Agency Theory

Agency Theory and Executive Compensation An Analysis of Agency Theory and Aligning Executive Stock Options with Corporate Objectives According to Jensen and Meckling (1976), any medium- or large-sized firm today is not directly managed by its owners (the shareholders) but rather by "hired hands" that is, professional managers. Presumably, these professionals are capable and diligent agents of the owners, but these professionals' interests are not always the same as the shareholders' interests. Shareholders want their agents to maximize the value of the firm.

The professional managers want to maximize their own welfare. They, for example, may want to create an organization with a great many employees as a way of wielding more power and getting more remuneration (there is a correlation between top executive pay and the size of the organization). This "agency problem" is addressed by modern firms in a variety of ways. Firms are often counseled to deal with this problem by better aligning the executive's rewards with that of the firm.

One popular way to do that is to give executives stock options, making them owners as well as agents. If a significant part of one's remuneration is from company stock, the reasoning goes, executives ought to act in the stockholders best interests.

To determine the efficacy of this assertion, this paper will a) review the literature on organizational behavior and business law as it pertains to "agency theory"; b) provide a discussion of the extent to which it should be argued that the "remedy" of executive compensation through stock options (or other forms of firm ownership) is effective today; and c) other alternatives modern firm should use to address the "agency problem" today. A summary of the research, salient findings and relevant recommendations will be provided in the conclusion.

Review and Discussion Background and Overview. According to Black's Law Dictionary (1990), "agency" refers to "a relationship between two persons, by agreement or otherwise, where one (the agent) may act on behalf of the other (the principal) and bind the principal by words and actions" (p. 62). The term also refers to a legal relationship in which one person acts for or represents another by latter's authority, either in the relationship of principal and agent, master and servant, or employer or proprietor and independent contractor (Black's, 1990).

Within this general theory, there are a number of individual behaviors that firms must take into account when devising appropriate compensation packages. For example, Lynch and Perry (2002) point out that, "Agency theory suggests that managers are more risk-averse than owners and must be compensated for undertaking risky projects" (p. 279). Stock firms, for instance, frequently provide their executives with some level of compensation in the form of stock options, thereby providing incentives for increased risk bearing (Fields & Tirtiroglu, 1991).

Likewise, Datta and Garven (1988 cited in Fields & Tirtiroglu) maintained that the distributional form also affects risk bearing, as the employees of direct writers have exclusive contracts with one firm. This arrangement, then, provides an incentive for agents to contract only with a low risk firm based on the contractual requirement that they produce business for one firm.

This reasoning is congruent with empirical evidence provided by Chung and Charoenwong (1991), who determined that growth companies were more likely to be riskier enterprises than their non-growth counterparts; therefore, managers require greater compensation for assuming this additional risk. Agency theory also suggests that managers' compensation should reflect how well (or poorly) a company is performing; in this regard, the research to date has indicated that total compensation increases with company performance.

As a result, agency theory also maintains, and prior studies have confirmed, that size, growth opportunities, and performance are associated with total compensation (Lynch & Perry, 2002). Likewise, in his book, Trust and Loyalty in Electronic Commerce: An Agency Theory Perspective, Karake-Shalhoub (2002) reports that in an examination of organizational behavior using a contractual framework, agency theory maintains that cooperative effort within organizations is frequently constrained by opportunistic behavior on the part of organizational members, and incentive systems and control structures can help mitigate problems associated with such behavior.

According to agency theory, there will be a fundamental disparity in the availability and quality of information, and opportunism represents yet another opportunity for consummation of service exchanges. Karake-Shalhoub suggests that the concept of inequitable access to and quality of information implies that one of the partners in the agency relationship enjoys a greater quantity and/or quality of information; however, both parties have incomplete information and are making decisions under uncertain conditions (Karake-Shalhoub, 2002).

"The information domain is usually circumscribed by the nature and quality of service delivered," Karake-Shalhoub says, and "In most instances, the information asymmetry is in favor of the service provider" (p. 109). This point is made by Gomez-Mejia and Tosi, who note that: In agency theory, the organization is seen as a nexus of implicit and explicit contracts among participants such as owners, employees, managers, other suppliers of capital, and so forth who make contributions to the organization and in return receive payments from it.

Owners are seen as principals who contract with and are dependent on the actions of the manager (the agent). The term "contract" is used to mean the agreement between the principal and the agent that specifies the rights of the parties, ways of judging performance, and the payoffs for them. The costs of this relationship are called 'agency costs.' These costs include, at least, losses to the principal because the agent does not act in the principal's interests and the cost of monitoring the activities of the agent. (p. 170).

Agency costs are an important consideration in stock valuation because management's willingness to redistribute cash flow back to shareholders at some point by investing in the firm itself shows that agency costs are under control and that the firm must be a good investment (Westphal & Zajac, 2001). Because agents are able to control organizational resources and are more likely to know about the tasks that they perform for the principal, an inherent information asymmetry exists that provides agents with an advantage over the principal (Pratt and Zeckhauser, 1985).

According to Gomez-Mejia and Toris, the principal will generally attempt to offset this asymmetry by developing control measures and corporate structures that are designed to prevent the agent from making decisions to divert resources away from the principal's interests. In his book, Changing Organizations: Business Networks in the New Political Economy, Knoke (2001) reports that, "Agency theory is the predominant explanation among finance economists for executive compensation and its relation to firm performance.

It originated as a general perspective on using incentives to gain control over organizational actors' behavior (Jensen and Meckling 1976)" (p. 264). Agency theory emphasizes risk-sharing among cooperating parties; in this regard, an agency relationship is a "contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent" (Jensen & Meckling 1976, p. 308).

An agent is paid for her services and retains some control or autonomy over her specific actions undertaken to achieve the principal's goal. Some common examples are the major entertainers and sports agents who are retained by movie stars and athletes to secure the best possible contracts from studios and team owners (Knoke, 2001).

In a business setting, the shareholders (principals) accomplish the same end by contracting through the board of directors with a CEO and top management team (agents) to operate the company in order to maximize profits, thereby increasing the shareholders' wealth. "In most theoretical versions," Knoke advises, "because principals lack the agent's skills and knowledge (information asymmetry), they cannot accurately assess the quality of an agent's performance" (p. 265).

In fact, even board members who enjoy daily interactions in many instances, more directly than most shareholders with the manager-agents, do not have the same intimate, day-to-day knowledge of company operations and managerial performances; in addition, any self-interested agent will typically pursue personal goals that do not fully coincide with a principal's goals (Knoke, 2001). As a result, an agent is always on the alert to opportunities to improve his or her own position by channeling efforts into those activities that may not produce the optimal value desired by the principal.

In this regard, Knoke writes: "For example, instead of maximizing the firm's current earnings and share value, a CEO may prefer to increase the company's long-term revenue or market share by spending resources on costly pet projects and corporate acquisitions that reduce the stock price" (p. 264). Clearly, the typical firm is characterized by asymmetrical access to and quality of the information being used to make management decisions at any given time.

The quality of this information, then, depends on who is receiving it and who is communicating it; if managers assert a privileged position to take advantage of an opportunity to improve their own position, firms should be shocked, perhaps, but not surprised: "In the jargon of agency theory, moral hazard tempts agents to take advantage of their privileges, producing agency costs for the principal" (Gomez-Mejia & Wiseman, 1997, p. 295).

Because people are just people and will tend to try to get away with whatever they can in their own best interests, then, it becomes increasingly important today to ensure that executive compensation and performance are understood; these issues are discussed further below. Compensation and Performance. The skyrocketing costs associated with executive compensation packages has emerged as one of the most compelling for researchers over the last decade (Baek & Pagan, 2002). Furthermore, the recent highly publicized accounting scandals involving Enron et al.

have created a perception among the American public that corporate executives are placing their own personal interests ahead of their shareholders' concerns.

In her essay, "What's Next in Corporate Pay Practices? An Enhanced Role for Compensation Committees and a Hard Look at Stock Options Are in the Offing," Anita Dennis (2004) reports that, "While the Sarbanes-Oxley Act of 2002 does not directly mandate changes in compensation methods beyond placing restrictions on personal loans to executives, its emphasis on corporate governance has been a catalyst for public companies to reexamine how they pay their top executives" (p. 59).

This reexamination is clearly in order as well; in fact, today, the median top executive compensation in S& P. 500 companies has risen from a just over $1 million in 1990 to approximately $2.5 million in 1996 (Hallock & Murphy, 1999). Furthermore, the percentage of total pay that is based on stocks and options also has increased from 30% to 50% during the same period; however, it remains unclear whether higher or better pay increases firm performance (Baek & Pagan, 2002).

"The answer depends on how firm performance is defined," these authors note, and "Under different assumptions, performance may mean the value of the firm, stockholders' return, accounting income, or revenue" (Baek & Pagan, p. 28). Although every business setting is, of course, unique, there remains some commonalities across the board that can be used for gaining insight into how each component affects an executive's actions in achieving one goal over another. Executive compensation packages are generally comprised of five basic components: 1. Base salary.

According to one survey, only 27% of a CEO's total compensation package is comprised of a base salary (Milkovich & Newman, 1999). As a percentage of the total package, salary has been declining in recent years but still remains an important consideration when formulating executive compensation packages today (Caruth & Handlogten, 2001). Executives' salaries are generally established by a corporate board of directors or by some type of special compensation committee created specifically for the purpose.

"Where a committee is used," Caruth and Handlogten advise, "it is normally a subcommittee created by and composed of members of the board of directors" (p. 232). Just as every corporate setting is different, the techniques that are employed to establish executive compensation levels also differ from company to company. In some cases, committees will review compensation data from competing organizations to help determine an appropriate executive pay rate; in other cases, companies may use a type of benchmarking to determine an equitable pay level.

According to Caruth & Handlogten, the actual salary level that is used will generally involve the following factors: organization size, company stage of development (e.g., start-up vs. mature), industry type (e.g., high tech, retail, manufacturing, etc.), financial resources available, and the organization's pay philosophy. 2. Short-term incentives.

A second component of executive compensation is an annual bonus that is awarded for achieving certain short-term goals related to sales, profits, or other similar factors; the criteria that are assigned to achieving these bonuses and their respective amounts are typically determined by the executive compensation committee or the board of directors. "Evidence suggests that use of short-term bonuses is fairly widespread among American corporations" (Caruth & Handlogten, 2001, p. 232). 3. Long-term incentives.

Because of their inability to discipline managers' actions with achieving corporate goals over those activities that might be in the managers' own best interests, many companies have opted for long-term incentives.

According to Caruth and Handlogten, there are five fundamental purposes associated with long-term incentives: (a) to tie executive interests to shareholder interests; (b) to encourage executives to engage in long-term planning for organizations; (c) to assist the organization in attracting, holding, and motivating capable high-level executives; (d) to reward executives for long-term financial success of the organization; and (e) to take advantage of tax considerations benefiting both the executive and the organization (Caruth & Handlogten, 2001, p. 233). Today, the six most commonly used long-term incentives are: a. Stock options; b.

Nonqualified stock options; c. Phantom stock plans; d. Stock appreciation rights; e. Restricted stock plans; and, f. Performance-based stock plans (Caruth & Handlogten, 2001). Stock options provide the executive with a right to purchase stock at a stipulated price over a fixed period of time in accordance with Internal Revenue Service regulations; however, nonqualified stock options do not conform to IRS requirements and are not afforded the same favorable tax treatment.

In some cases, so-called "phantom stock plans" are simply rights that are assigned to an executive; however, in these cases, no stock is actually held and no voting rights accrue to the shares (Caruth & Handlogten, 2001). Once employment terms or conditions are achieved, the executive is awarded cash, shares of stock, or some combination of cash and shares; however, any stock appreciation rights assigned to the executive are linked to increases in the price per share of a company's stock (Caruth & Handlogten, 2001).

After successfully accomplishing the established appreciation goals, the executive may then be entitled to receive stock or cash; restricted stock plans, though, provide an outright grant of stock to an executive at a reduced price (Caruth & Handlogten, 2001). These shares, however, do not transfer to the executive or cannot be sold prior to a specified date. Finally, performance-based plans provide an executive with a predetermined number of shares when predetermined performance goals are achieved within a stipulated timeframe (Caruth & Handlogten, 2001).

Despite the perceived benefits from this alternative, many firms did not follow through on their initiatives. According to Westphal and Zajac (2001), from the late 1970s to mid-1980s, many firms in the U.S. used long-term incentive plans in response to increasing external pressures for better managerial accountability; these plans were designed to better align executive compensation with shareholder interests but many firms did not actually implement the plans (i.e., they made no grants under the formally adopted plans).

"By decoupling the plans from practice, top managers were able to avoid higher compensation risk in their pay packages" (Westphal & Zajac, p. 202). 4. Indirect monetary compensation (benefits). Executives typically receive a higher level of benefits than other organizational employees because many benefits -- life insurance, disability coverage, and so on -- are directly linked to compensation levels. But executives may also receive benefits over and above those directly linked to pay; however, there are certain ERISA and tax-code regulations that constrain what companies are allowed to do for their executives.

According to Caruth and Handlogten, a specific benefit that large organizations frequently provide their high-level executives is a golden parachute. "A golden parachute is a financial settlement with a key executive whose employment is terminated because of merger acquisition, or liquidation of the firm. It typically includes severance pay, stock options, and bonuses. The purpose is to allow an executive to maintain an appropriate lifestyle until he or she can find other employment" (Caruth & Handlogten, 2001, p. 233). 5. Perquisites.

According to Black's, "perks" are "Emoluments, privileges, fringe benefits, or other incidental profits or benefits attaching to an office or employment position in addition to regular salary or wages" (p. 1141). Perquisites are increasingly being viewed by the IRS as taxable, as the authors caution firms to take this into consideration when formulating executive compensation packages. Furthermore, and notwithstanding their growing unpopularity among some firms, short-term incentives are still receiving more emphasis today than an executive's base salary (Caruth & Handlogten, 2001).

For example, according to Caruth and Handlogten, "Over time the emphasis placed on each of these components has fluctuated, largely because of tax considerations. Currently, base salary plays a smaller role in executive compensation than short- and long-term incentives" (p. 232).

For executive compensation purposes, a firm is simply an economic organization that is characterized by some internalized transactions; some of the techniques available to prevent managers from making sub-optimal decisions include monitoring by a board of directors and outside large shareholders, as well as the forces from corporate control markets and managerial labor markets (Baek & Pagan, 2002).

By contrast, Jensen and Meckling suggest that a more direct way to motivate firm managers to work on behalf of their shareholders is to link their success to that of the shareholders through management equity ownership (Jensen & Meckling, 1976) or performance-based compensation (Jensen & Murphy, 1990). In recent years, there has been considerable debate concerning whether the structure of CEO compensation packages in large firms has been designed so as to ensure that executive decision making is directed toward maximizing firm performance (Gomez-Mejia & Tosi, 1989).

For example, in his essay, "The Effect of CEO Stock Option Grants on Shareholder Return," Emmett H. Griner (1999) reports that: A controversy has developed around the question of whether or not the costs of stock option compensation outweigh the benefits. Despite numerous academic studies of stock option compensation, the empirical evidence is inconclusive (Yermack, 1995). If the benefits of stock option compensation outweigh the costs, then grants of CEO stock options should lead to increases in shareholder returns.

If the costs of stock options outweigh the benefits, then grants will not lead to increased return. (p. 427). Despite the growing body of research on executive compensation packages, some fundamental constraints continue to exist in empirically determining whether higher pay and/or higher pay-performance sensitivity results in a higher stock return performance; however, because information on the level and structure of top management compensation is publicly available, the efficient capital market hypothesis suggests that this information has already been taken into account in the current stock price (Baek & Pagan, 2002).

According to Jensen and Meckling (1976), the "negligence and profusion" of directors in joint-stock companies was recognized as early as in 1776 by Adam Smith (p. 306). In their essay, "Out-of-the-Money: The Impact of Underwater Stock Options on Executive Job Search," Boswell, Boudreau, and Dunford (2005) note that for more than 20 years, stock option grants have become an increasingly popular form of executive compensation in the United States and abroad. Likewise, Hall and Murphy (2002) reported that in 1999, 94% of S& P. 500 companies granted options to their top executives, up from 82% in 1992.

Stock options have also increased in terms of their proportion of executives' total compensation. Hall and Murphy (2002) further reported that in 1999, stock options accounted for 47% of the total compensation of S& P. 500 executives, up 22% from 1992.

Besides stock option grants and base salary, executive pay packages generally include several other components, such as annual bonuses tied to firm performance, benefits, and other long-term incentives such as restricted stock grants; however, recent reports indicate that stock options now represent the largest single component of executives' total compensation packages (St.-Onge, Magnan, Thorne, & Raymond, 2001).

Because stock options represent such an important component of an executive's compensation package today, identifying effective and timely methods of disciplining managerial actions to achieve corporate goals just makes good business sense; these issues are discussed further below. Aligning Stock-Option Plans with Corporate Objectives. According to Baek and Pagan, the benefits of providing incentives that are more in line with a company's goals will be realized almost immediately: "The effect of improved management incentives will be manifested in the stock price upon the announcement of such events" (p. 29).

This gain, though, will only be realized if the management incentive packages developed are truly tied with corporate objectives; because savvy managers achieve an intimate understanding of the relationship of their behaviors and activities with a company's bottom-line, it will take much to overcome this natural tendency to pursue those behaviors that will be most self-rewarding. While researchers such as Abowd (1990) identified positive abnormal returns (AR) with performance-based pay approaches; however, Yermack (1997) points out that there are two problems with event study analyses.

"First, the identification of event dates is ambiguous. Second, even if one pinpoints the exact event date and finds a positive abnormal return, the finding is consistent with two different hypotheses" (in Baek & Pagan, 2002, p. 30). In reality, a closer examination of what transpired "behind the scenes" may be required in order to accurately gauge the effectiveness of these improved incentive packages.

For example, a positive abnormal return could suggest that some reduction in agency costs through better alignment of incentives is required; however, it might also simply mean that top executives are able to time the events or the announcements of "good news" (Baek & Pagan, 2002, p. 30). Other researchers have sought to associate managerial stock ownership and compensation with Tobin's Q.

ratio, which is defined as the market value of the firm divided by the costs required to replace the assets; for example, citing a study by Morck, Shleifer, and Vishny (1988), the authors report that Q. tends to increase with managerial ownership between 0% and 5%, and decrease within the 5% to 25% range; it again increases after the 25% level (Baek & Pagan, 2002). The study by Morck et al. concerning corporate ownership structure found that Tobin's Q.

increases as board ownership increases from 0% to 5%, decreases as board ownership increases from 5% to 25%, and slowly increases as board ownership increases beyond 25%. According to Dhatt, Kim and Mcconaughy (1995), these results tend to support the view that both convergence-of-interest between owners and managers and entrenchment are factors at play in this analysis.

These authors suggest that the convergence-of-interest operates at the low and high ends of board ownership where, respectively, the market for corporate control is effective and where very high ownership prompts efficiency by increasing the costs of perquisite consumption directly incurred by management; however, when board ownership is between 5% and 25%, the threat of outsiders taking control is sufficiently reduced and the direct cost of perquisite consumption to management is low enough to encourage entrenchment (Dhatt et al., 1995).

McConnell and Servaes (1990) determined that the firm value is optimized when insider ownership is between 35% to 45%. Cole and Mehran (1998) posited that removal of ownership restrictions allowed the firm to identify an optimal ownership structure. For a sample of 94 thrift institutions that converted from mutual to stock ownership during 1983-1987, they identified noteworthy increases in percentage ownership by the largest inside shareholder, institutional investors, employee stock ownership plan (ESOP) participants, and stock returns from pre (year -3 to -1) to post (year 1 to 3) period (Baek & Pagan, 2002).

Finally, for firms that experience increases in inside ownership above (below) the median level, raw and industry-adjusted stock return increases are significantly positive (negative), and the difference is statistically significant; for firms that experience above-median ESOP ownership increase, stock return change is significantly negative (Baek & Pagan, 2002). Direct investigations of the relationship between pay and Tobin's Q. ratio also exist. Using data for 500 executives from 75 of the largest U.S.

manufacturing firms over the 1964-1981 period, Murphy (1985) finds a statistically significant relationship (albeit small) between total compensation level and stock performance. The result indicates that a firm realizing a 10% rate of return will increase the total remuneration of an executive by 2.1%. Gibbons and Murphy (1990) also find that CEO salary and bonus is positively related to stock return, but negatively related to industry performance. Jensen and Murphy (1990) also find the relationship between executive wealth change and shareholder wealth change statistically significant but economically insignificant.

In a comprehensive study of firm performance using 1979-1980 compensation data for 153 randomly selected manufacturing firms, Mehran (1995) finds that performance, as measured by Tobin's Q. And return on assets (ROA), was positively related to the proportion of equity-based compensation, management ownership of stocks and options, and research and development expenses over sales.

Other studies (e.g., Core, Holthausen, and Larcker, 1999) have determined the average ROA (one, three, or five years) and stock returns are negatively related to the "predicted excess compensation"; this factor is controlled by stock ownership and board of directors' variables. Other studies, however, did not identify substantive evidence that management ownership affected performance after controlling for endogeneity between ownership and performance (Baek & Pagan, 2002). Combining capital market data with accounting data has proven a valuable technique; Q.

implicitly uses the correct risk adjusted discount rate, imputes equilibrium returns, and serves to minimize the inherent distortions that are the result of tax laws and established accounting conventions (Foss, 1997). While originally introduced in macroeconomics, these attractive properties have recently given Q. A wider variety of applications in industrial organization research as well (Foss, 1997); however, there have only been a few analyses of the impact of executive pay structure on corporate technical efficiency to date (Baek & Pagan, 2002).

In this regard, in 1985, Murphy examined stock performance using only the largest firms and does not account for managerial stock ownership. While Mehran (1995) used Tobin's Q. To measure performance, Baek and Pagan point out that Q. may represent the growth opportunity of a firm rather than current annual performance.

The return on assets measure used by these past researchers, therefore, is frequently open to manipulation by management; consequently, achieving a better understanding of the association between executive compensation and firm's productive efficiency is important to those interested in designing compensation packages that will result in better firm performance in both the short and the long run (Baek & Pagan, 2002). Managers with equity-based compensation may increase the short-term stock performance in many ways: 1, Increased productive efficiency; 2. Reduced expenses such as wages, interest expenses, R& D, or taxes; 3.

Short-horizon investments at the expense of long-term stock performance; 4. Riskier investments at the expense of bondholders' wealth; and, 5. Earnings manipulation (Baek & Pagan, 2002). The studies to date indicate that American companies employ at least some of the above-mentioned approaches to equity-based compensation. In 1991, researchers determined that CEOs tended to reduce discretionary expenditures such R& D. And advertising in their last years to boost accounting earnings and bonus (Baek & Pagan, 2002).

In addition, Narayanan (1996) suggested that all-cash (all-stock) management compensation resulted in under- (over-) investment; in this regard, Amihud and Lev (1981) argued that managers want a compensation plan that lowers personal risk and they may engage in risk-reducing activities. Likewise, DeFusco, Johnson, and Zorn (1990) determined that, when stock volatility increases, shareholders experience wealth gains, and bondholders experience losses.

The widespread and growing use of bonuses has made them a necessary target for organizational researchers; however, the literature on pay, pay satisfaction, and its measurement has not produced a measure of lump-sum bonus satisfaction. Agency theory as conceptualized by Jensen and Meckling (1976) has been the dominant theoretical framework for examining the effects of contingent pay in general, and on the use of lump-sum bonuses in particular, as a method of linking individual rewards to organizational performance.

Agency theory suggests that by linking pay to organizational performance, such as through the use of lump-sum bonuses tied to organization success, firms can encourage behavior that is better aligned with the organization's interests (Jensen & Meckling, 1976). The research to date that has investigated bonuses has been concentrated on the use of various bonus schemes as a percentage of executive pay; therefore, there remains a gap in the research because the use of bonuses needs to be addressed at other organizational level (Baek & Pagan, 2002).

Even in the realm of executive compensation, though, empirical investigations have shown weak or statistically insignificant relationships between executive pay and organizational performance (Baker, Jensen, & Murphy, 1988; Jensen & Murphy, 1990). One explanation for these findings offered by Baek and Pagan is that applications of agency theory thus far have examined only the use or size of bonuses rather than affective reactions to pay.

As a result, there remains a paucity of research concerning how individuals react to bonuses, such as how executives feel about the structure and size of their bonuses. According to Short and Sturman (2000), "Lump-sum bonuses are cash payments to employees that are not added to employees' base wages" (p. 673). Lump-sum bonuses are therefore allocated when the organization can afford (or chooses) to distribute the rewards, and do not cause larger fixed labor costs in the long run.

In addition, lump-sum bonuses are a part of an individual's compensation that is not guaranteed, and are usually paid in recognition of some goal achievement, such as individual performance, team performance, or organizational performance (Milkovich & Newman, 1999). Short and Sturman caution, though, that it should be kept in mind that in spite of the fundamental differences in how organizations may determine lump-sum bonuses, the above definition focuses on the distributed reward: contingent cash payments.

As a result, while the type of bonus (e.g., individual-based, team-based, organizational based) may vary, much like the type of benefits may vary (e.g., flexible benefits, types of benefits provided, etc.) or type of raises may vary (e.g., COLA, merit, across- the -board increase), lump-sum bonus satisfaction focuses on the affective reaction to the compensation received, although it certainly may be influenced by the determination process (Short & Sturman, 2000).