Investing in a company with a flawed management remuneration scheme is akin to entrusting a Formula 1 car to a driver whose only incentive is to finish the race as quickly as possible, regardless of the number of crashes along the way. For quality investors, understanding how executives are compensated is crucial, as these schemes can significantly influence management behavior and, consequently, company performance.​

In this article, I briefly outline the characteristics of effective and ineffective management remuneration schemes, highlighting the good, the bad, and the downright ugly.

The Good: Aligning Incentives with Long-Term Value Creation

Skin in the Game: Fostering an Ownership Mentality

Effective remuneration schemes align the interests of executives with those of shareholders. This alignment is often achieved through share-based (not options-based!) compensation, which encourages managers to focus on long-term value creation rather than short-term gains. When executives have a personal financial stake in the company’s future, they’re more likely to make decisions that benefit all stakeholders.​

A seminal study by Jensen and Murphy (1990) emphasizes the importance of linking executive wealth to shareholder wealth, demonstrating that such alignment can lead to better company performance. ​

Metrics That Matter: Emphasizing ROIC and Margin Quality

When pay depends on performance, the first design question should always be “Which outcomes are truly worth paying for—and can executives rig the score?” The most resilient remuneration systems lean on metrics that (a) capture genuine economic value creation and (b) are largely outside management’s short-term control—so they reward hard-won operating excellence rather than accounting cosmetics.

Return on Invested Capital (ROIC)

ROIC (NOPAT divided by the average invest­ed capital base) reveals how deftly management converts resources into returns above the hurdle rate. Incentive plans that (i) compare ROIC to a pre-set WACC band and (ii) weight multi-year rolling averages blunt the allure of end-of-year asset pruning or deferred maintenance. Steadily lifting ROIC supports sustainable growth because it forces capital rationing: only projects that promise to out-earn the hurdle survive.

Economic Value Added (EVA)

EVA (in simple terms, ROIC minus WACC) directly tests whether each dollar of investment beats its true opportunity cost. Because the cost-of-capital hurdle is fixed in advance and the capital base is measured from audited balance sheets, managers cannot meaningfully “juice” the number other than by running the business better or divesting value-destroying assets. Using the year-on-year change in EVA (ΔEVA) further dampens one-off shocks and motivates continual improvement: every additional dollar of profit that exceeds the capital charge lifts ΔEVA, while profit that merely keeps pace with capital growth does not.

Reported EBITDA-Margin

Boards often debate whether to strip out “non-recurring” items, but every subtraction re-opens the door to lobbying and late-cycle adjustments. A cleaner, simpler safeguard is to tie incentives to the as-reported EBITDA margin—the exact figure published in the audited financial statements. Because this number is calculated under GAAP/IFRS rules and scrutinised by external auditors, executives cannot tinker with the denominator through bespoke exclusions. Rewarding sustained gains in the reported margin keeps the focus on genuine pricing power, mix, and cost discipline while eliminating “adjusted EBITDA” negotiations that can dilute accountability. Rolling multi-year averages or a payout bank further smooth short-term volatility without sacrificing the integrity of the metric.

Research by Baker, Jensen, and Murphy (1988) highlights the effectiveness of performance-based incentives, showing that well-structured compensation plans can drive executives to improve these key financial metrics.

Balancing Time Horizons: Short-Term vs. Long-Term Incentives

An optimal remuneration scheme balances short-term achievements with long-term objectives. Short-term incentives (e.g., annual bonuses) can motivate immediate performance, while long-term incentives (e.g., stock options vesting over several years) ensure that executives remain committed to the company’s enduring success.​ The pioneering work of Holmstrom and Milgrom (1991) on multitask principal-agent analyses underscores the importance of balancing incentives across different time horizons to prevent short-termism and promote sustained value creation.​

The Bad: Misaligned Incentives and their Consequences

Profit-Based Bonuses: A Double-Edged Sword

While tying bonuses to net profit might seem logical, it can lead to unintended consequences. Managers may engage in earnings management practices—such as deferring necessary expenditures or recognizing revenue prematurely—to meet bonus targets. These actions can distort the company’s true financial health and undermine long-term stability.​

Overemphasis on Short-Term Gains

Compensation structures that heavily favor short-term performance can encourage executives to prioritize immediate results over sustainable growth. This short-termism can lead to underinvestment in areas like research and development, ultimately harming the company’s competitive position.​ Research by Graham, Harvey, and Rajgopal (2005) reveals that many executives admit to sacrificing long-term value to meet short-term earnings targets, illustrating the dangers of disproportionate short-term incentives.​

The Ugly: Incentivizing Counterproductive Behaviors

EPS Growth-Based Incentives: A Risky Proposition

Basing executive compensation on earnings per share (EPS) growth is oftentimes problematic. Managers might resort to debt-financed share buybacks to artificially boost EPS, increasing financial leverage and potentially compromising the company’s financial health.​ A study by Almeida, Fos, and Kronlund (2016) found that firms often engage in share repurchases to meet EPS targets, sometimes at the expense of long-term investment, highlighting the perils of EPS-linked incentives.

For example, in 2014, Humana showed just how elastic “performance” can be. With net income already off 21 %, the board approved a $500 million accelerated buyback that vaporised 3.4 million shares. The arithmetic was surgical: the reduced share count nudged full-year EPS from $7.49 to $7.51, slipping past the $7.50 bonus-trigger which had been agreed for that year by a single cent. That wafer-thin gain unlocked a $1.68 million bonus for CEO Bruce Broussard and sweetened pay across the C-suite—despite the weaker underlying results.

Options Without Performance Hurdles: Rewarding Volatility

Granting stock options without performance conditions can encourage executives to pursue risky strategies that increase stock price volatility. Since options gain value with higher volatility, managers will be tempted to undertake projects with uncertain outcomes, jeopardizing the company’s stability.​The work of Hall and Murphy (2003) nicely illustrates the complexities of stock options in executive pay, noting that without proper safeguards, such incentives can lead to excessive risk-taking.​

“Adjusted” Metrics: The Art of Creative Accounting

Some remuneration schemes rely on “adjusted” financial metrics, excluding certain expenses to present a rosier picture of performance. This practice can mislead stakeholders and reward executives for results that don’t accurately reflect the company’s economic reality.​ Black and Christensen (2009) nicely highlight how the use of non-GAAP metrics in compensation can obscure true performance, calling for greater transparency and consistency in financial reporting.​

Conclusion: Crafting Effective Remuneration Schemes

Incentive structures profoundly influence executive behavior and company outcomes. Well-designed remuneration schemes that align with long-term value creation, emphasize meaningful performance metrics, and balance short-term and long-term incentives can drive sustainable success. Conversely, poorly structured schemes will sooner or later encourage behaviors that undermine a company’s financial health and erode shareholder value.​

For you as an investor, scrutinizing a company’s executive compensation plan is not just advisable—it’s imperative. After all, when the captain is rewarded for the ship’s speed rather than its safe arrival, it’s time to question who’s steering the vessel.