Question

Explain thoroughly why the end of year bonus has, in the past, been regarded as providing incentives for employees to think only about the short term.

Answer 1

Solution:-

This issue has gained a lot of attention in the last decade or so, particularly after the 2008 crisis when it was found that executive compensation on wall street resulted in unethical business practices at the investment banks and other financial services firms.

The objective of management of a business is to maximise the wealth of its shareholders which is achieved by maximising the value of shares in the market. This, however, must be noted that the when we say the above objective, it means creating long-term sustainable wealth for shareholders with long-term sustainable stock prices and not just temporary rise in prices.

In order to encourage management to achieve their objectives, they are offered year-end bonuses to offer them a motivation to raech the goals. These year-end bonuses are generally based on upon the short-term yearly performances of employees.

Just like the wall street case in 2008, it has been seen that the idea of year-end bonus often backfires with the managers focusing on short-term performance of the business (as their bonuses are linked to it) which may result in temporary hike in stock prices, as well as yielding them their bonus cheques but doesn't result in long-term sustainable value creation for the business.

This is due to the fact that short-term bonuses encourages management to focus on just the yearly performance which may come at the cost of long-term business growth and encourages them to do things such as making expensive mergers & acquisitions, expand into the 'next hot' business of the moment, making investments from short-term perspectives, focusing on short-term profitability instead of long-term product quality, innovation, investment in R&D, customer relationships, etc.

When the year-end bonuses shift objectives of management/employees from long-term value creation on sound business principles to maximising the year-end profits, it has dire long-term consequences for the management.

This is why short-term bonuses often result in management do things that create short-term business performance, temporary hike in stock prices but not long-term sustainable growth for the business.