How Should Pay Be Linked to Performance?
Online forum now CLOSED. Professor Jim Heskett sums up 98 reader responses from around the world. As he concludes, is there another subject as important as this one about which we assume so much and know so little?
Pay for performance: Why do we assume so much and know so little? Pay for performance is an important element of good management, judging from responses to this month's column. The question of what kind of pay for what kind of performance, however, becomes much more complex, suggesting a practice in need of further examination. Taken to an extreme, it leads to a conclusion such as that of Renat Nadyukov: "Sometimes we forget why we pay people." Sivaram Parameswaran concurs, saying, "in the compulsion to stay on par with other players, we lose track of real value and performance."
Generally speaking, respondents favored schemes designed to reward long-term as well as short-term performance, encourage retention, recognize special needs of an organization, be based on the achievement of both financial and non-financial objectives, and in general create value for shareholders. However, there is a sense, expressed by John Ippolito, that there is a lack of perception in boards of directors of "what constitutes 'creating value' in the enterprise … many boards are too ready to turn over the keys to the incoming CEO—then watch the stock price to see if he or she did a good job."
Ashok Malhotra favors "reasonable incentives for short-term performance" and "higher incentives for long-term performance." The rationale, as Mark Evans explains, is that "a CEO must develop and implement strategies that provide long-term sustainable outcomes to the benefit of shareholders." However, Gary Johnson cautions that "Because excitement is so critical to success, pay for performance value can be diminished the longer the time delay for receiving performance pay."
Xu Jian comments that "competitors hire (our employees for their) competence. So beyond paying for (their) performance, why don't we think more about (paying to retain them) for (their) competence?" Pallavi Marathe concurs, saying that "Salary and retention are interlinked these days … (the latter) is also of utmost importance." Jim Chorn asks, "Do you give (mid-range managers) larger incentives in the hope of retaining them?"
Special needs sometimes dictate pay in relation to expected performance. Veronica Serrano suggests that this occurs when "extraordinary performance or major business change is required." Whether this is the case or not, several voiced the need to link pay to both financial and non-financial performance measures. As Ellis Baxter put it, "… sanity is paying for what you want to have done…." Karla Ortega commented that "… a well-structured compensation plan communicates corporate objectives to your employees…."
The perverse effects of pay for performance were also targeted. Sylvia Lee pointed out that "we want knowledge sharing but reward knowledge hoarding." In commenting on executive pay, CEO Nari Kannan noted that CEOs seek "less loss on the downside, more gains on the upside. The company's goals are the (opposite)." Claude Des Rosiers warned that "There are enough challenges to get people in an organization to work together (without compounding the problem by paying for individual performance)."
Ira Kay and Steven Van Putten report, based on extensive data, that they have found a correlation between executive pay and long-term total returns to shareholders. But CEO pay increased substantially even in low-performing firms in their study. Their book represents a useful effort to shed light on the issue. But is there another subject as important as this one about which we assume so much and know so little? How do you explain this? What do you think?
To read more:
Ira T. Kay and Steven Van Putten, Myths and Realities of Executive Pay (Cambridge University Press, due out summer 2007).
Two news items caught my eye recently. The first was the report from the Home Depot annual meeting contrasting this year's investor-friendlier tone set by the company's new CEO, Frank Blake, with last year's, led by then-CEO Robert Nardelli. It's hard to tell how much of the investor-friendlier tone was created by the fact that Blake is earning about 70 percent less in base pay than Nardelli, totally aside from the fact that the latter also took home a nine-figure package in incentives. Home Depot's stock has had lackluster performance under both CEOs. But there are those who say that Nardelli's task of leading a transition from a highly decentralized, founder-led organization to one more reliant on shared services and central direction was enormous and that he was making good progress. How much is that worth?
The second item was a report of the decision by Moody's Investors Service to begin taking into account the spread in pay packages between the top two executives in the organizations whose bonds it rates. Presumably, the larger the spread, the lower the bond rating, reflecting the higher implied risk associated with a large spread. As Mark Watson from Moody's put it, "We are rating the company, not the person. A bus might come by and knock the (top) person over."
There are several assumptions implicit in these two items. First, there are limits within which pay can elicit performance. Above a certain amount of incentive, does pay provide an incentive for or even influence performance? The Moody's decision might suggest the assumption that pay reflects value to an organization, and possibly also potential performance. In other words, one's pay in relation to the leader reflects one's value (or even likelihood of being promoted) if the leader were to get hit by a bus today. A third assumption is that good leaders are very hard to find and are worth every penny they are paid, regardless of structural imperfections in the ways that compensation packages are negotiated and determined.
There are a number of reasons why pay may not reflect performance. First, many of the larger pay packages are negotiated by those being hired from outside the organization. Most often, an outside hire is prompted by poor performance by insiders. So in a sense, the bargaining power of the outsider is increased, regardless of the performance that may be delivered later. It is one of several reasons for the careful planning of executive succession. Further, many pay packages are determined on the basis of what others in comparable jobs, regardless of performance, are being paid. This creates a natural disconnect between pay and performance. Third, current pay often reflects past performance, not current or expected performance.
And to what extent does substantial pay for performance elicit short-term decision making that can even exacerbate management turnover? Does it encourage playing the "roller coaster" earnings game, in which executives in an organization can make enormous performance-based incentives in the odd years and none in the even years (ironically, when the large performance-based pay is reported to the public), thus netting a substantial performance bonus while producing little long-term benefits for owners? Is it even fair to ask those lower in the organization, who may be less able to afford it, to put part of their pay package on the line?
If pay is linked to performance, should it be to past, present, or expected performance? Or should pay be linked more closely to past, present, or expected value to the organization? Or are these differences academic? Do cross-company comparisons confuse the matter even further? Just how should pay be linked to performance? What do you think?