Appendix A
Foundation Stones of Performance-Related Pay Schemes
This appendix is adapted from David Parmenter, The Leading-Edge Manager's Guide to Success: Strategies and Better Practices (Hoboken, NJ: John Wiley & Sons, 2011).
Performance-related pay is broken both within the private sector and in government and nonprofit agencies. Jeremy Hope1 in this quote:
“…But despite hundreds of research studies over 50 years that tell us that extrinsic motivation (carrot and stick financial targets and incentives) doesn't work, most leaders remain convinced that financial incentives are the key to better performance.”
The Billion-Dollar Giveaway
Performance bonuses give away billions of dollars each year based on methodologies where little thought has been applied. Who are the performance bonus experts? What qualifications do they possess to work in this important area other than prior experience in creating the mayhem we currently have?
When one looks at their skill base one wonders how did they acquire gravitas in the first place? Which bright spark advised the hedge funds to pay a $1 billion bonus to one fund manager who created a paper gain that never eventuated into cash? These schemes were flawed from the start; “super” profits were being paid out, there was no allowance made for the cost of capital, and the bonus scheme was only “high side” focused.
The Foundation Stones
There are a number of foundation stones that need to be laid down and never undermined when building a performance-related pay scheme that makes sense and will move the organization in the right direction.
The Foundation Stones include:
- Base the performance-related pay schemes on a relative measure
- Super profits should be excluded from schemes
- Schemes should be free from “profit enhancing” adjustments
- Schemes should take into account the full cost of capital
- At-risk portion of salary separate from the scheme
- Avoid any linkage to the share price
- Team based rather than on an individual
- The bonus should not be seen as an annual entitlement
- Linked to a balanced performance
- The downside of having “deferral provisions”
- Test scheme to minimize risk of being manipulated
- Schemes should not be linked to KPIs
- Schemes need to be communicated
- Schemes should be tested on past results
Base the Performance-Related Pay Schemes on a Relative Measure
Most bonuses fail at this first hurdle. Jeremy Hope and Robin Fraser,2 pioneers of the beyond budgeting methodology, have pointed out the trap of an annual fixed performance contract. If you set a target in the future, you will never know if it was appropriate, given the particular conditions of that time. You often end up paying incentives to management when, in fact, their performance was substandard. A good example of this would be in the private sector if rising sales did not keep up with the market growth rate.
Relative performance targets measures involve comparing performance to the marketplace. Thus, the financial institutions that are making super profits out of this artificial lower interest rate environment would have a higher benchmark set retrospectively, when the actual impact is known. As Jeremy Hope says, “Not setting a target beforehand is not a problem as long as staff are given regular updates as to how they are progressing against the market.” He argues that if you do not know how hard you have to work to get a maximum bonus, you will work as hard as you can.
Super Profits Should Be Excluded from Schemes
Super profits should be excluded from performance-related pay schemes and retained to cover possible losses in the future. In boom times, annual performance targets give away too much. These “super-profit” years come around infrequently and are needed to finance the dark times of a recession. Yet, what do our remuneration experts advise? A package that includes a substantial slice of these super-profits, but no sharing in any downside. This downside, of course, is borne solely by the shareholder.
There needs to be recognition that the boom times have little or no correlation to the impact of the teams. The organization was always going to achieve this, no matter who was working for the firm. As Exhibit A.1 shows, if an organization is to survive, super-profits need to be retained. If you look at Toyota's great years, the percentage paid to the executives was a fraction of that paid to the executives in Detroit who had underperformed.
Exhibit A.1 Retention of Super-Profits
Source: David Parmenter, The Leading-Edge Manager's Guide to Success: Strategies and Better Practices. Copyright © 2011 by David Parmenter. Reprinted with permission of John Wiley & Sons, Inc.
This removal of super-profits has a number of benefits:
- It avoids the need to have a deferral scheme for all unrealized gains
- It is defensible and understandable to employees
- It can be calculated by reference to the market conditions relevant in the year. When the market has become substantially larger, with all the main players reporting a great year, we can attribute a certain amount of period-end performance as super-profits
When designing a bonus scheme, the super-profits component should be removed from the calculation rather than used to create a windfall gain to all those in the bonus scheme. If a bonus pool has maxed out, then staff would rather play golf than go hard to win further business. The ceiling in Exhibit A.1 is shown for illustration purposes only.
Schemes Should Be Free from “Profit-Enhancing” Adjustments
All profits included in a performance bonus scheme calculation should be free of all major “profit-enhancing” accounting adjustments. Many banks generated additional-profits in 2010–2013 as the massive write-downs from the Global Financial Crisis were written back when loans were recovered.
This activity is no different from many other white collar crimes that occur under the eyes of poorly performing directors.
One simple step you can take is to eliminate all short-term accounting adjustments from the bonus scheme profit pool of senior management and the CEO. These eliminations should include:
- Recovery of written-off debt
- Profit on sale of assets
The aim is to avoid the situation where management, in a bad year, will take a massive hit to their loan book so they can feather their nest on the recovery. This type of activity will be alive and well around the globe.
These adjustments do not have to be made for the loan team's bonus calculations. We still want them motivated to turn around nonperforming loans.
Schemes Should Take into Account the Full Cost of Capital
The full cost of capital should be taken into account when calculating any bonus pool. A trader can only trade in the vast sums involved because they have a bank's balance sheet behind them. If this was not so, then the traders could operate at home and be among the many solo traders who also play in the market. These individuals cannot hope to make as much profit due to the much smaller positions their personal cash resources facilitate.
Each department in a bank should have a cost of capital, which takes into account the full risks involved. In today's unusual environment the cost of capital should be based on a five-year average cost of debt and a risk weighting associated with the risks involved. With the losses that bank shareholders have had to tolerate the cost of capital should be set in some “higher risk” departments as high as 25 percent.
With the current artificially low base rate, a fool could run a bank and make a huge bottom line. All banks should thus be adjusting their cost of capital based on a five-year average in their performance-related pay schemes.
At-Risk Portion of Salary Separate from the Scheme
Any at-risk portion of salary should be separate from the performance-related pay scheme. The at-risk portion of the salary should be paid when the expected profits figure has been met (see Exhibit A.2). Note that, as already mentioned, this target will be set as a relative measure, set retrospectively, when actual information is known.
Exhibit A.2 At-Risk Component of Salary
Source: David Parmenter, The Leading-Edge Manager's Guide to Success: Strategies and Better Practice., Copyright © 2011 by David Parmenter. Reprinted with permission of John Wiley & Sons, Inc.
| Remuneration | |||
| Mgr 1 | Mgr 2 | Mgr 3 | |
| Base salary, paid monthly | 48,000 | 64,000 | 80,000 |
| At-risk salary (bonus is paid separately) | 12,000 | 16,000 | 20,000 |
| Salary package | 60,000 | 80,000 | 100,000 |
| Relative measure, set retrospectively | not met | met | exceeded |
| Percentage of at-risk salary paid | 40% | 100% | 100% |
| At-risk salary paid | 4,800 | 16,000 | 20,000 |
| Share of bonus pool | nil | 5,000 | 10,000 |
| Total period-end payout | 4,800 | 21,000 | 30,000 |
When the relative target has been met or exceeded, the “at-risk” portion of the salary will be paid. The surplus over the relative measure will then create a bonus pool for a further payment, which will be calculated, taking into account the adjustments already discussed.
Avoid Any Linkage to the Share Price
Performance-related pay schemes should avoid any linkage to share price movements. No bonus should be pegged to the stock market price as the stock market price does not reflect the contribution staff, management, and the CEO has made.
Only a fool believes that the current share price reflects the long term value of an organization. Just because a buyer, often ill informed, wants to pay a certain sum for a “packet” of shares does not mean the total shareholding is worth that amount.
Providing share options is also giving away too much of shareholder's wealth in an often disguised way. As strategy guru Henry Mintzberg has clearly stated, “Executive bonuses—especially in the form of stock and option grants—represent the most prominent form of legal corruption that has been undermining our large corporations and bringing down the global economy. Get rid of them and we will all be better off for it.”
Jeremy Hope points out in his book Reinventing the CEO,3 these incentives have been behind many corporate failures. Due to the pressure to manipulate the accounts, the share price is too great for the CEO and senior management to resist.
With share options it is so easy to get it wrong, and in fact give away more wealth in a period than the actual net profits created. In other words, you have given away future profits that may never be generated, and often not by the executives in question.
There is another more damaging issue in that these measures focus executives on manipulating the short term at the expense of innovation where the costs are often front-loaded and the rewards back-loaded.
Team Based Rather Than on an Individual
Basing accountability and rewards on teams, rather than individuals, has been talked about for years. It is much more closely linked to McGregor's4 “Theory Y” view that people are motivated by self-esteem and personal development, rather than by additional incentives (Theory X). In Theory Y organizations produce better results by encouraging their people to be creative, to work collaboratively, to improve their skills, and to derive satisfaction from their work.
Only a simpleton would believe that you can separate out an individual's contribution to the bottom line. As Harvard professor of business administration Robert Simons5 asks, “How do we measure the contribution of a single violin player in relation to the successful season enjoyed by a symphony orchestra?”
As Jeremy Hope points out:
The profit-sharing system can only be understood in the context of its purpose. It is not intended to be an incentive for individuals to pursue financial targets; rather, it is intended as a reward for their collective efforts and competitive success.
The Bonus Should Not Be Seen as an Annual Entitlement
The finance sector has a belief that the bonus is a right and in many cases it has already been spent. We need to move bonuses out of the annual cycle. Southwest does this very cleverly.
Linked to a Balanced Performance
Performance-related pay schemes should be linked to a “balanced” performance. The balanced scorecard has been used, I would argue, largely unsuccessfully, as a vehicle to pay performance. Schemes using a balanced scorecard are often flawed on a number of counts:
- The balanced scorecard is often based on only four perspectives, ignoring the important environment-and-community and staff-satisfaction perspectives
- The measures chosen are open to debate and manipulation
- There is seldom a link to progress in the organization's critical success factors
- Weighting of measures leads to crazy performance agreements such as those shown in Exhibit A.3
Exhibit A.3 Performance-Related Pay System That Will Never Work
Source: International Institute of Management. David Parmenter, The Leading-Edge Manager's Guide to Success: Strategies and Better Practices. Copyright © 2011 by David Parmenter. Reprinted with permission of John Wiley & Sons, Inc.
| Scorecard Perspective | Perspective Weighting | Performance Measure | Measure Weighting |
| Financial Results | 60% | Economic value added Unit's profitability Market share growth |
25% 20% 15% |
| Customer Focus | 20% | Customer satisfaction survey Dealer satisfaction survey |
10% 10% |
| Internal Process | 10% | Ranking in external quality survey Decrease in dealer delivery cycle time |
5% 5% |
| Innovation and Learning | 10% | Employee suggestions implemented Employee satisfaction survey |
5% 5% |
An alternative would be to link the scheme to the organization's critical success factors. See an example of an airline scheme in Exhibit A.4.
Exhibit A.4 How the Performance-Related Bonus Would Differ Across Teams (Airline)
Source: David Parmenter, The Leading-Edge Manager's Guide to Success: Strategies and Better Practices, copyright © 2011 by David Parmenter. Reprinted with permission of John Wiley & Sons, Inc.
| Operational Team | Public Relations Team | Maintenance Team | Finance Team | ______ Team | |
| Financial performance of team | 30% | 30% | 30% | 30% | __ |
| Progress in the critical success factors (CSFs) | |||||
| Timely departure and arrival of planes | 20% | 0% | 20% | 0% | __ |
| Timely maintenance of planes | 10% | 0% | 30% | 0% | __ |
| Retention of key customers | 10% | 0% | 0% | 0% | __ |
| Positive public perception of organization—being a preferred airline | 10% | 30% | 0% | 0% | __ |
| “Stay, say, strive engagement with staff” | 10% | 20% | 10% | 20% | __ |
| Encouraging innovation that matters | 10% | 20% | 10% | 20% | __ |
| Accurate, timely information which helps decisions | 0% | 0% | 0% | 30% | __ |
| 100% | 100% | 100% | 100% | ||
In this exhibit, all teams have the same weighting for the financial results. Some readers will feel this is too low. However, when you do more research on the balanced-scorecard philosophy, you will understand that the greatest impact to the bottom line, over the medium- and long-term, will be in the organization's critical success factors.
The operational team at one of the airports has a major focus on timely arrival and departure of planes. You could argue that this should have a higher weighting such as 30 percent. However, this team does impact in many other critical success factors. This team clearly impacts the timely maintenance of planes by making them available on time; and impacts the satisfaction of our first class, business class, and gold-cardholder passengers. The public's perception of the airline is reflected in the interaction between staff and the public, along with press releases and the timeliness of planes.
Ensuring that staff members are listened to, are engaged successfully, and are constantly striving to do things better (Toyota's Kaizen) is reflected in the weighting of “stay, say, strive” as well as the catchphrase “encouraging innovation that matters.” There is no weighting for “accurate timely information that helps decisions” because other teams such as IT and accounting are more responsible for this, and I want to avoid using precise percentages such as 7 percent or 8 percent, which tend to give the impression that a performance pay scheme can be a science-based instrument.
The public relations team has a major focus of creating positive spin for the public and for the staff. All great leaders focus in this area (a superb example is Sir Richard Branson). The weights for the public relations team will focus them in the key areas where they can contribute. By having innovation success stories and recognition celebrations, staff will want to focus in this important area of constant improvement, which has been demonstrated so well at Toyota over the past couple of decades.
The maintenance and accounting teams' focus is narrower. The accounting team has a higher weighting on “stay, say, strive” and “encouraging innovation that matters” to help focus their attention in these important areas. This will improve performance and benefit all the other teams they impact through their work.
The Downside of Having “Deferral Provisions”
The treatment of unrealized gains is a sensitive issue. Some performance-related pay schemes include deferral provisions in an attempt to avoid paying out bonuses on unrealized gains that may never materialize. The question is whether the cure is worse than the ailment. The issue comes back to the impact on human behavior.
Already some financial institutions have adopted a deferral mechanism on unrealized gains to avoid situations like the “$1 billion bonus to one fund manager who created a paper gain that never eventuated into cash.” There are some downsides that need to be mitigated, including:
- We do not want all stocks sold and bought back the next day as a window dressing exercise that dealers/brokers could easily arrange with each other
- The financial sector is driven by individuals who worship the monetary unit, rather than any other more benevolent force—this is a fact of life. A deferral system will be very difficult for them to accept
- Staff will worry about their share of the pool when they leave—the last thing you want is a team leaving so they can cash up their deferral pool while it is doing well
- Dead wood may wish to hang around for future paydays out of their deferred bonus scheme
It is my belief that while some sectors may be able to successfully establish deferral provisions, they will be fraught with difficulties in the financial sector. In some cases, it would be better to focus on the other foundation stones especially the removal of super profits, and take into account the full cost of capital.
Test Scheme to Minimize Risk of Being Manipulated
All performance-related pay schemes should be tested to minimize the risk of being manipulated by participants in the scheme. All schemes in which money is at stake will be gamed. Staff will find ways to maximize the payment by undertaking actions that may well be not in the general interest of the organization.
The testing of the new scheme should include:
- Reworking bonuses paid to about five individuals over the last five years to see what would have been paid under the new scheme and compare against actual payments made
- Consulting with a cross section of staff and asking them, “What actions would you undertake if this scheme was in place?”
- Discussing effective best-practices with your peers in other companies: this will help move the industry standard while avoiding the implementation of a scheme that failed elsewhere
Schemes Should Not Be Linked to KPIs
Performance-related pay schemes should not be linked to KPIs. KPIs are a special performance tool, and it is imperative that these are not included in any performance-related pay discussions. KPIs, as defined in Chapter 6, are too important to be gamed by individuals and teams to maximize bonuses. Performance with KPIs should be considered a “ticket to the game.”
Although KPIs will show how teams are performing 24/7, daily, or weekly, it is essential to leave the KPIs uncorrupted by performance-related pay. As mentioned in Chapter 2, it is a myth that by tying KPIs to pay, you will increase performance. You will merely increase the manipulation of these important measures, undermining them so much that they will become key political indicators.
Certainly most teams will have some useful monthly summary measures, which I call results indicators. These result indicators help teams track performance and be the basis of any performance-related pay scheme.
Schemes Need to Be Communicated
Performance-related pay schemes need to be communicated to staff using public relations experts. All changes to such a fundamental issue as performance-related pay need to be sold through the emotional drivers of the audience. With a performance-related pay scheme, this will require different presentations when selling the change to the board, chief executive officer (CEO), senior management team, and management and staff. They all have different emotional drivers.
As mentioned in Chapter 10, many change initiatives fail at this hurdle because we attempt to change the culture by using logic, writing reports, and issuing commands via e-mail. It does not work. The new performance-related pay scheme needs a public relations machine behind it. In addition you should “road test” the delivery of all of your presentations in front of the public relations expert before going live.
Schemes Should Be Tested on Past Results
Performance-related pay schemes should be road tested on the last complete business cycle. When you think you have a good scheme, test it on the results of the last full business cycle, the period between the last two recessions. View the extent of the bonus on the net profit.
You need to appraise the scheme with the same care and attention you would apply to a major fixed asset investment. See Exhibit A.5 for an example of this test, and Exhibit A.6 for a checklist.
Exhibit A.5 Testing the Performance Scheme on Past Results
Source: David Parmenter, The Leading-Edge Manager's Guide to Success: Strategies and Better Practices. Copyright © 2011 by David Parmenter. Reprinted with permission of John Wiley & Sons, Inc.
| 1991 | 1992 | 1993 | 1994 | 1995 | 1996 | 1997 | 1998 | 1999 | 2000 | ||
| Annual profits (excluding all cost of capital charges) | 180 | 180 | 200 | 220 | 240 | 350 | 370 | 390 | 410 | 450 | |
| Removal of accounting entries | (30) | ||||||||||
| Super profits clawback | (10) | (20) | (30) | (30) | (40) | ||||||
| Full cost of capital | (30) | (30) | (30) | (32) | (35) | (60) | (62) | (62) | (75) | (75) | |
| Adjusted profit | 150 | 150 | 140 | 188 | 205 | 280 | 288 | 298 | 305 | 335 | |
| Expected profit based on market share | 140 | 140 | 140 | 160 | 180 | 260 | 260 | 265 | 280 | 290 | |
| Profits subject to bonus pool | 10 | 10 | 0 | 28 | 25 | 20 | 28 | 33 | 25 | 45 | |
| Percentage of pool | 33% | 3 | 3 | 0 | 9 | 8 | 7 | 9 | 11 | 8 | 15 |
| 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | ||
| Annual profits (excluding all cost of capital charges) | (240) | (60) | 290 | 310 | 460 | 520 | 210 | (700) | (125) | 200 | |
| Removal of accounting entries | (20) | (40) | (40) | ||||||||
| Super profits clawback | (20) | (30) | |||||||||
| Full cost of capital | 0 | 0 | (40) | (42) | (65) | (70) | (30) | 0 | 0 | (30) | |
| Adjusted profit | (240) | (60) | 230 | 268 | 335 | 380 | 180 | (700) | (125) | 170 | |
| Expected profit based on market share | 190 | 220 | 300 | 350 | 170 | 160 | |||||
| Profits subject to bonus pool | 40 | 48 | 35 | 30 | 10 | 10 | |||||
| Percentage of pool | 33% | 0 | 0 | 13 | 16 | 12 | 10 | 3 | 0 | 0 | 3 |
Exhibit A.6 A Checklist to Ensure That You Lay Down These Foundation Stones Carefully
| Checklist | Is it covered? |
| 1. To be based on a relative measure rather than a fixed annual performance contract | |
| All fixed in advance, annual targets for bonuses are removed |  Yes No |
| Relative measures are introduced to take account of: | |
| • Comparison against market share | Yes No |
| • Comparison against other peers | Yes No |
| • Changes in input costs (e.g., where bank base rate is very low) | Yes No |
| Progress against the relative measures are reported three to four times a year | Yes No |
| 2. Super profits should be excluded from schemes | |
| Super profit scenarios have been analyzed | Yes No |
| Historic trends analyzed to estimate when super profits are being made | Yes No |
| Drivers of super profits identified (e.g., the interest margin banks had in 2009 meant that even a fool would have made super profits) | Yes No |
| Super profits removed from net profit as a percentage of each $m made rather than have a ceiling | Yes No |
| Model tested against past 10 or 20 years retained profit/losses to ensure formula is right | Yes No |
| 3. Schemes should be free from “profit-enhancing” adjustments | |
| Eliminate all short term accounting adjustments including: | |
| • Recovery of written off debt | Yes No |
| • Profit on sale of assets | Yes No |
| • Recovery of goodwill | Yes No |
| 4. Schemes should take into account the full cost of capital | |
| All departments that have a specific profit sharing scheme should have a “cost of capital,” which takes into account the full risks involved. | Yes No |
| Calculation of cost of capital should be done over a long period covering at last one full boom to bust cycle. | Yes No |
| 5. At-risk portion of salary separate from the scheme | |
| Test the new system on previous years | Yes No |
| Human resources to discuss the change on a one-to-one basis with all managers affected | Yes No |
| Prepare an example of the new scheme and publish in a secure area of the HR team's intranet section | Yes No |
| 6. Avoid linkage to the share price | |
| Remove all bonuses that are linked to share prices | Yes No |
| Remove all share options from remuneration | Yes No |
| 7. Team based rather than the individual | |
| Remove all individual schemes | Yes No |
| Amend all contract templates | Yes No |
| 8. The bonus should not be seen as an annual entitlement | |
| Link schemes to longer term saving (e.g. Southwest Airlines) | Yes No |
| 9. Linked to a balanced performance | |
| Remove all balanced scorecard weightings from schemes | Yes No |
| Reward performance in the critical success factors | Yes No |
| 10. The downside of having deferral provisions | |
| Test any deferral provisions before implementation | Yes No |
| 11. Test scheme to minimize risk of being manipulated | |
| Rework bonuses paid to about five individuals over the last five years to see what would have been paid under the new scheme and compare against actual payments made. | Yes No |
| Consult with some clever staff and ask them, “What actions would you undertake if this scheme was running?” | Yes No |
| Discuss with your peers in other organizations the better practices that work—this will help move the industry standard at the same time as avoiding implementing a scheme that failed elsewhere. | Yes No |
| 12. Schemes should not be linked to KPIs | |
| Remove all KPIs from performance-related pay | Yes No |
| Remove all KPIs from job descriptions | Yes No |
| Remove all KPIs from annual performance agreements | Yes No |
| 13. Schemes Need to Be Communicated | |
| Sold changes via the emotional drivers | Yes No |
| Have prepared presentations that are targeted specifically at: | |
| • The board | Yes No |
| • CEO | Yes No |
| • Senior management team | Yes No |
| • The staff on performance related pay schemes | Yes No |
| 14. Schemes should be tested on past results | |
| Road test the bonus scheme on last complete business cycle (e.g., between 10 to 20 years) | Yes No |