Spotlight on pay-for-performance system

You are the chairman of a public company. The CEO has just resigned "to pursue other interests" after a profits warning. Your headhunter thinks the prominent CEO of a successful company in another industry might be available.

However, he wants a basic salary double that of the previous incumbent, plus a bonus, and stock options worth at least twice the basic salary. In addition, he expects a guaranteed severance package if things do not work out.

This sort of remuneration is unheard of in your company and would spell a major change in its reward systems. Should you pursue this possibility, or promote an internal candidate with lesser expectations?

The predicament posed highlights the issues and risks involved in adopting pay-for-performance systems. How can we ensure that even if we are prepared to pay someone abundantly, we will get value for money, and, anyway, what constitutes value for money?

Research in Britain and the US suggests that there is little correlation between performance and chief executives' salaries. A dissection of the pay/performance relationship shows why it is so problematic to match pay and performance. There are five inter-related questions to be answered in applying pay-for-performance. These are: Why? (the performance criteria); How? (how will the criteria be measured?); When? (a short versus a long term perspective); What? (what form of reward); Who? (who decides, on whose behalf?).

On the why question, a key performance criterion centres on shareholder value. Capitalism proposes share price as an anchor indicator for other types of performance measures, especially profitability.

Profitability, in turn, is deemed to result from superior management decisions and practices. If share price is a good proxy for performance, it should be tightly correlated to profitability and management behaviour. Unfortunately, a link-up among these criteria is not apparent.

In the present bull market, even relatively mediocre profitability performers have enjoyed rising share prices. The tenuous link between profit and share price highlights the tendency to speculation and the astronomical price/earnings ratios of some companies. Often, companies are valued, not for their intrinsic value creation, through products and services to customers, but on the fervent hope that they will attract a takeover bid, especially if in a trendy industry, viz., many Internet and biotechnology companies have never posted a profit. Why did the share price of AIB rise so dramatically for a spell some months ago? Why was Telecom so oversubscribed?

An increasingly accepted performance criterion is Economic Value Added (EVA). This measure seeks to assess the intrinsic value created by the company rather than merely its "paper" value. EVA subtracts cost of capital from after tax profit. Cost of capital includes interest paid, dividends, and the cost of equity through capital gains to shareholders.

Stern Stewart are the arbiters of the EVA concept and publish EVA league tables for London-quoted companies. In 1997, of 20 Irish listed companies, eight had negative EVAs. In the same year, 141 of 200 of the largest UK companies had negative EVAs. According to Stern Stewart, shareholders would be better off if these companies were taken over or installed new management.

Performance levels can be affected by environmental circumstances beyond management's control. In a buoyant external environment, a company might seem profitable, but compared to peer companies in the same industry, it could be doing relatively badly. Should the executive team of such relative laggards be rewarded or penalised?

Task allocation among a management team enables some members to outshine others, if they are given high profile jobs that carry large rewards. Sometimes, this results in ingratiation with powerful executives, as individuals jockey for position. This exemplifies how politics, rather than performance, can be a decisive factor in reward systems.

Turning to the how - performance measurement - common wisdom suggests quantifiable objective outcome measures, such as share price, Return on Investment (ROI) or EVA are best used. This simplistic view fails to recognise the complexity of performance. How can it be captured in one figure? Even for repetitive and predictable tasks, people are now expected to initiate ideas - to add some personal value beyond the bare numbers. At senior levels, where complex issues of leadership, vision and strategic direction are involved, how can performance be quantified, much less so by a single number?

How can we be sure that what gets measured is the correct basis for building the company's success. In "On the folly of rewarding A while hoping for B", originally published in the 1975 Academy of Management Journal, Mr Steve Kerr demonstrated that reward systems often remunerate undesirable behaviour while failing to recognise beneficial behaviour. A prevalent example is the espoused desirability of teamwork, while actually measuring and rewarding individual achievement.

The when question falls naturally out of the what and how questions. Are we interested in present performance or are we discounting the present in favour of the future? The time frames should vary between industries - for example the fashion industry versus the pharmaceutical industry. Companies are often accused of denominator management - starving the company of long-term investment to make ROI look good - but executives might be responding to pressure from impatient investors, especially in public companies.

The popular response to the what question - stock options as a form of reward -is an attempt to make executives focus on the longer term. A preoccupation with shareholder value has prompted the conclusion that stock options as a large component of executive compensation align managers' with shareholders' interests. The greater the rise in share price, the greater the compensation to executives. But do aligned interests automatically give executives the capability directly to affect share price anyway?

In Ireland, an Irish Management Institute (IMI) survey indicates that 35 per cent of the respondent companies operated a share incentive scheme in 1998, compared to 30 per cent in 1997. However, many of the companies are not publicly quoted, so share price values would not be based on exaggerated market multiples.

In the present market, rewards by way of stock options can go out of control. Of the total $576 million (£411 million) paid to Disney CEO Michael Eisner in 1998, almost $570 million was in stock options. In a rising market, stock options reward both superior and below par performance. According to Prof Alfred Rappaport, of North-western University, indexed options can be a solution to this problem. Options can be exercised only if shares rise by more than a chosen benchmarked index. Indexing incorporates environmental influences, whether friendly or adverse. Thus, in a hostile environment or bear market, executives in those companies that are coping relatively well are still rewarded.

Investment guru Warren Buffett sums up doubts about stock options. He denounces them as "wildly capricious in their distribution of rewards, inefficient as motivators, and inordinately expensive for shareholders".

Of course, the rewards managers consist of more than stock options. They include a basic salary and bonuses for meeting performance targets. The IMI survey indicates that bonus schemes are more prevalent at higher levels in Irish companies. Nearly 40 per cent of respondents pay in excess of one-fifth of salary as a bonus.

Common ingredients of compensation in Ireland are "fringe benefits", such as pension plans and health schemes. For the elite director class, other prerequisites include chauffeur driven cars, personal assistants, first class travel and accommodation, club memberships, and tickets to premier sporting, arts and entertainment events. These perks are not a substitute for inflated remuneration. They are a supplement to it.

Are executives motivated primarily by money? If so, the more you pay, the greater the effort, and the better the result. This assumes a direct relationship between effort and result, but it is frequently not so. Another fallacy is the idea that more is better. It is likely that there is some threshold above which increments do not matter. Perhaps the key is to find the threshold which will attract the CEO you want in the first place.

Money is important as a motivator, not only in the material, but also in the symbolic sense. The executive will often judge the value of a package, not in absolute terms, but relative to those of comparable peers. This fact accounts, partly, for some of the spiralling pay packages in Britain and the US. The final question is who decides on whose behalf. For CEO pay in publicly quoted companies, the decision is usually delegated to a remuneration committee, comprising non-executive directors, who are thereby deemed to be "independent". However, the true independence of some committee members has been queried, since they might owe their appointments to the executives. A potential conflict of interest could arise when the firm of the non-executive director conducts business with the company in question - for example, as a legal adviser. An awareness of such conflicts has prompted the British Trade and Industry Minister Mr Stephen Byers to propose a new corporate governance framework, giving shareholders direct influence in setting directors' pay.

We can track, directly, costs to the bottom line, or share dilution, when pay policies are implemented on behalf of shareholders. However, indirectly, if shareholders are to benefit from company performance, other stakeholders cannot be ignored.

The pay packages of senior executives may make other employees feel dissatisfied by comparison. And if the expense is passed on to customers or subsidised by taxpayers, these intangible and unquantifiable factors may come to mitigate long term viability of shareholder investment, more than any immediate share price rise or boost to profits.

Some food for thought as our company chairman considers the headhunter's proposal.

Dr Eleanor O'Higgins is a lecturer in strategic management and business ethics at the Graduate Business School, UCD.