Bonuses Despite Billion Dollar Bailouts
Skip to content
Finance & Accounting May 1, 2010

Bonuses Despite Billion Dollar Bailouts

Managerial incentives, capital reallocation, and the business cycle

Based on the research of

Andrea Eisfeldt

Adriano Rampini

No issue in recent American politics has stirred more passion than that of excessive executive pay, especially in poorly performing firms. In March 2009, when media outlets reported that high-level managers of the insurance firm AIG would receive bonuses—though the company had needed billions in government bailout money just to stay afloat—President Obama called the payouts outrageous and promised that he would work to block them. Politicians across the spectrum echoed the president’s anger and derided the bonuses as an affront to common sense. But work by Andrea Eisfeldt, an associate professor of Finance at the Kellogg School of Management, and Adriano Rampini, an associate professor at Duke University, suggests that there is an economic logic behind giving bonuses to badly performing executives. Though politically toxic, such bonuses serve a purpose.

The research focuses on the influence that managers have on the timing of the revelation of bad news, which can be used to downsize and restructure poorly performing firms. More broadly, high-level managers have a major impact on the potential for economy-wide capital reallocation and restructuring. In theory, there should be a high level of capital reallocation during an economic downturn, with assets being shifted from bad managers to good managers. This is because the differences between well and poorly performing firms are larger in recessions. Also in theory, there are strong incentives for corporate takeovers during bad economic times, since stronger firms can buy the assets of weaker firms at a lower cost. Yet these theoretical likelihoods do not hold true. Capital reallocation across firms slows during bad times and, as Eisfeldt and Rampini have shown in previous work, trade between firms diminishes. “There’s something inhibiting reallocation in recessions,” Eisfeldt says. “There’s more sand in the wheels of the economy.” But why?

Managers play an important role in the answer because they have private knowledge about their suitability for the job and about the firm’s overall performance. They know how well their company is likely to be doing some time down the road, based on information that is available only to them. This is good news because the information can help the firm correct its course and improve its performance, but bad news because the managers may keep the information to themselves.

Incentives for Honesty
And this is where the bonuses come into play. The popular anger they have stirred is based on the belief that they reward poor past performance. But Eisfeldt and Rampini’s research suggests that their function is less about the past than the future. Bonuses provide managers with an incentive to be honest about their own performance and about the firm’s prospects earlier rather than later, when shifting capital to more productive managers and more productive uses can have the greatest impact.

“If you want your managers to reveal early when there’s bad news, you have to give them an incentive,” Eisfeldt notes. “You know that the managers are going to have a lot of control over information about what’s going on with the firm. One year ahead, one quarter ahead, they will have an idea about whether things are going well or going poorly. And if you want them to report when things are going poorly, you don’t want them to take a big hit in their compensation. In fact, you may want to reward them. If you’re going to fire them with nothing, they’re going to try to hide that fact.”

The effects of the incentive to conceal bad news extend far beyond the fate of individual firms. They help to account for the sluggish pace of capital reallocation and low rates of economic productivity in the overall economy. And there is a certain irony in this equation, because it means that bonuses could have a significant positive impact during an economic downturn—yet this is precisely when they seem most nonsensical. The irony is heightened by the fact that managers require bigger bonuses to be truthful during bad economic times, since they have fewer outside options.

Exit Strategies
“If I’m a bad manager, I will always require a bonus to tell you that,” Eisfeldt explains. “But in good times, I know that I’m going to get a decent job after you fire me. I’m not that worried about telling you. In bad times, I know that if you fire me, I’m in a bad position. So I become desperate to hold onto what I have. You would need to pay me more to let go of what I have in bad times, and you may decide not to incentivize me to do that. So that’s exactly what would stop capital reallocation from happening in bad times.”

The authors’ focus on the leverage that managers possess even in bad times—and the impact of their behavior on the broader economy—is innovative and has been well -received: in June 2009 their work was awarded second place in the annual Jensen Prize competition, established by The Journal of Financial Economics to honor the best articles appearing in its pages the previous year.

“People usually think that the board will just fire the managers,” Eisfeldt says. “But in practice managers have private information. They have to reveal that they should be separated. They play an active role in the decision.” The upshot is that, strange as it may seem, bonuses paid to poorly performing executives can be a good investment for the health of individual firms and the nation’s economy as well.

“People are getting all up in arms about these big bonuses, but there are reasons you have to pay them,” Eisfeldt maintains. “There is restructuring that needs to happen, and these are top-level managers. You want them to participate. Restructuring is going to be bad for them, so you have to give them some upside. It’s like with crime and punishment—if you do a hit-and-run, there’s a much worse punishment than if you hit someone and stick around and deal with it. You need to give people the incentive to help the firm do the right thing, even when it’s not the best thing for the manager.”

Featured Faculty

Member of the Department of Finance faculty between 2000 and 2011

Member of the Department of Finance faculty between 1998 and 2006

About the Writer
Theo Anderson is a writer in Evanston, Illinois.
About the Research

Eisfeldt, Andrea L. and Adriano A. Rampini. 2008. Managerial incentives, capital reallocation, and the business cycle. Journal of Financial Economics, January, 87(1):177-199.

Read the original

Most Popular This Week
  1. One Key to a Happy Marriage? A Joint Bank Account.
    Merging finances helps newlyweds align their financial goals and avoid scorekeeping.
    married couple standing at bank teller's window
  2. Take 5: Yikes! When Unintended Consequences Strike
    Good intentions don’t always mean good results. Here’s why humility, and a lot of monitoring, are so important when making big changes.
    People pass an e-cigarette billboard
  3. How Are Black–White Biracial People Perceived in Terms of Race?
    Understanding the answer—and why black and white Americans may percieve biracial people differently—is increasingly important in a multiracial society.
    How are biracial people perceived in terms of race
  4. Will AI Eventually Replace Doctors?
    Maybe not entirely. But the doctor–patient relationship is likely to change dramatically.
    doctors offices in small nodules
  5. Entrepreneurship Through Acquisition Is Still Entrepreneurship
    ETA is one of the fastest-growing paths to entrepreneurship. Here's how to think about it.
    An entrepreneur strides toward a business for sale.
  6. Take 5: Research-Backed Tips for Scheduling Your Day
    Kellogg faculty offer ideas for working smarter and not harder.
    A to-do list with easy and hard tasks
  7. How to Manage a Disengaged Employee—and Get Them Excited about Work Again
    Don’t give up on checked-out team members. Try these strategies instead.
    CEO cheering on team with pom-poms
  8. Which Form of Government Is Best?
    Democracies may not outlast dictatorships, but they adapt better.
    Is democracy the best form of government?
  9. What Went Wrong at AIG?
    Unpacking the insurance giant's collapse during the 2008 financial crisis.
    What went wrong during the AIG financial crisis?
  10. The Appeal of Handmade in an Era of Automation
    This excerpt from the book “The Power of Human" explains why we continue to equate human effort with value.
    person, robot, and elephant make still life drawing.
  11. 2 Factors Will Determine How Much AI Transforms Our Economy
    They’ll also dictate how workers stand to fare.
    robot waiter serves couple in restaurant
  12. When Do Open Borders Make Economic Sense?
    A new study provides a window into the logic behind various immigration policies.
    How immigration affects the economy depends on taxation and worker skills.
  13. Why Do Some People Succeed after Failing, While Others Continue to Flounder?
    A new study dispels some of the mystery behind success after failure.
    Scientists build a staircase from paper
  14. Sitting Near a High-Performer Can Make You Better at Your Job
    “Spillover” from certain coworkers can boost our productivity—or jeopardize our employment.
    The spillover effect in offices impacts workers in close physical proximity.
  15. How the Wormhole Decade (2000–2010) Changed the World
    Five implications no one can afford to ignore.
    The rise of the internet resulted in a global culture shift that changed the world.
  16. What’s at Stake in the Debt-Ceiling Standoff?
    Defaulting would be an unmitigated disaster, quickly felt by ordinary Americans.
    two groups of politicians negotiate while dangling upside down from the ceiling of a room
  17. What Happens to Worker Productivity after a Minimum Wage Increase?
    A pay raise boosts productivity for some—but the impact on the bottom line is more complicated.
    employees unload pallets from a truck using hand carts
  18. Immigrants to the U.S. Create More Jobs than They Take
    A new study finds that immigrants are far more likely to found companies—both large and small—than native-born Americans.
    Immigrant CEO welcomes new hires
  19. How Has Marketing Changed over the Past Half-Century?
    Phil Kotler’s groundbreaking textbook came out 55 years ago. Sixteen editions later, he and coauthor Alexander Chernev discuss how big data, social media, and purpose-driven branding are moving the field forward.
    people in 1967 and 2022 react to advertising
  20. 3 Traits of Successful Market-Creating Entrepreneurs
    Creating a market isn’t for the faint of heart. But a dose of humility can go a long way.
    man standing on hilltop overlooking city
Add Insight to your inbox.
More in Finance & Accounting