Professor of Finance; Academic Director, Centre for Corporate Governance (CCC)
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This is the reasoning behind performance-based pay: encourage executives to go above and beyond. Incentive-based pay has been blasted since the global financial crisis. A recent article by Dan Cable and Freek Vermeulen of London Business School rounded up a lot of the damning research nicely. But, none of this research is actually on CEOs. The CEO’s job is critically different from rank-and-file employees. It is important to take these differences into account and not extrapolate from results derived out of context.
Offering reward for performance could, admittedly, result in a ‘teaching the test’ mentality, not unlike paying teachers according to their students’ exam grades. For example, if an executive is paid based on company profits for the year, he or she is likely to focus solely on bringing about short-term profit, perhaps ignoring longer-term goals, like staff engagement. If performance is to be measured, it needs to be measured holistically.
For many jobs this is impossible, but for executives there’s a perfect ready-made barometer: the long-run stock price. In the long run, every executive decision will eventually show up in the stock price. The stock price captures not just current profits, but expected future profits, growth opportunities, balance sheet strength, corporate culture, customer satisfaction, relations with stakeholders, and so on. For example, my research has shown that even something as intangible as treating workers fairly is eventually reflected in the stock price. For example, the 100 Best Companies to Work For in America beat their competitors’ stock returns by 2 to 3% every year.
Of course, the key words are ‘in the long run’, so we should pay the CEO according to the long-run stock price. And that’s a second difference between executives and other workers. While regular employees cannot afford to wait several years before their bonus is decided, executives’ base salaries are already so high that they can.
We mustn’t forget the other face of the incentive-based pay coin: punishment for poor performance. People often imagine fat-cat CEOs raking in piles of cash year after year, but that’s what happens when salaries are fixed. An executive under that pay system is essentially getting away with doing a bad job while shareholders get penalised for his or her mistakes. Cable and Vermeulen argue that most executives are motivated by their own natural ambition. Research proves them wrong: firms that give CEOs high-equity incentives do better than those that give low-equity incentives by 4 to 10% a year, according to the Journal of Finance, and further tests suggest that incentives cause superior performance.
If you’re a board member of a FTSE 100 company, would you choose a new CEO who is willing to tackle difficult challenges, explore new territory and reorganise old systems, or one who is happier to rely on a reliable, yet tired approach? Offering a pay package that remains much the same despite your performance will get the attention of plodders who are scared of innovation. For example, Google was already very successful and could have settled for the status quo, but incentive pay spurred the executives on further and they restructured into Alphabet, unlocking even more value. In one study, incentive-based pay not only motivated the current employees of a company, but caused plodders to leave and be replaced by more motivated employees. Overall performance rose by 44%.
But rewards are so much more than simply reward. They stand for an organisation’s values. If you pay the CEO the same, regardless of his or her performance, you send a signal that performance does not matter. If, instead, the CEO will be punished for poor performance and rewarded only for long-run, sustainably good performance, this sends a positive signal to employees, customers, suppliers, and the wider world.
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