The seven deadly sins of executive pay

Mar 12 2009 by Nic Paton Print This Article

Executive pay has become the snarling face of this recession, a brickbat that the public and politicians are using to hammer boardrooms and management teams, however unfairly.

But, according to new research, many organisations have left themselves wide open to such attacks by taking an overly simplistic, one-size-fits-all approach to measuring the performance of their top executives.

The research by consultancy Mercer has identified the "seven sins" of executive performance measurement, flaws in approach that have been used by many major companies, particularly financial services organisations, in how they measure and reward the performance of their executives.

What's more, companies that fail to learn the lessons of the past few months, and fail to address key issues in their incentive programmes, will continue to suffer the slings and arrows of public discontent, it has argued.

"Developments over the past six months have heightened the focus on incentive plans and the measures for setting targets and rewarding performance," warned Mark Hoble, a principal in Mercer's executive remuneration team.

"Despite increased scrutiny of rewards for performance, many companies continue to struggle with defining and managing their performance measurement system," he added.

"Most apply a standard approach to executive performance measurement, but what works for one company might fail for another," he continued.

The seven most common performance measurement sins, according to Mercer, are:

1. Using earnings per share (EPS) as the main driver of shareholder value.

As one of the most common metrics used in discussing corporate performance, EPS is easily understood by executives and investors and is generally reported by the press as an indicator of the success of a company, conceded Mercer.

But EPS can be affected by changes in accounting policy and does not account for the cost of capital and the capital structure of the business, it argued.

It tended to yield growth percentages that can be misleading or meaningless when calculating growth from a small base or from negative earnings, the consultancy added.

EPS also highlighted the difficulty of determining the validity of one-time, non-recurring and extraordinary items.

Most importantly, actual EPS performance, as opposed to performance against expectations, was not always well correlated with creating long-term shareholder value, it argued.

2. Assuming that total shareholder return (TSR) is the only performance metric required.

TSR, argued Mercer, allows objective benchmarking of performance against peer companies but the relationship between executive behaviour and TSR results is less direct.

TSR was often affected by factors outside management's control or influence, including macroeconomic factors, broad market trends and specific sector competitive issues.

It also represented actual performance and expectations of future performance, therefore rewarding for TSR could mean rewarding for results that had not yet been delivered.

What this meant was that participants, particularly those below the most senior executive level, could not meaningfully affect this measure, given the number of possible drivers of share price.

The most effective incentive programmes, it recommended, needed to include metrics that were linked directly to the business strategy, provided a clearer line of sight to executive behaviour and measured outcomes, not expectations.

3. Believing a balanced scorecard is the best framework for measuring performance.

Scorecards, pointed out Mercer, measure results against a range of factors and are used to paint a more holistic picture of performance outcomes than can be captured by one or two metrics. They recognise the trade-offs in decision-making, such as maximising returns today versus investing for future growth.

Yet "balanced" scorecards, which typically place equal weight on financial objectives and a host of other operational and strategic objectives, might not appropriately reflect business priorities.

Some business goals inevitably were more important than others, and using too many measures risked diluting executive focus.

Scorecards were often more effective therefore if they were "unbalanced", as they provided greater flexibility to reflect the business strategy as it evolved.

Concentrating on fewer metrics could also send a clear message to executives regarding business priorities, while at the same time holding them accountable for the most important dimensions of performance, it recommended.

4. Using a measure just because a competitor or peer uses it too.

Performance metrics should be selected based on a variety of internal and external factors, emphasised Mercer.

Simply adopting metrics used by peer companies could cause organisations to fail because of inherent differences between the businesses.

Growth-related metrics usually played a more prominent role in performance measurement in younger companies, for example, while profitability or return-based metrics tended to become more important as a company matured.

Performance metrics therefore needed to support an organisation's unique business strategy.

5. Assuming that, to be effective, performance measures must be commonly accepted and well understood by everyone

The simplest measurements are often adopted because companies fear over-complexity will make incentive plans too difficult to communicate and administer, pointed out Mercer.

However, more complex metrics may actually include additional information that more accurately captures performance results, it suggested.

Some complexity can be a good thing in that it may be necessary to deal with specific business measurement challenges such as performance in a cyclical industry, a merger or acquisition, or ensuring the profitable use of capital.

Simple performance measures may make plan administrators happy, but an overly simple plan may be less likely to deliver the results that shareholders expect, it argued.

Simplification of administration and communication should be undertaken only after the ideal performance programmes has been designed.

6. Making your budget and strategic plan your performance target

In European companies, incentive payments are often linked to company performance compared to the planned budget, argued Mercer.

While these may seem commonsense standards for assessing performance, using only internal measures can often lead to under- or over-calibration of performance and a misalignment of incentive payments.

For example, executives may be under-rewarded for achieving target results in the case of a stretch budget and over-rewarded if the budget is conservative.

Companies that set goals based purely on their own historical performance are therefore likely to build incentive payments into their budget even in poor years, it pointed out.

Creating targets from a number of different perspectives, rather than relying solely on the strategic plan and budget, will generally more accurately assess performance.

And providing a more objective basis for evaluating performance and breaking the link between incentive plans and the budget tends to help maintain the integrity of the budget-setting process, while also reducing the tendency of executives to underestimate the company's future potential, it suggested.

7. Believing that all senior executives should be rewarded using the same performance measurement programme

Most companies reward all executives using the same performance vehicles and plan metrics, as common goals encourage collaboration and team-work, Mercer conceded.

Yet large, more diversified organisations often require more differentiation as business units can have different strategic priorities or may be in very different stages of business development, it added.

Differences in talent needs, often driven by business characteristics or geographical factors, can also present unique performance measurement challenges.

Companies must therefore balance the objective of fostering collaboration and team work with the need for customisation.

For senior executives, at least a portion of the incentives should be tied to overall corporate performance to ensure proper alignment with shareholder interests, it recommended.

The consultancy also outlined eight "virtues" that would allow companies to improve how they rewarded their executives for good performance.

These were:

1. Identify what you need to accomplish to beat the competition and generate sustainable economic profits. Then design your performance measurement system around those factors.

2. Pick internal and external performance measures that accurately reflect the behaviours and outcomes you want to achieve, given your company's current strategy and stage of development. Revisit these as your priorities change.

3. Consider using standard performance measures such as EPS and TSR, if helpful – but don't rely on just one or two metrics to assess performance.

4. Create a robust target-setting process. If your industry offers a viable number of comparable peers to allow for relative goal setting, consider setting incentive targets based on how your company performs on specific measures versus those of your competitors.

5. Make sure your goals and incentives are clearly defined and applied across business units and that they encourage the appropriate balance between collaboration and accountability.

6. Build sustainable, long-term performance into your measurements to ensure payments are not made, for example, on the basis of one year's good performance that could be overturned in subsequent years.

7. Ensure your short- and long-term incentive plans are aligned to avoid paying twice for the same performance – or paying high annual incentives year after year without ever reaching your long-term goals.

8. Be clear about what specific behaviour you want to encourage and what measurable outcomes you want to achieve – and follow through with clear, consistent communication to help participants understand exactly what's expected of them to achieve their incentive targets.