Let's Pay for Performance … But How?
In spite of its naysayers, pay for performance still makes sense to most of us, according to those responding to this month's column. But there is a difference of opinion of about when and how it works and how it should be structured.
Not everybody agrees, of course. Comparing the simplicity of (especially short-term) responses to the complexity of the pay-for-performance challenge, Ravindra Edirisoorlya went so far as to say that "Current P4P model(s) may lead to another economic bubble and another strong market correction." Phil Clark went even further, commenting that "When you try to institutionalize pay-for-performance you actually ruin the concept." (In fact, there is some evidence that performance pay that is not institutionalized may often be more effective than award systems that are institutionalized.) Helmut Hildebrandt, calling pay for performance "a huge waste of time," said "I think a different logic applies if it (is) used to emphasize team spirit."
Others were supportive of the concept if the proper performance measures could be found. As Jill Machol put it, "There is nothing inherently wrong with pay for performance, only in the way that specific plans have been designed and implemented." Mathews Daniel Kapito helped frame the challenge. As he put it, "People are different… pay linked to performance will only motivate to specific (and presumably individualized) levels." Peter Lee added "The real issue is what you consider to be performance… Performance is all about quality-quality of effort as well as results."
Gerald Nanninga suggested that "let's solve the problem by using non-financial measures." Joseph Violette backed that up with a comparison of two different systems under which he worked, preferring pay for performance "based on my direct impact on profit, relationship with my client, project team performance and development of individual members of my team …"
Joe Schmid commented that "Delinking compensation from financial performance is not an answer. At issue is the short-term/long-term balance of stockholder interests." Srinivasan suggested that a program should contain both. Phillip Gelman added, "If managers were assured that their obs (?) were secure for several years, it might be possible for them to take the long- and proper-view."
Yadeed Lobo articulated the problem faced by corporate boards when he commented that "it is very difficult for board members … to judge relative performance…(it also) involves measuring… (such things as) professional resolve and personal humility." This all suggests that the ideal pay for performance approach should take into account such things as short- and long-term performance, specific individual motivators, effort as well as results, and the context in which performance is being measured. Now put that into the hands of a compensation committee that meets perhaps 10 times a year, and what is the likelihood they'll get it right? We say we should pay for performance, but how? What do you think?
Pay for performance sounds right. It aligns managers and investors. It has been the gold standard for compensation at least since proponents of agency theory 25 years ago began advocating the use of stock options in compensation packages. Its use is a source of praise in the evaluation of governance by rating agencies that provide guidance to shareholders in proxy voting.
As a result, pay for performance is almost universally employed in the US and increasingly elsewhere, even though the forms it takes ebb and flow. But now questions are being raised about whether pay for performance at its core is fatally flawed or at least misused.
Mihir Desai, the Mizuho Financial Group Professor of Finance at Harvard Business School, has written recently decrying the practice of tying executive compensation to a company's stock price. He equates P4P to "outsourcing" the appraisal of management to compensation committees—a practice that encourages managers to act for near-term success of the business. This pleases investors who have a short-term interest, at the expense of the long-term performance of the company.
One way to address this issue would be to remove the irrationality of the markets (itself a controversial topic) from the calculation of compensation by linking performance-based pay to numbers such as operating profit. This does not mitigate the argument against short-term incentives. Nor does it address the tendency of compensation committees to rely on numbers rather than judgment. Going even further, perhaps nonfinancial measures, such as those related to product quality, customer perceptions of service quality, or success in developing talent, should be injected in some way into the calculation.
Regardless of the solution favored, Daniel Pink reminds us that all of these practices run counter to a great deal of research questioning the value of extrinsic (monetary) incentives in influencing desired effort, especially if they are routinely expected and aimed at managers who may be relatively insensitive to added monetary awards.
Any effort to inject long-term thinking into pay for performance requires some amount of judgment on the part of those responsible for compensation. For example, awards can be made subject to performance, however it is measured, over longer periods of time. But what is the right length of time? How much of the total compensation should it involve? How is it explained clearly to managers who are not financially oriented? Longer-term incentives involve delays in compensation that may make a job much less attractive to managers with shorter-term needs or interests. On the other hand, it may serve as a way of sorting out managers with a longer-term view of the job.
What we can conclude from the discussion is that no single approach to paying for performance fits every organization. But the discussion suggests several pertinent questions:
Should pay for performance be decoupled from company valuation? Should more judgment on the part of compensation committees be required in determining performance pay? Or does this introduce new potential problems to the process? Can the effectiveness of pay for performance be improved by extending payout periods or determining performance on non-financial criteria? Or should reliance on pay for performance be reduced in the total compensation package?
Is "pay for performance" losing its allure? What do you think?
To Read More:
Mihir Desai, The Incentive Bubble, Harvard Business Review, March, 2012.
Mihir Desai, Compensation Practices and Incentives, Harvard Magazine, September-October 2012.
Daniel H. Pink, Drive: The Surprising Truth About What Motivates Us (New York: Penguin Riverhead Books, 2009).