The Long-Run Performance of Firms Adopting Compensation Plans Based on Economic Profits

Proponents of compensation plans based on economic profits argue that these plans control for deficiencies in stock-based or earnings-based bonus plans and thereby better align managers’ and shareholders’ interests. We examine whether compensation plans based on economic profits do in fact produce better investment decisions. We use a sample of 51 firms adopting economic profit plans between 1986 and 1994 to examine compensation, ownership, and governance structures, and long-run operating and stock price performance. While we document significant improvements in operating performance subsequent to adoption of the compensation plans, a sample of nonadopting matched firms shows similar significant improvements. There is no significant difference in the stock price performance of the two groups in the four-year period following an adoption. We conclude that economic profit plans are no better than traditional plans that provide a blend of earnings-based bonuses and stock-based compensation in terms of their ability to create shareholder wealth.