Blog Article

When executive incentives go bad

Posted by Carl Sjostrom

Carl Sjostrom

For me, arguing against a link between executive pay and performance is like arguing against motherhood and apple pie. After all, you hire an executive to perform for your business – so why not pay them for how well they do that?

The problem is that there’s no single, agreed definition of ‘performance’; it’s in the eye of the beholder. So while to a commuter, performance means affordable, punctual trains, to the Board it might mean cutting costs for bigger shareholder returns.

Where companies go wrong is that they fail to either set the right target(s), or to convince the world why prioritising costs over other factors, like customer satisfaction, is the right thing for the business. And people end up thinking that bonuses reward failure.

Take the recent news that bosses at Network Rail in the UK will be able to collect bonuses if they hit their targets this year, which met with cries of outrage from customers whose fares have gone up 16% since 2010. The Swedes, Danes and Norwegians had a similar reaction to the news that airline bosses at SAS would get bonuses after laying off 800 staff – and shareholders at Air France KLM voted against a €400,000 pay-off for a departing CEO. Surely, people said, somebody must have noticed late departures and other service issues; surely lowering costs shouldn’t mean raising pay?

Here’s how companies can get paying for performance wrong – and how to prevent it.

Incentives can go ‘bad’ when companies…

  • don’t define the purpose of the incentive. Sometimes, they have bonuses simply because the Board thinks that not having them would make them uncompetitive.
  • aren’t sure why they measure what they measure. Do their metrics incentivize performance and behavior that’s in line with the corporate strategy, or do they even work against it? Classic examples are companies that have a strategy to increase market share, but give management short-term cost-cutting and profitability targets, which remove the oxygen needed for growth.
  • measure what’s easy to measure, rather than the performance they need to survive or succeed in the long term. Often companies revert to measuring the ultimate outcomes of implementing a strategy, rather than process itself. But that focuses on what executives achieve, not how they do it – and the ‘how’ might be way out of line with the strategy. (A number of financial services companies are considering this in the wake of the credit crisis.)
  • don’t explain why they’ve set the targets that they have. This can mean that people either don’t understand what the company’s trying to achieve (and the incentives it’s using to get there), or they disagree with it. The result? Customers vote with their feet, investors withdraw their funds and regulators impose ever more regulation.

Three ways to avoid these pitfalls

  1. Choose measures that encourage the right behaviors as well as the right outcomes. If, for example, there’s a risk of cannibalization between business units (one unit stealing customers from the other, rather than from the competition), the company may need to counteract profit targets with metrics like product weighting or collaboration targets. And short-term, market-driven financial targets may need long-term, strategic targets to counter short-sightedness.
  2. Take everyone’s perspective into account. Corporate reputation is very important, particularly in service industries. So it’s just as critical to take into account how any executive incentives you bring in will land with your customers and investors as it is to consider technical aspects, like implementation, costs and bottom line performance.
  3. Make sure your targets reflect the culture of the organization. If, for example, a company is successful due to its team-based, collaborative way of working, bringing in an incentive that encourages individuals to compete can have immediate impact on how the business performs.

It all comes back to what you’re paying for and why. To implement a successful reward program, you need a firm grasp on what the company believes in, what success means and how its pay policy will help it to get there.

 

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