Performance-Based Compensation: Definition, How It Works, Types

What Is Performance-Based Compensation?

Performance-based compensation is an incentive-based form of compensation that can be paid to portfolio managers of investment funds. Regulated mutual funds with performance-based compensation may add approximately 0.20% to their management fees for performance-based incentives. Within the investment industry, hedge fund managers are most well known for receiving high levels of performance-based compensation.

Performance-based compensation also refers to additional compensation paid out to employees that have performed above and beyond their job requirements at an extremely high quality.

Understanding Performance-Based Compensation

Performance-based compensation rewards an investment manager or an employee for meeting certain performance targets or for high-quality work. For investment managers, it provides incentives to make smart and risk-appropriate investment choices that result in an appreciation of invested assets. This allows them a percentage of the returns in addition to the managerial fees they charge.

For employees, performance-based compensation is a reward for their hard work and acts as an acknowledgment of their contribution to the firm as well as functioning as an incentive to stay with the company. Most employee bonuses are performance-based compensation.

Investment Company Performance-Based Compensation

The Investment Company Act of 1940 governs the mutual fund industry and sets certain requirements that have helped to shape the compensation standards for portfolio managers. Investment companies must have a board of directors that approves the compensation schedule of managers.

Companies must also file a registration statement including a prospectus and statement of additional information, clearly and transparently outlining all the information on the fund including compensation.

Standards and documentation for publicly traded funds are generally expected to be consistent across the industry for easy comparison by investors. This consistency has also generally led to standardized fees charged by mutual fund managers as part of the fund’s total annual operating expenses.

Mutual fund portfolio management fees can range from 0.50% to 2.50% with active fund managers requiring higher compensation. Portfolio management fees typically comprise the majority of a mutual fund’s total annual operating expenses. Across the industry, mutual fund managers can also receive performance-based fees. These fees are detailed in their registration statement documentation and approved by the board of directors.

Hedge Fund Manager Performance-Based Compensation

Across the investment industry, hedge fund managers are more broadly known for their performance-based fees. Hedge funds are much less regulated than traditional mutual funds and therefore have greater latitude for fee schedule structuring.

They also typically employ more complex strategies that they develop, with the goal of offering higher returns than mutual funds, which they justify as a reason for higher performance-based compensation.

Hedge fund managers will typically charge a "two and twenty" fee schedule requiring higher management fees than mutual funds from their investors. The two and twenty hedge fund fee structure indicates a flat 2% fee as well as a 20% performance fee.

The 2% fee is based on the fund’s assets under management (AUM). The 20% fee is performance-based compensation that is typically triggered when performance outperforms a benchmark by a specified amount. The 20% fee is paid to the hedge fund manager from the fund’s profits.

Employee Performance-Based Compensation

Employees earn a traditional salary but performance-based compensation seeks to reward them for their high performance above their job requirements. Performance-based compensation is most often awarded as a year-end bonus, though bonuses throughout the year are possible.

Another common performance-based compensation is the awarding of stock options. An employee is given the option to purchase a company's stock at a discount when the price of the stock is above the exercise price. For example, shares of the company could be trading at $100 and the employee is given the option to buy at $90.

Performance-based compensation at companies is meant to motivate employees to work harder as they will reap the rewards of its success.