Incentives - Effectiveness and Efficiency

Abstract

That people respond to incentives is a common belief. This became even stronger during the course of the financial crisis in 2008/09 as incentive schemes of banks are broadly considered as main reason for the crisis. This paper covers the question if and how incentives work evaluated by their impact on company performance, i.e. on market capitalization and profit before tax. Based on a unique data set for German executive directors of DAX companies (30 largest listed companies in Germany), it can be proved that neither short nor long term incentives plans necessarily support the company success. It rather depends on the efficiency of each plan, i.e. on its design. Special attention has to be paid on target setting. Short term focused objectives of STI plans often miss their targets, whereas long term oriented objectives of LTIs significantly support the company success. Targets of incentive schemes have to consider specific employee and company characteristics and should be accompanied by a proper performance management. To foster the incentivation and to solve the prisoner’s dilemma between employers and employees by a quasi-endless game, additional measures may be helpful, such as share ownership guidelines.