‘claw back’ where the bonus is directly recovered from the employee’s account since it recovers the issued bonus by declaring what is known as a “malus” or negative bonus, which reduces the amount in the reserve fund.

Becker and Peter suggest that the reason why bonus banking is being touted as the ‘holy grail’ of incentive planning is because it eliminates the three ‘evils’ that had been associated with hefty and unguarded bonus payouts.

These three ‘evils’ are; use of performance measures that have been overstated and out of touch with economic realities such as the lack of consideration of risk-adjusted performance in measuring overall performance, payment of hefty bonuses annually while in reality, the input of the employee usually takes more than a year to gain meaningful economic value and finally, unrealistic payment timelines-most financial companies especially banks pay at least half of the bonus in hard cash while the employee is guaranteed the other half regardless of performance as long as he or she remains employed (11).

Bonus banking offers somewhat satisfactory answers to these three ills associated to bonus payments. First, the bonus banking plan recognizes that payment of full annual bonuses is unrealistic and so stems the practice of paying out such bonuses. Secondly, it makes a provision for future financial problems that may result from poor employee or corporate performance. The payment timeline also offers some form of security to the company in case it overstates its assessment of employee performance.

Theoretical framework

As earlier stated, the financial meltdown in 2008 led to an increasingly critical public on Wall Street companies. This has led to development of new concepts that look to stem the excesses of the financial sector.

To achieve this, Sten Stuart, a US based firm, has been a strong advocate of incentive plans that take into account the real economic value that an employee adds to the organization. In fact, the firm developed the theory of ‘economic value added’ (EVA) which a financial performance tool that is meant to assist companies to calculate their real profit. Firms that have been using the EVA concept have according to Becker & Peter (11), advocated for bonus banking.

The theoretical concept behind bonus banking is very appealing to compensation committees since it seems like a tenable incentive plan that reduces a company’s reliance on annual performance measures that have been strongly criticized.

Additionally, these committees are attracted to the idea that they can align their incentive plans with both medium and long-term shareholder value creation. There is also the added advantage that comes with bonus banking which is a reduction of ‘gaming’ where employees are more focused on earning bonuses than they are committed to the overall growth of the organization.

The standard practice of bonus banking nowadays involves the banking of the full bonus declared. The withdrawal clause usually specifies that the employee can withdraw an amount from 33% to 50% of the bonus in a given year. Throughout the year, the employer monitors the employee’s performance so as to assess his or her economic contribution. This plan allows the employer to gauge the level of motivation and also know which employee adds more value to the firm.

At the same time, the bonus banking scheme ensures that the employees remain motivated since they still have access to their bonus payments as long as they stay committed to meeting organizational goals. In fact, proponents of bonus banking have argued that it works better than the annual full bonus payment plans since the employee feels the need to stay longer in the firm so as to receive higher bonuses.

According to Callum McCarthy, chairman of the Financial Services Authority (FSA) there is a need for the financial sector to come up with new incentive structures that conform to economic realities.

While bonus banking seems to be an alternative to the much criticized annual full bonus payouts, it remains to be seen the steps that banks and other players in the industry will take to stem the tide of criticism against them. Alternatives will need to put in place mechanisms where the company rewards its employees without destabilizing the entire industry.

While most banks and financial services firms that have stayed afloat during the recession seem to have a choice in deciding what steps to take to maintain reasonable incentive plans, companies in the Troubled Asset Relief Program have no such options but to cut their employee’s bonus payouts.

Sabow agues that there is an increase in the trend of basing incentives on performance (2). This has resulted from the hit the financial services sector has taken for its overstretched reward programs. Bonus banking offers such a performance based structure which enables the firm to adjust its costs in a manner that is economically viable.

Issues arising

While bonus banking seems to be a wonderful incentive plan that is sustainable in the long run, several issues arise that threaten to make bonus banking to be only good on paper. Most of these issues have to do with communication, management and implementation of the plan. The main area of focus is the impact on employee motivation and their general perception of the bonus banking incentive plan.

The main challenge that bonus banking faces mainly has to do with communicating and managing the incentive plan while still keeping it effective in bringing about motivation in employees. In firms where the employees had become used to annual payouts, sometimes in cash, introducing bonus banking can easily prove to be a demotivating factor. This is because of the employee’s perception that they are not assured of the payments. Additionally, the employees remain unsure about the security of the amount banked.

Becker and Peter state that in many incentive schemes, the trend is that the more remote the amount paid out, the weaker the scheme. Using this analysis, bonus banking introduces remoteness in payouts and thus appears to be a weaker incentive scheme. The two analysts add that the many complex performance measures that come with bonus banking can have the effect of influencing the employees’ focus on maximizing on the current financial goals at the expense of long term organizational goals (11).

In addition to the problem of payouts and performance measures, bonus banking plans have been said to be overly punitive in nature. This is because when the employee’s performance dips, a negative bonus is applied which has the effect of reducing the balance of the banked bonus.

This makes the employee feel like they are being excessively punished for poor performance. The reason why bonus banking is perceived as excessively punitive is because it eats away at what the employee had already earned. In simple terms, bonus banking plans have the effect of telling the employee that because of his or her poor performance during the current financial year, they do not deserve the bonus they had earned the previous year when they had performed superbly.

The above reasons explain why most financial services firms have been reluctant to adopt bonus banking as a feasible incentive plan. The possible effects it may have on employee performance and retention are enough for most firms to avoid the plan especially where the firms need to retain talent. Becker and Peter state that when markets are bullish and there is a scarcity in talent, an organization using bonus banking is bound to lose out to competition in terms of attracting the most skilled employees (12).

While the above challenges may seem insurmountable, another negative aspect of bonus banking looms which has the effect of making compensation committees and wary boards to say a flat ‘no’ to bonus banking. This aspect relates to the future of bonus payouts when the company enters into troubled financial waters.

There is nothing that can be more frustrating for a company in financial turmoil to be making bonus payments to former employees or employees whose performance has led to the financial problems in the first place. This is why annual payouts have always been popular with both employers and employees. The employer gets to pay when the company’s financial status is sound while the employee gets rewarded for their good work during the year. Deferring payment can end up hurting both the firm and the employee.

Another challenge for bonus banking lies in the construction of performance measures so as to take into account long term goals of the organization. While bonus banking relies on rolling annual targets, this method is not a guarantee for long term success. Many compensation committees looking to stay afloat in a tough economic environment may not find bonus banking a sure way out and may prefer to go for more ‘conventional’ solutions.

In light of these challenges, most banks and firms in the financial services sector have shown reluctance in adopting bonus banking despite its possible benefits. Ippolito states that while most institutions are looking to change their reward programs, punishing of executives and other top earners in the firm will not yield any meaningful solution out of an economic crisis.

Instead he suggests that the financial sector needs to improve its risk assessment methods while also diversifying the industry to avoid volatility and vulnerability in times of financial crises. Firms in the sector should work on building sufficient reserves that might shield them from inevitable losses (8).

Alternatives

Since bonus banking seems to be insufficient in addressing the needs of the financial sector, there is need to look at the other options available that may be more attractive to compensation committees. Becker & Peter suggest that instead of banking the bonus, some part of it should be deferred into restricted stock whose value is equivalent to the bonus. This method has the effect of turning the focus of the employees towards long term creation of shareholder value.

This may be beneficial to the company since it brings about employee commitment towards improving the firm’s share price through better performance (12). Additionally, the ownership of the stock gives the employee a sense of responsibility and focus towards the company’s long term goals. This method is more effective than bonus banking where the company aims at long term value creation.

Another option suggested by Becker & Peter (12) is the basing of incentives on a longer timeframe. A timeframe of two or three years based on a solid financial tool such as risk adjusted returns based on cash returns has the effect of bringing about a long term focus by employees on company goals. Such an assessment based on cash returns rather than profit estimates seems to be a more viable way of improving long term goal commitment.

Martin indicate that the main focus for a company should be to harmonize its overall reform strategy with its reward programs. She states that any reward program that the company introduces should be checked to ensure that it goes along with the company’s main strategy rather than inhibiting it (6).

In the same sense, bonus banking can be a good reward program if it can be harmonized with the company’s long term strategy without threatening the achievement of set goals. The same rationale applies to the so-called alternative reward schemes.

Wise agues that the companies under the Treasury Department’s TARP program need to come up with realistic reward programs for their top executives such that they meet federal regulations while at the same time retaining talent within the organization (4).

This can only be achieved through performance based measures such as bonus banking which cut down on the executives’ pay but still keeping them with a sufficient reason to continue working for the organization. This is a scenario where bonus banking maybe a preferable alternative to any other reward program.

Conclusion

While bonus banking seems to have benefits and setbacks, its success as a reward scheme is dependent on several variables. One such variable is the organizational strategy. For a firm that has its main strategy as reducing costs so as to get back onto a stronger financial footing, bonus banking can be a viable reward scheme since it involves issuing a bonus while at the same time regulating its payment.

This can be effective to keep costs at a minimum and only make payments where there is an absolute necessity or with minimum effect to the firm’s cash statement or bank balance (Becker & Peter 12).

Another variable is the financial situation prevailing in the markets at the time. At a time where there is a bullish run in the stock markets and other financial institutions are enjoying stable finances, then bonus banking is not a viable option since it would have the effect of risking a loss of employees to other firms with better pay terms. However, the reverse is true for tough financial times in the sector and a poorly performing stock market (Martin 6).

The last variable that seems to affect the viability of bonus banking as a good reward scheme is employee satisfaction. In firms that are comfortable paying a large bonus or using any other motivational technique to keep their employees (especially the top executives) satisfied enough to remain in the company, then bonus banking would be easier to implement.

However, for those firms that already had disgruntled employees even before the introduction of bonus banking, such an introduction would be a catalyst for an employee ‘flight’. In summary, the efficacy of bonus banking is dependent on the prevailing dynamics in the company. However, there is no guarantee that it can be an effective reward program (Becker & Peter 12).

Works Cited

Becker, Irv and Peter, Christie. “Bonus Banking: A Better Way to Reward?” Directorship, 2 (2009):11-12

Ippolito, Michael. “Executive pay for sustainable performance: restoring investor trust in financial services institutions.” Hay Group: The Executive Edition, 2 (2009):8-10

Martin, Dana. “An action plan for compensation committees.” Hay Group: The Executive Edition, 2 (2009):3-6

Sabow, Steve.”The Wall Street Journal / Hay Group 2008 CEO compensation study.” Hay Group: The Executive Edition, 2 (2009):1-3

Wise, David. “What TARP means for the future of executive pay.” Hay Group: The Executive Edition, 2 (2009):3-7

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