Chief Executive Officers are often driven more by their short-term personal interests than by the long-term good of their company. Therefore, it is a critical responsibility of the board of directors to ensure that executive compensation is linked to such performance targets that cannot be easily gamed by the CEO and so, can be achieved only if he creates actual and sustainable value for the company. Only such performance targets may be deemed to be good. Also, since they are difficult to manipulate, CEOs would statistically be as likely to meet these targets as to miss them; it is unlikely that, if no manipulation takes place, CEOs will just overperform most of the time. However, recent research has found that, in actual practice, CEOs meet their targets far often than they miss them.
The performance targets of CEOs are often based on a single metric such as quarterly profitability or earnings per share. Such a system can be easily manipulated by them – by, for example, cutting the research and development spending that is critical for the organization's future. In contrast, when their payouts depend on three to five performance targets – based on metrics that are not closely correlated – CEOs are found to be just as likely to miss a given target as they are to exceed it.
Boards often determine their CEO's performance goals based on the company and sector growth forecasts provided by external analysts and the CEO himself. In self-interest, CEOs often lowball forecasts to get easily achievable targets. However, the resulting low performance targets prevent their company from growing to its full potential. Another feature of the executive compensation structure compounds this problem. Most boards specify a minimum performance threshold for their CEOs, below which the CEO receives no bonus. Then, his rewards rise steeply until the target is reached. Rewards for performing beyond this target grow much more slowly and eventually taper off. Thus, a CEO does not receive much personal profit from achieving spectacular results as opposed to merely satisfactory ones and, therefore, rarely strives for them. The result of all this is a sated CEO but a stunted company.
Adapted from https://hbr.org/2017/09/comp-targets-that-work
