The Problem with Pay for Performance

How Not to Argue for Bonuses. Reprinted with permission from PIRC Alerts, 17 July 2012. PIRC is the UK’s leading independent research and advisory consultancy providing services to institutional investors on corporate governance and corporate social responsibility.

Regular PIRC Alerts readers will be aware of our scepticism about the motivational value of performance-related pay. As such, we’re always interested when the use of performance pay is justified.

For example, in an interview with the FT last week, departing Network Rail chair Rick Haythornthwaite sought to defend the organisation’s use of performance-related pay. This comes after Network Rail bosses were caught in the crossfire about awards at RBS, and agreed to waive theirs. However, in seeking to defend the use of performance-related awards, Haythornthwaite reveals the confused thinking that lies behind them.

First, he argues that a greater emphasis on performance-related rewards means lower fixed costs (in terms of senior staff remuneration). But he goes on to state that salary is paid for by delivering “success” with performance-related rewards only made for “exceptional success.” In theory this would suggest that in most years only a salary is paid since “exceptional” success is, by definition, not a regular occurrence. If this characterisation were accurate, one would expect to see fixed pay continue to constitute the bulk of executive reward, with occasional extra reward when truly merited. In other words, the effect on “fixed costs” would be rather limited.

If, on the other hand, an organisation is regularly paying out bonuses for “exceptional success” this might suggest that their definition of “exceptional” is rather limited. Arguably the behaviours they are rewarding with bonuses should instead be covered by salary.

In addition, if an organisation really is concerned by “fixed costs” in terms of the remuneration of directors, this suggests that executive reward is a considerable outgoing. This argument might have a bit of merit in a bank, but is it really true in the rail network? To us it sounds like an argument taken from another sector, where the context is different.

In fact, his most telling comments relate to the need to attract talent from the private sector. At a senior level in PLCs it is normal for there to be a huge focus on variable pay. But, in our view, the explosion in performance-related reward (both as a proportion of the typical package, and in absolute value) has served to legitimise the redistribution of capital from owners to managers. If rewards were based on a simpler model of base pay and limited incentives then shareholders would see this more clearly. Instead, they are typically drawn into the detail of performance linkage, and as such miss the wood for the trees.

The reality, perhaps hinted at, is that if organisations like Network Rail want to attract private sector talent then they need to have large incentive schemes primarily because this boosts the overall package. Everyone expects the schemes to pay out regularly, so the typical annual package is well above the base salary, but it can also be claimed that only success is being rewarded.

Perhaps we are getting closer to the point when it becomes clear what the main function of performance-related reward is for companies. It is not that such schemes incentivise executives, or that that they achieve alignment with shareholder interests, or that they reduce “fixed costs” in top pay. Rather, it is that it makes large increases in executive reward more palatable to shareholders and policymakers. A truly radical approach to executive pay reform needs to abandon the repeated attempts to recalibrate incentive schemes and instead focus on simplification – with much less emphasis on performance-related rewards.

The U.S. made a huge mistake in the early 1990s when we passed legislation that permitted companies to write off executive compensation amounts of more than $1 million only if executives hit specified performance goals. For many, $1 million became the baseline and incentives focused too much attention on the next quarter’s share price.

Last month, it was announced that Britain give shareowners a “say on pay” with teeth. Will it calm public anger or reduce the acceleration of soaring executive earnings?

In Killing Conscience: The Unintended Behavioral Consequences of ‘Pay for Performance,’ (video link) Lynn Stout offers explain’s why revisions to the Internal Revenue Code (Section 162(m)) didn’t work and why the new legislation in Britain may not either:

First, incentive schemes frame social context in a fashion that encourages people to conclude purely selfish behavior is both appropriate and expected. As a result, pay-for-performance rules “crowd out” concern for others’ welfare and for ethical rules, making the assumption of selfish opportunism a self-fulfilling prophecy.

Second, the possibility of reaping large personal rewards from incentive schemes tempts people to cut ethical and legal corners, and for a variety of reasons, once an individual succumbs to temptation, future lapses become more likely. The result can be a downward spiral into opportunistic and unlawful behavior.

Third, industries and firms that emphasize incentive pay tend to attract individuals who, even if they are not psychopathic, nevertheless are more inclined to selfish behavior than the average.

According to Stout (Can Say On Pay Increase Social Responsibility?, Forbes, 7/3/2012):

Firms that can attract conscientious rather than purely self-interested employees – teachers who want students to learn, doctors who want to help patients, CEOs who want to leave a legacy rather than simply take as much money as possible – have an advantage. Behaviroal science suggests that for many tasks, emphasizing nonmaterial rewards – greater job responsibilities, a better parking space, an ‘Employee of the Month’ plaque – may work as well or better than emphasizing material rewards like cash bonuses or stock options.

Prosocial behavior is triggered by:

  1. Instructions from in-group authority
  2. The prosocial behavior of others
  3. The magnitude of benefits

Marcia Narine argues that applying Stout’s thinking to executive pay would cause compensation committees to ask questions such as the following (Does a Corporation Have a Conscience and Can It Tempt Ethical People to Do Bad Things?, The Conglomerate, 12/14/2011):

Does the company’s messaging tell employees that it doesn’t care about ethics? Is it rewarding other people to act in the same way? And is it signaling that there is nothing wrong with unethical behavior or that there are no victims?

Such action needs to be reinforced by the demands of shareowners. In 1994 there was a 3rd Restatement of Trust Law drafted by the National Conference of Commissioners on Uniform State Laws. This is basically the current standard fiduciaries should be following. Section 2 is the heart of it, setting out the Standard of Care; Portfolio Strategy; Risk and Return Objectives. Subdivision (c) sets out a list of usual considerations, such as economic conditions, tax consequences, expected total return, needs for liquidity, etc. The interesting consideration is that in subdivision (c)(8):

an asset’s special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries

We need to draw this provision to the attention of our funds and their beneficiaries and we need to extend the concept to mutual funds. What “special value” does any specific investment have to one or more of the beneficiaries? We’re not just looking at money, not just the fund itself, but other benefits that fiduciaries are obligated to consider and to provide.

These could be clean air, clean water, inexpensive living quarters, healthy food, efficient public transportation, convenient places to exercise, continuing education, a healthy local economy to grow old in, a reversal of global climate change, etc. Such values must be incorporated into the standards applied by investors so that they can in turn be reflected in the values of corporations.

I’ll end this post with another quote from shareowners in the UK. This from a recent newsletter of ShareSoc:

The key arguments against large bonuses are that 1) they are demonstrably ineffective at improving the performance of executives or their companies based on academic research; 2) pay is one of the least effective motivators for any employees so high pay is not a high motivator as any experienced manager will tell you – you simply cannot bribe people to do a job well.

Removing the bonus culture from banks would be one simple step in reforming their overall culture (the other would be separating investment banks from retail/commercial banking operations). Bonuses should revert to what they were once perceived to be. An exgratia payment for exceptional performance from a share of exceptional profits. They should not be paid simply for achieving budgets!

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