We discuss how to successfully incorporate them into your remuneration framework without being criticised for being too soft.

 

Financial or earnings measures from the basis of most performance-based remuneration. However, it is rational to balance “what” has been achieved financially, with “how” it was achieved and whether or not it can be sustained in the future. Drastic cuts to expenditure and investment can increase earnings in the short-term, but compromise them in the long-term. Non-financial measures can provide balance to the overall performance measurement process.

 

There are various ways to group these metrics, but we have allocated them into five broad measurement categories:

• Productivity/Efficiency & Quality
• Risk Management
• People & Culture
• Customer Focus
• Growth & Innovation

 

The metrics used to measure performance in each category will vary depending on the industry and the current company strategy. Sample metrics for each category are shown below.

 

Productivity/efficiency metrics could include:

• Production level per FTE
• Waste/defect/error rates
• Production cycle time

 

Risk management metrics could include:

• Safety – injury rates
• Reputational damage
• Sustainability and environmental impact

People & culture metrics could include:

• Employee engagement outcomes
• Voluntary turnover rates, particularly for high potential employees
• Time to fill

Customer focus metrics could include:

• Customer satisfaction, preferably with external benchmarks
• Net promoter score
• Internet/social media feedback

 

Growth & innovation metrics could include:

• Market share
• Products per customer
• Percentage of revenue from new products

 

Non-financial metrics have been successfully used for decades as part of a balanced scorecard approach to calculating short-term incentives. Many of the sample metrics above will be very familiar. Other commonplace measures include development and commercialisation milestones, used by exploration, technology and biotech companies.

 

Successfully incorporating non-financial metrics in LTIs has been more elusive. Only one S&P/ASX 50 company has used a scorecard LTI, with multiple measures over multiple financial years, without an investor backlash, although others have tried, like the Commonwealth Bank of Australia (CBA) and Newcrest Mining (NCM).

 

Newcrest received a 45% “no” vote in 2014 after advising investors of the intention to introduce a strategic scorecard for a proportion of the FY15 LTI. Very little detail was provided in relation to how measures including organisational health, diversity and growth were going to be assessed. In 2015 Newcrest provided investors with specific metrics and hurdles for most of the scorecard metrics and the “no” vote reduced to 2%. Despite this, the scorecard has now been removed in favour of relative TSR. No doubt there were other irritants in 2014, such as the 2013 removal of STI deferral, but the lack of clear disclosure of how performance was going to be assessed is problematic for investors, regardless of the metric.

 

The CBA experience is not dissimilar.

 

The lesson from Newcrest and CBA is the importance of full disclosure. Our design and communication check list includes:

• Why were the individual measures and metrics chosen?
• How will the metrics underpin the strategy and/or contribute to future earnings?
• What are the hurdles and will they require regular calibration?
• How does the performance for each measure or metric link to remuneration outcomes?

 

For example, a mining company might include one or more safety metrics to:

• Ensure that safety requirements are given a high priority within the company to reflect established core values
• Reduce productivity losses due to injuries
• Improve LTIFR per million hours worked relative to industry benchmarks
• Reduce the available incentive if the LTIFR exceeds benchmark levels

 

There are several alternatives methods of linking scorecard performance to remuneration outcomes. Some measures, such as productivity and growth may lend themselves to a direct link with an established portion of an incentive award. For example, assuming that 40% of a technology company’s award is based on financial outcomes, then a further 20% may be based on growth in market share, 20% on employee retention and engagement and 20% on innovation.

 

Risk management and people & culture measurements may be more appropriately applied as modifiers. This means that a payment which has been determined based on financial and other scorecard measures, is modified up and/or down, depending on the modifier outcomes. Safety measures that apply a meaningful reduction in the award for failing to meet established standards, send a strong message to managers. The message to all stakeholders is that, while earnings growth is important, we will not sacrifice the safety of our employees and contractors to achieve it.

 

While reductions in awards may appear to be punitive, they align well with the concept of malus or clawback. Multiple modifiers can be used that ensure improvements in performance are real and not at the expense of effective risk management, or employee engagement, or customer service.

 

As with all performance measurement systems consideration should be given to the risks, including:

• Inadequate measurement or tracking systems and processes
• The timing of measurement
• Unintended consequences such as underreporting of poor outcomes to minimise the impact on remuneration

 

There is no reason that non-financial measures that are aligned with strategy, well defined, with quantitative metrics, should be relegated to short-term incentives. They can form part of an effective long-term reward framework – just don’t call them soft.

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