Performance and Reward

Rewarding Virtue - Effective Board Action on Corporate Resposnsibility

This most interesting report was recently brought to my attention. The executive summary can be accessed from:
http://www.bitc.org.uk/resources/publications/rewarding_virtue.html.

I have examined the report from an Executive Pay perspective. It is very noticeable that many of the points made in the report have points about executive pay lying behind them. There are very clear links between good practice on Executive Pay and good Corporate Responsibility.

In the following commentary I frequently refer to the book Performance and Reward. To find out more about this book follow the link "View the book" in the left hand column of this blog.


Tempatations against Corporate Responsibility

The report summary discussed two main "temptations" to be irresponsible.

1) Market failure creating incentives to be irresponsible.
This is precisely why it is so important that executive directors are rewarded only for long term performance. The graph top, right of page 4 suggests that (except in the case of persistent market failure) at 3-5 year delay on performance assessment would substantially remove the incentive to behave irresponsibly.
The report talks about the balance between short and long term rewards. The important point in the Performance and Reward book is that if Total Shareholder Return (TSR) is used as a performance measure for executive directors then the appropriate balance is 100% long term, 0% short term, because the long term TSR metric properly captures the lasting impact of all short term actions.

2) Internal incentives, e.g. from pay schemes, to act irresponsibly.
Executive directors (and other senior managers) usually seek to align the incentive schemes of their staff with their own incentive schemes in order to make sure that the staff and rewarded if and only if the director is rewarded. This means that incentive schemes tend to cascade down organisations. In other words if the directors rewards are based on appropriate long term measures then it is likely that the directors will resolve most other problems lower down the organisation.
The more difficult internal incentive problem concerns the incentives arising from promotion prospects. It is all too easy to promote people for good short term performance.


Exacerbating factors

The report summary notes that the two "temptations" can be exacerbated by pressure from investors and competitors.

1) Pressure from investors for short term returns is a very real and big problem that I suggested might be worthy of more research by ECCR. I sometimes fear that we have a "persistent market failure" problem here, which could be disastrous for our economies in the long term.

2) Pressure from competitors is discussed up "keeping the sector healthy" below.


The Report's six recommenations

Executive pay is an important background issue in all of the six recommendations of the report. I can't help feeling that the report has not quite grasped the nettle in working out the full implications in respect of executive pay.

1) Set Values and Standards
Executive pay is key to the values of the company. (See discussion of the Leadership Message in Performance and Reward, page 168ff.) Does the company have any values beyond seeking financial reward?

2) Think Strategically about Corporate Responsibility
This is a very important point, but it obviously prioritises the long term over the short term. Short term rewards are a big threat to this aspiration. [It is also interesting to notice how the HBOS example sees complexity as a long term problem. The credit crunch witnesses to this. (Complexity is also a problem in executive pay - see page 47, 143-146 of Performance and Reward.)]

3) Be constructive about regulation (This is discussed under "keeping the sector healthy" below).

4) Align Performance Management
This is clearly about pay, but the need to prioritise long term performance should come over much more strongly.

5) Create a Culture of Integrity
"Values" and Leadership Message are important here. This means that the level of executive pay is important. If the company incentives are too heavily dependent on financial reward then the main "value" in the company becomes "maximise your personal pay" which is a bad starting point for ethics. A more ethical organisation is going to focus more on the intangible rewards discussed at the end of page 3 of the report.
Also common incentives are very important here. See Performance and Reward pages 28-32. It is very hard for Director A to criticise Director B for behaviour which is necessary for Director B to get his bonus. However if the directors all have the same corporate objectives then they are much more accountable to each other for their behaviour.

6) Use Internal Control to secure responsibility
The common incentives point continues to be important here. Without it, it is very hard to blame someone for stretching boundaries to achieve a reward outcome. Precisely the reason that the incentive was set was to make the person stretch boundaries to achieve it!


Keeping the Sector Heathly

The report makes important points about being constructive about regulation and working with competitors to solve market failure problems. Incentives for "keeping the sector healthy" are extremely important to the public good, but are seriously undermined by comparitive forms of performance measurement. This is discussed in detail in Performance and Reward pages 37-41. The incentives would work far batter if all companies only used absolute measures of company performance. [The trouble is that it is comparative considerations that are used to justify high executive pay - so they are very popular].

The point can be taken even further. It is important that all executive directors have incentives to keep the world and national economies healthy and prosperous in the long term. Comparative performance measures certainly work against this. Defined Contribution Pension Schemes for executive directors would help here - see Performance and Reward 138-9.


Conclusion

It is very clear to me that Executive Pay is an extremely important issue that can either support or frustrate efforts to improve Corporate Responsibility. In fact my personal suspicion is that the bad practice on executive pay since the mid 1980s has been a big factor leading to the problems in Corporate Responsibility that we have seen in more recent years.

Labels: common incentives, comparitive performance, Corporate Responsibility, long term