The performance-pay conundrum
Pay for performance. Though this phrase is now a command for managers, Rupert Merson argues that it’s often hard to determine what true performance is — and how to pay for it.
“If you cannot measure it, you cannot manage it.” Though a cliché, switch this around and we have a recipe for perfect management: make sure you have the right measurement tools and you can manage anything. This is true for managing a corporation or for managing a small company.
Yet, matching real measurement with effective management is often an elusive goal. The more we wrestle with our businesses, the more we seek to perfect the indicators that tell us how our businesses are performing. And the more we try to deduce actionable conclusions from them, the more it becomes evident that much of what really matters within the business continues to escape our attention, despite the increasingly sophisticated measurement tools at our disposal. Businesses are always far too complicated to be reduced to the easily measurable.
One of the most common, and increasingly controversial, manifestations of a connection between measurement and management is performance-related remuneration. Unfortunately, the mechanics of connecting pay to performance are difficult to establish effectively. If you want individuals to be influenced by their remuneration, then you have to avoid making their incentive packages too complicated.
The fact is that most senior team members’ roles are complicated, and the individuals who hold them are responsible for dozens of variables, many of which sit uncomfortably with each other. To connect remuneration to all aspects of such an individual’s performance is an impossible task. To connect remuneration to just a selection of the most important of an individual’s deliverables is to invite dysfunctional behaviour, as staff will be encouraged to focus on those aspects of their roles that will increase their incomes at the expense of those that do not. For any senior role, therefore, it can be difficult to develop individually tailored performance targets.
This takes us right into the heart of corporate governance, of course: if what you really want is to align managers’ interests with the interests of their businesses, it’s critical to be sure they are rewarded when these businesses do well. But determining when a business does well can, in itself, be difficult. Determining profit is an art, not a matter of fact. Seemingly healthy profits one year might be bought at the cost of the long-term health of the company.
Paying for performance
Nonetheless, if you are looking to recruit or reward knowledge or experience, you should be prepared to pay for it. Equity is now an expected component of the package of a senior member of any business, but equity as remuneration is better in theory than it is in practice. Giving and receiving shares in a private company has its own complications. To be given equity inevitably begs questions about when those shares might be sold and in what circumstances. A new member of the management team with equity is thus likely to have half an eye on a financial strategy that will enable him to realise his investment — which might have very little to do with the interests, long or short term, of the other shareholders.
In recent years, executives have received options over equity as an important component of their remuneration packages. For many businesses thinking about equity as an incentive, share options can look like another way of having your cake and eating it. Assuming options are granted at least at current business value, an option will only become a share if the business increases in value. Option schemes are inherently complicated and expensive to establish. Also, because the individual probably will not have to give much (if anything) for them at the outset, it is easy to see option schemes as all gain and no pain, and therefore not so great a motivation as might at first appear. Additionally, as with equity, options are only meaningful if the holder can at least imagine a time when they are realisable.
But the real truth about options is that neither companies giving them, nor shareholders receiving them, have really thought of them as aligning the interests of shareholders and management. When options sink “under water” (that is, the price of the shares subject to the option declines in value to a position at which it would be cheaper to buy the shares on the market rather than via the option), some companies have been only too quick to re-price the options using the lower share price as a reference point, arguing that managers still need an “incentive” even though their performance to date has only resulted in the share price declining. Actions of this sort on the part of companies demonstrate that, for many, an option is really a deferred performance-related bonus masquerading as a mechanism for aligning managers with shareholders. As with most fudges, it often achieves neither objective.
Intractable problems?
If a manager’s performance does not warrant a bonus, the manager should not receive a bonus and should be disappointed. That a company believes it needs to give bonuses despite poor performance suggests that base pay is wrong and options are being used as an excuse for not paying properly to start with, that remuneration is connected to the wrong measure of performance, or that the reward has nothing to do with performance in the first place. Re-pricing options has the effect, therefore, of alienating managers from shareholders, not aligning them.
Management thinker Alfie Kohn (Punished by Rewards, Houghton Mifflin, 2003) argues that performance-based reward ultimately acts as a disincentive. The concept operates all right in the short term; but, in the long term, performance-based reward just does not work. Kohn even argues that performance-based reward discourages risk taking: individuals will do what they need to do to get the reward, and then no more. Quality champion W.E. Deming is more fulsome when he says that “… [the system by which merit is appraised and rewarded is] … the most powerful inhibitor to quality and productivity in the Western world … [It] nourishes short-term performance, annihilates long-term planning, builds fear, demolishes teamwork, nourishes rivalry and … leaves people bitter.”
Remuneration continues, therefore, to be an intractable problem for those responsible for governance frameworks inside and outside organisations. These individuals should at least:
- Appreciate the complex nature of the problem they are dealing with
- Recognise and protect their companies and their stakeholders from the consequences of an over-powerful director and her influence on her own remuneration
- Recognise how reward for achievement is different from incentive for performance not yet delivered, and
- Appreciate how, at a level that differs from individual to individual, incentive turns into greed, something that is quite different and in nobody’s interests
No small matter
Establishing the right remuneration levels in a small business brings challenges all their own. The first finance director in a business, the recruitment of whom marks a key stage in the evolution of governance in a growing business, can seem particularly expensive. That person is quite likely to be the highest-paid employee in a young business — but as one venture capitalist put it: “I always tell companies we’re looking to invest in that a quality finance director will more than pay for himself within a year.” Many businesses without a decent finance director will argue that they cannot afford one and will leave the recruitment of a finance director until it’s too late — when the control of the most important governance element in the business is in the hands of someone who is unqualified and unable to add serious value.
Not surprisingly, many founders of new businesses look for ways of structuring a remuneration package that allows the business to keep the cake while giving the candidate the illusion of eating it. Giving options, or equity, is often seen as a route to making them very rich if they happen to work for major listed companies. In smaller businesses, as noted before, it is more likely to be an excuse for not paying them properly in the first place. It can be easily forgotten that performance management is not just a matter of remuneration.
Appraisal, assessment, training and development should be key components of any governance framework, as should forms of non-financial recognition such as title, promotion, status and authority. These are no longer “fringe benefits”; in a rapidly changing world, they are live issues. The costs of not taking them seriously far outweigh the time and financial costs required to invest in them properly. They are all forms of pay, and they affect performance.
Rupert Merson (rmerson@london.edu) is a Teaching Fellow in Strategic and International Management and Entrepreneurship at London Business School. He is the author of Rules Are Not Enough: The Art of Governance in the Real World (Profile Business, 2010).