Published by Jan De Visch, on 08/02/2010
Say-on-Pay, enhanced pay disclosure, performance-based compensation, and appropriate pay delivery are all key mandate issues facing the Board of Directors around the world. How can we spend so much time on enhancing compensation governance issues when we continue to build upon a questionable link between compensation and accountability?
When the economy bubbled with growth, bankers celebrated annual bonuses as a mark of celebrity, like pop stars and footballers. When it all started to crumble, perverse incentives were found everywhere, and not just for the bankers or hedge fund managers, but throughout different industries.
There are at least four conflicts that emerge from our desire to link remuneration with accountability.
The first conflict is that we tend to value “commission over omission” (Mainelli Giffords, 2009). We want to believe that people made a difference. We over-pay for luck, we under-appreciate preparedness and we under-penalise failure to anticipate. Remuneration committees find it difficult to account for luck.
The second conflict is that we value ” gains over losses”. Remuneration committees are happy to pay out when things are going well. In fact, when things go very well they pay out too much. But when losses occur, they tend to make people suffer too much for both accidents and mistakes. Given that losses are disproportionately penalized, yet serious remuneration only kicks in for positive results, an unintended result is to increase risk-taking. If you get paid well for gains, but get kicked out for small mistakes, you might as well risk a big mistake.
The third conflict is that we value “present over future”. Preparing a company for the future is not as important as good results today. This leads to under-investment. We tend to discount the future at such a rate that we tend to penalize the person who plans for a rainy day if the rainy day does not arrive. We tend to reward the person who does not plan for a rainy day so long as it does not rain or, when it does, everyone else is rained on too. Since returns are directly related to risks, should not exceptional returns be presumed to entail higher risks and, therefore, the payout of incentives be spread over longer periods?
The fourth related conflict is that we value ‘peer group titles’ over ‘real added value’. The goal of providing appropriate performance-based executive compensation means selecting and using the appropriate peer group(s) to begin with. Choosing the most appropriate peer group is imperative, since the design and adjustments in the pay process are typically calibrated and disclosed in terms of the peer group. The issue with most peer groups is that the designers of the peer group (board or external compensation consultant) give limited thought to the real added value of the role holders. Often concrete peer groups are compounded on the basis of their titles, neglecting that the real added value of role holders with similar titles can differ a lot. It is for example assumed that all CEO’s are setting strategic three-year plus goals for management, including a good faith attempt to create profit, free cash flow, and return on invested capital greater than the company’s cost of capital. In reality a lot of CEO’s are focusing on shorter term operational goals. It appears that far too many boards have no grounding in effective accountability design and defensible executive compensation principles and practices (Mark Van Clieaf, 2009).
In the absence of an objective framework for understanding and designing an effective organization structure and executive accountability, many CEOs have defined their own role, accountabilities, and level of authority. Even those few directors with some knowledge of accountability design often fail to use their knowledge. More than one director has told us that they have not established clear three- to five-year accountabilities and performance metrics for their executive team for fear of seeming confrontational. Designing an effective accountability structure and integrating it with executive compensation are the most powerful levers that a board has to protect itself and reward the financial interests of its shareholders.
Methods of accountability measurement – a warning
Methods of accountability require measurement, but evaluation also requires judgement. Measurement can displace judgement. Professor Marilyn Strathern’s statement of Goodhart’s Law is: “When a measure becomes a target, it ceases to be a good measure.” As Goodhart noted, “financial institutions can…easily devise new types of financial assets,” which may slip through the good intentions of the remuneration committee.
One corollary to Goodhart’s Law might be (Mainelli & Giffords, 2009): “When a target is overtaken by time pressures, it turns into a measure of popularity.” There are numerous examples where remuneration committees either cannot or will not take responsibility for agreeing that today’s actions are, or are not, a responsible approach to the future. Performance is evaluated on historical numerical benchmarks rather than taking subjective, future probabilities into account. Instead of evaluating a fund manager on long-term prospects they evaluate on just this year’s performance (tough if he or she has just had a bad year), killing the fund manager’s interest in long-term prospects. Current available measures are more likely to be popularity measures, such as growth of funds under management.
This pursuit of popularity is evident in CEOs seeking to be on the front covers of business magazines, in managers pursuing popular strategies rather than correct ones (no one ever got fired for following the herd), in regulators pushing people to do what others are doing or remuneration committees relying on outside consultants who judge whether management is doing what everyone else is doing. In a financial system where we value commission over omission, losses over gains and present over future, all the while measuring popularity, it is no surprise that we increase risk.
Applying Levels of Work and Levels of Capability to identify excessive compensation
The Levels of Work approach, initially developed by Elliott Jaques, provides a base to develop a fair compensation system. The basic insight is that you can easily distinguish different levels of complexity in work, each creating a specific added value. Once boards step back and define the level of work required at what hierarchical level in the organisation, and thus the related level of accountability, the tasks of determining the strategic time frame for planning and the required roleholders Level of Complexity the role holder needs to be able to deal with, management become much clearer and easier to accomplish. Mark Van Clieaf (2009) argues that you can only answer the question HOW MUCH executive compensation is fair and equitable if you have first answered the question FOR WHAT?
– For what level of work, innovation, and value add in the management structure?
– For what level of performance, risk management and sustained value creation?
– For what strategic performance period that aligns to the business strategy, and the risk horizon and risk appetite of the company?
– For what level of equitable pay differential in the management structure?
Only by addressing these questions can Directors, Management and shareholders determine if executive compensation is fair and equitable or excessive. Yet today our informed estimate is 80 % of boards cannot answer these fundamental questions which impact strategic accountability design, enterprise risk and executive compensation fairness.
An opportunity to fair remuneration
Current accepted approaches to executive compensation benchmarking and analysis (including poor peer groups and pay chasing pay) do not provide the insight we believe Directors require to make defensible pay decisions on compensation fairness – pay decisions that would stand the test of being fair and equitable for ALL stakeholders.
We need a new guiding principle where executive accountability, performance measurement and executive compensation are aligned with both the business strategy and management structure of the organization to create long-term enterprise value. We also need a new guiding principle where differential and value adding work and differential performance justifies differential executive pay.
P.S. Jan De Visch is also the author of the book ‘The Vertical Dimension. Blueprint to Align Business and Talent Development’. It can be ordered on www.biz-plaza.eu/shop
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