Executive pay structures that rely on bonuses can encourage decisions that prioritise short-term gain over the sustainable performance and ethical conduct of the business. This, in part, is why executive pay has become a topic of increasing concern to regulators and shareholders alike.
But there are steps boards can take to encourage leaders to focus on the long term, according to Wim Van der Stede, CIMA Professor of Accounting and Financial Management at the London School of Economics.
Remuneration committees should take the following factors into consideration when putting together compensation packages, Van der Stede said. When it comes to bonuses, measurability and sustainability are key.
Annual bonuses can be quite effective in settings where performance can be adequately measured, especially where there is a direct link between the actions and decisions taken and their results, which can help to alleviate some potential short-term dysfunctional consequences of large bonuses.
Because this is a lot to ask from any incentive system, firms should not exclusively rely on short-term, annual bonuses, but rather complement them with other types of incentives, Van der Stede added. Doing so provides the opportunity to mitigate any measurement problems or address any areas where the goals are not aligned with the long-term objectives of the business.
Regulators and shareholder groups are increasingly interested in the link between performance and bonus pay, but transparency in this area is also important to internal stakeholders. When employees perceive executive bonuses to be unjustified or disproportionate, this can trigger resentment and undermine engagement, with knock-on effects for performance and culture.
Bonuses should be maximally motivating towards the achievement of long-term sustainable performance, but not excessive. However, excessive is a relative term, Van der Stede said. The magnitude of the bonus needs to be assessed within the sector to ensure that firms can offer a competitive pay package and attract, motivate, and retain the right type of talent. Excessive bonuses yield non-incremental benefits and, therefore, constitute an inefficient use of resources at best, and are likely to exacerbate short-termist behaviour at worst. Companies should tweak the design of compensation packages regularly to ensure that they remain competitive but not excessive.
Evaluating sustainable performance
To gauge whether performance is sustainable, some longer-term metrics must be taken into account.
“Some combination [of long- and short-term metrics] is probably best, where maybe only 70% of the incentive pay is based on the realisation of current performance and the remaining 30% is based on, say, three-year returns or market, equity-based performance for publicly traded companies, and/or some non-financial measures,” Van der Stede said.
The right split between short- and long-term measures depends on the length of the company’s business cycle and the nature of the business model. For example, when a pharmaceuticals company invests in research and development, it can be a number of years until the benefits of the investment are seen.
The horizon over which performance is measured also needs to be carefully calibrated. It needs to be long enough to establish whether the performance was sustainable, but the longer it is, the less motivating effect the bonus has, explained Van der Stede. So a balance needs to be struck between the various dimensions of inherently complex incentive plan designs.
“If you keep an eye on some of these non-financial measures related to customer satisfaction, employee development, share of sales from new products, and so on, you will have a gauge of your ability to continue to do well in the future, especially when the chosen measures are leading indicators of future financial performance.”
“Of course, non-financial measures can be manipulated, too, and thus even the best incentive systems stand no chance when not embedded in, or supported by, the right culture,” Van der Stede added.
Another option is to defer part of bonus payments, so, for example, only two-thirds of the bonus earned is paid out at the end of the period, and the other third is put into a bonus bank, Van der Stede explained.
The deferred amount that is eventually paid out will vary according to performance on that performance measure in future quarters or periods. So, if the employees, managers, or executives have done something to boost profits now, in a myopic rather than substantial fashion, it may never be paid out because the performance on which the bonus was earned did not prove sustainable.
Encouraging a long-term focus
Organisational culture, tone from the top, and career progression can also help create a focus on the sustainability of the business.
In an organisation whose leaders consistently and reliably maintain focus on the long term, employees will be less likely to choose the “earn while we can” option when faced with a choice between doing something that increases their bonus now and something deemed to have a beneficial long-term effect.
Similarly, an organisation that focuses on promoting employees who never miss their targets could be sending a message that hitting targets is the only way to progress.
A more holistic approach to performance evaluation which also considers all the key aspects of the job is likely not only to make for a more effective incentive plan, but also to help shape the culture, Van der Stede said. When people who place importance on factors such as collegiality, business development, talent development, and new delivery initiatives are promoted to leadership roles, they will also expect their staff to exhibit these characteristics, rather than simply prioritising targets to maximise their bonus.
—Samantha White (Samantha.White@aicpa-cima.com) is a CGMA Magazine senior editor.