The other side of the argument: Performance-based pay does work

Performance-based pay has come under fire since the global financial crisis.

An example is the work by Dan Cable and Freek Vermeulen of London Business School summarised HERE.

Guerdon Associates readily acknowledge that many incentive frameworks fail. But incentives can work well if some basic guidelines are followed (for example, see HERE) .

By saying performance incentives do not work the Cable and Vermeulin paper ignores the sheer weight of history in executive reward. Executive incentive pay has been around for millennia, despite what you may hear from various commentators that it is a recent phenomenon. Performance pay provided the incentive to be faster, more innovative, and more agile for heroes of history who were, in effect, just executives. Centurions received extra pay for success in conquering the Roman Empire’s many enemies. Readers of Julius Caesar’s “Commentaries” will be familiar with how his legions’  innovative engineering works contributed to their success, while the chief engineer on his campaigns came home to be one the richest men in Rome. Sir Francis Drake’s pay as a privateer was entirely on a commission basis, agreed with the schemes’ equity holders who included the first Queen Elizabeth. He and fellow privateers inspired smaller, faster and more agile ships that out manoeuvred Spanish galleons, while their innovative armaments were more rapid firing. Marc Brunel’s great engineering feats in tunnel, railway and ship design and construction were achieved with handsome bonus payments to himself and his project managers that, in today’s money, were the equivalent of millions of dollars. In the 20th century incentive plans became a standard component of remuneration as the revered Peter Drucker advocated pay-for-performance in his famous management-by-objectives mantra.

Cable and Vermeulen would argue that “executive incentives” are different. They say that “large bonuses and share options have been held responsible for overly risky behavior and short-term strategies”, in effect causing the GFC. However, incentive pay did not cause the GFC (see HERE and HERE).

In addition, pointing the finger at option grants fails to take into account other factors present (see HERE).

Cable and Vermeulen present evidence that performance measures often only capture one element of a worker’s job, and may have a distorting effect on their work. For example, paying teachers according to student test scores may induce them to “teach to the test.” Company boards as well as external stakeholders are recognising this, tying performance pay across multiple factors.

Alternatively, financial incentives may work best in roles where there is a comprehensive performance measure that appropriately weights all the different dimensions.

There is just such a measure for executives, when you get down to it – the long-run total shareholder return. In the long run, executive decisions will be reflected in the share price and dividends. The share 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, weighting them by their relative importance for company value.

Although critics, including some proxy advisers, have often called share price or absolute TSR reductive, research shows it is a more comprehensive reflection of all factors that may contribute to company performance.

Cable and Vermeulen argue that executives may “cook the books” in the short-run if they are measured on some metrics, but the effects of such transgressions will be reflected in the share price and TSR in the long-run. G20 countries have recognised this by regulating that banker pay (at least) be partly deferred into equity.

In contrast, doing away with incentives would cost the CEO nothing, if the incentives are swapped for a guaranteed fixed salary. What many observers do not fully recognise is that incentive structures mean poor performance is punished. A CEO’s total potential remuneration is reduced when they do not meet the targets.

A CEO with a fixed salary and no variable pay, would not have total remuneration reduced when shareholders are suffering (particularly if performance is not bad enough to lead to firing).

Executive pay is already moving the mix to reward longer-term performance (see HERE).

A Journal of Finance paper (see HERE) found companies that provide CEOs with high long-term equity incentives outperform those with low equity incentives by 4-10% per year. Moreover, the outperformance is over the long-term.

Cable and Vermuelen argue that executives are intrinsically motivated, and that extrinsic motivators like performance-based pay will only crowd out these intrinsic motivators. It is difficult to support such a broad statement. Evidence suggests that executives without incentives may simply pursue the “quiet life” and allow the status quo to persist, avoiding hard tasks like major reorganizations, hard negotiations, understanding or getting on top of the disruptive economy or unpopular decisions. Indeed, a Journal of Political Economy paper (see HERE ) showed that CEOs with few incentives (in this case, due to takeover protection) did fail to close down old plants or create new plants – they just coasted, and productivity and profitability suffered.

As much as many directors and other stakeholders may hope, the weight of evidence, and indeed, human history, is that incentives do have an impact on behaviour. And, if the incentives are tied to valid performance measures, delivering them in equity will contribute to enhanced long-term growth in TSR.

© Guerdon Associates 2024
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