An entire industry has mushroomed around it. Platoons of remuneration consultants rubber-stamp it, board committees by the score ruminate over it, proxy advisors live on it, vending their advice to super fund types, themselves hooked by it. Executive remuneration incentives. Pages are devoted to them in every annual report. Devilishly complicated schemes, double-Dutch to all but the “rem” cognoscenti. For business, KPIs (key performance indicators) are an article of faith but is there a defensible link between executive pay and performance? Will a CEO perform better for $4 million or $8 million? Who knows? We do know the banks are underpinned by taxpayers. They are are oligopoly quarantined from risk by government guarantees yet their executives rake in millions in incentives. What has it delivered? The systemic corruption on display at the Royal Commission. Former Big Four bank executive and chief of shareholder advisory firm Regnan, Amanda Wilson, reports.
Those outraged about the bad behaviour inside our financial institutions have largely focused on individuals and paid scant attention to the real culprit plaguing our companies: a rampant incentive culture.
Having led the performance and reward function of a big four bank, and subsequently as CEO of an investment research and shareholder advocacy firm, I know there are voices in the investment and human resource communities who plead with companies to implement more sustainable approaches to remuneration and managing human capital generally.
Those voices are drowned out by the more vociferous and powerful – super funds, asset managers and their advisors, and the metrics-obsessives within companies – who want to see more pay “at risk” for senior executives because, in their left-brained view of the world, that is the only way those executives will “perform”.
Once entrenched for senior executives, at-risk reward, by necessity, cascades throughout the organisation, with pre-ordained KPIs attracting a certain percentage of one’s annual, or longer term, target incentive, supplemented by a plethora of bespoke sales-based plans at customer-facing levels. (It should be noted that incentives refer specifically to rewards linked to defined outcomes, in contrast to after-the-fact bonuses).
Following the GFC and various financial scandals, the backlash against excessive executive pay (even though the equity-based incentive plans endorsed by investors had often delivered those excesses), and the growth of the sustainable investment movement, executive performance metrics were changed. Long-term incentive performance periods were lengthened from 3 to 4 or 5 years (as if executive tenure and performance can neatly map to investment time horizons) and score cards gave increased weight to factors like customer satisfaction, employee engagement and workplace health and safety.
Some of us, although welcoming a more holistic view of performance, were sceptical about this approach. Firstly, financial thresholds usually had to be met before any incentives are payable, thus privileging the hard stuff over the soft. Secondly, we were starting to ask what the still-hefty base pay was for? Several of us went further and mused that the main incentive for keeping a company financially healthy, with satisfied customers and healthy staff, ought to be getting to keep your job – but we were dismissed as dinosaurs. Directors, most of whom have little expertise in human capital theory and psychology of incentives, remained convinced that incentives were critical in the so-called war for executive talent.
The ramifications of using incentives as the primary, if not only, tool in the management box, are blindingly clear. Here are six reasons why.
Firstly, they encourage an unrealistically linear view of the world, wherein it is possible to predict the impact an executive will have on corporate performance, with clumsy “after-the-fact” tweaks to account for unforeseen variables.
Secondly, they lead to a close-mindedness. New opportunities are ignored and risks downplayed because a reward that visibly marks you as a winner or a loser is at risk.
The third argument against an over-reliance on incentives is they encourage rent-seeking behaviour: uncertain pay outcomes are like fertiliser for rent-seeking. They nurture a sort of insecurity that encourages a tactical hoarding mentality – for example not taking long-term investment decisions – because you never know, really, how this nebulous thing called “performance” will pan out.
The fourth reason is one we are all aware of: incentives lead to the gaming of results. All the accounting tricks in the book are utilised to deliver the payload. This often provokes a nerdy numbers battle as proxy advisors and companies fight it out to make their macho financial – and severely limited – case.
My fifth point is that incentives lead to a “what I earn defines me” mentality. All the other benefits and challenges of leadership tend to be sublimated beneath a final, annual number. Factors like the pride in leading an iconic Australian institution, of providing a happy, productive workplace, of genuinely meeting or exceeding customers’ needs (not manufactured wants) are in perennial support roles to the main act.
Finally, they encourage an almost deliberate blindness regarding overall pay quantum and the relativities therein – with even our regulators saying that quantum is not their focus.
And yet the incentive mindset is now so intractable a part of corporate leadership in Australia that its “rats in a lab” type philosophy has swamped HR practices. This has had a corrosive effect on corporate culture, as so clearly shown in the royal banking commission outcomes to date (and detailed in the APRA report into CBA released this week). There is voluminous and compelling research that demonstrates incentives actually diminish intrinsic motivation and frequently have unintended consequences.
None of this is to say there is no place for incentives in listed companies. They can be very effective for short-term, clearly defined objectives. And there is no doubt executives owning equity can provide alignment with at least the cohort of shareholders who own the stock for exactly the same time period. But to avoid future scandals in our financial services industry (and other sectors) the true impact of incentives at every level and function should be evaluated. They should be removed altogether from central/compliance functions so these can deliver frank and fearless advice without penalty.
And as for the “war for talent”? The executive labour market remains rife with artificial barriers to entry, as evidenced by the still-startling lack of diversity. Maybe if more leaders and staff were selected based on their demonstrated intrinsic motivation – and a lack of interest in incentives – we’d get sustainable growth in value rather than incentive-driven highs and their inevitable hangovers.
This story first appeared in the AFR and has been reproduced with the permission of the author.