The idea that executive remuneration should depend on achieving certain desirable outcomes is a seductively attractive notion. We were pleased, therefore, to see the comments of public-sector specialist Deb Te Kawa. She stated bluntly: “There is no reason for [the political party in question] to meddle with Chief Executive performance pay.” She pointed to international research “that shows individualised performance pay is not an effective incentive for higher performance for complex roles such as the ones public service chief executives perform”.
Te Kawa highlighted the negative impact of individualised performance pay on the collaborative team-based approach and collective leadership critical to achieving better results. She also noted that collaborative and collective leadership needs to extend to the working relationships between institutions.
Te Kawa also observed that some matters that affect chief executive performance (and thus—potentially—their remuneration) are beyond their control. For example, she highlighted the impact of a poorly performing Minister or a chaotic ministerial office. Far too many politicians Te Kawa observed, have proved to be “…out of their depth, unfit for the role, unable to commission advice or shape a positive relationship with their chief executives or colleagues, let alone be capable of taking the kinds of difficult and complex decisions they need to take”. Somewhat judiciously she qualified that statement by adding “especially in Australia and the United Kingdom” —but we can acknowledge that similar ministerial performance issues have also come to light in this country.
Te Kawa’s comments were targeted at the core public service. However, chief executives in many other kinds of organisations are also vulnerable to comparable shortcomings in their boards. Similarly, her earlier comments on internal and inter-organisational leadership are not confined to government departments but apply equally in most organisational contexts.
We have written before about the shortcomings of performance pay both in concept and application and Te Kawa’s piece prompted us to review something we wrote on the subject some years ago.[1] Our conclusions then also apply today and we reprise them below. Custom and practice aside, boards still operating a contingent remuneration system would do well to look at the arguments.
Arguments in favour of incentive payments
The payment of performance incentives (particularly financial bonuses) has long been a practice in many parts of the business sector where remuneration can be linked to productivity (eg, piecework pay for factory workers, commissions for sales executives). Over time the practice has been extended to senior executive remuneration packages whether or not an individual's function in the business can be directly tied to the achievement of measurable business objectives like increased sales and profitability. Arguments in favour of the payment of performance incentives to chief executives tend to be based on the following assumptions and beliefs:
• It is fundamentally wrong to reward someone primarily for tenure (ie, staying in the job); what should be rewarded is ‘achievement’.
• Paying incentive rewards helps discriminate between high performers and others seen as less effective.
• The possibility of earning a ‘bonus’ will incentivise the potential recipient to work harder, smarter and in a more focused way (and s/he will direct others under their authority towards the same objective).
• An incentive will increase the probability of the desired objective being achieved, if not exceeded.
• If the performance incentive is in a form that provides an actual or potential equity stake, it will align the interests of executives more closely with those of ‘owners’.
• The right performance incentives are needed to attract and retain high-performing executives.
• Payment of performance incentives reinforces desired behaviours and reduces the incidence of undesired behaviours.
• Recipients of performance incentives feel better about themselves because of the recognition involved.
Performance-based remuneration is not solely based on the positive notion of rewarding superior performance for its own sake. The concept of performance pay has also been strongly influenced by ‘Agency Theory’ which emphasises the transactional dimension of the employment relationship. Its basic premise is that agents (eg, chief executives) will seek to take advantage of their principals (eg, boards/shareholders).
It follows that a remuneration structure designed to link an agent’s interests more closely with those of their principals will manage or mitigate this risk. Agency Theory greatly influenced early corporate governance theory. As a result, the basic premise of executive incentive payments became, for many, an article of faith.
Arguments against incentive payments
It is surprising that belief in what has been called, ‘the redemptive power of rewards’ [2] is still widespread, despite little empirical evidence for the effectiveness of financial performance incentives. A prominent critic of performance incentives commented as long ago as 1993 that “… rewards typically undermine the very processes they are intended to enhance”. [3] More recently, organisational behaviour experts Pfeffer and Sutton explained that there is a:
…belief that people work primarily for money, and because motivation is the most important factor affecting individual task performance, financial incentives are the most important of all motivators. It follows that getting the incentive scheme right is critical for organisational success, for both motivating and aligning behaviour… The result is that companies build complicated and expensive incentive schemes that routinely fail to produce the behaviour that leaders want or even intended.[4]
Major concerns about performance-based remuneration, particularly at the chief executive level, can be summarised:
1. There is no evidence that it works and plenty to the contrary. For more than 40 years, research has been consistent in pointing out that rewards succeed at securing only one thing: temporary compliance. For lasting changes in attitude and behaviour, rewards—like punishment—are strikingly ineffective. Once the rewards run out, people revert to old behaviours.
2. It is logically flawed. If incentive payments are needed to motivate a chief executive to achieve more than he or she would anyway out of personal and professional pride, what board would want to employ such a chief executive? Concern about chief executive under-performance should be tackled directly—through effective performance planning, appraisal, and coaching—rather than indirectly through adjustments to remuneration. The argument for rewarding performance rather than tenure is similarly flawed. Performance pressures are such that few chief executives get paid, if they ever did, for serving time.
3. It is manipulative and coercive. Punishments and rewards are not really opposites. “Do this and you'll get that” is not vastly different from “Do this or something (bad) will happen to you”. There is no question that when chief executives do not get the reward (bonus) they feel they have earned, they feel punished. If they receive a lower payment this year than last, they also feel deprived. The idea of putting a certain proportion of a chief executive's total remuneration 'at risk’ is even more coercive. [5]
4. Many chief executives are not motivated by additional incentives. Anecdotally, chief executives across a wide range of sectors say that the ‘carrot’ of their bonus payment has no positive effect on their performance. To some, the very idea of an additional performance incentive is a personal affront, tantamount to a bribe. Personal and professional pride in achievement and enhancing their personal reputation is what motivates them as does the chance to be associated with, and contribute to, the worthwhile purpose of their organisation. This is consistent with numerous studies that show employees invited to prioritise satisfaction with various aspects of their working environment, rate financial rewards comparatively low on the list.
5. Performance pay fails to distinguish between extrinsic and intrinsic motivators. Extrinsic motivators are the equivalent of the carrot and stick (reward and punishment); they are externally imposed. Intrinsic motivators come from within the individual. For example, enjoyment of the job, satisfaction of achievement and the opportunity for personal growth. Research has shown that any contingent payment system tends to undermine intrinsic motivation. Extrinsic motivators can be particularly destructive when tied to jobs that (like that of a CEO) involve interesting or complicated tasks.[6]
6. It distorts organisational performance. Undoubtedly, some chief executives are highly motivated by the prospect of earning a significant financial reward. However, there is an old saying that ‘what gets measured gets done’. Of increasing concern is that ‘making the numbers’ (eg, quarterly financial results) invariably means unduly emphasising short-term considerations at the expense of creating long-term value. At the extreme, the pursuit of internal financial incentives has destroyed corporate reputations (e.g., Wells Fargo Bank).
7. It inhibits creativity. When a chief executive is offered a substantial incentive, s/he is less inclined to take risks, explore possibilities, play hunches, or deal with anything of relevance to the incentivised activity problem is not immediately evident. A working environment in which people feel controlled is not an environment conducive to exploration, learning and progress. Consequently, without a culture that encourages experimentation, one common casualty of performance incentives is creativity.
8. It discourages improved organisational performance. Psychological studies typically show that the more people are led to think about rewards, the more they prefer easy tasks and the more they are likely to try to influence performance standards in the same direction. As one commentator has said: “Do rewards motivate people? Absolutely. They motivate people to get rewards”. In extreme cases the pursuit of personal reward leads to unethical and unlawful behaviour. [7]
9. It ruptures relationships. Research and experience show that organisational excellence depends on teamwork, both because of the exchange of ideas it fosters and the climate of social support it creates. Chief executives depend on the performance of others. When a chief executive is awarded a substantial personal bonus, it sends a completely opposing signal about what is valued, with serious implications for internal trust and co-operation. It also introduces a strong incentive for a chief executive to conceal any problems s/he may have and to present themselves to their board as being what Kohn described as ‘infinitely competent’. [8]
10. It allows the board to avoid addressing the fundamental issues in its working relationship with the chief executive. Too many boards use their decisions about variable remuneration as an indirect way of signalling displeasure with their chief executive's performance. The opacity of this approach is not, however, conducive to an effective and sustainable working relationship. There is no substitute for an open, honest, constructive and continuous dialogue between board and chief executive about ‘how things are going’, along with the development of associated agreements concerning mutual support and teamwork.
11. Executive performance can be difficult to assess for entitlement purposes. Getting objective and reliable performance measurements for remuneration purposes is particularly difficult in the public and not-for-profit sectors. Such organisations have broad, complex objectives including many that are as much process- as outcome-oriented. It is increasingly recognised that a similar problem exists in the private sector with the growing appreciation of the importance of non-financial performance measures.
12. Contingent remuneration is vulnerable to ‘political’ consideration and manipulation. When assessment is subjective, it is easy for judgments about the extent of rewards to be either ‘too soft’ or ‘too hard’. Thinking about how external stakeholders may react (eg, to generous awards) can also distort a board’s decision making. But we have seen boards agree to boost chief executive remuneration independently of performance just to ‘keep their chief executive happy’.
13. It creates expectations (and even performance) that cannot be sustained. A chief executive who receives a performance bonus this year will expect another one, even more generous, next year. This can very easily lead to the chief executive being paid more than is reasonable in terms of stakeholder and public acceptability, affordable in terms of organisational resources, and necessary in terms of chief executive motivation. The psychological literature suggests that, under incentive-based compensation systems, people are likely to become less interested in their work. This leads to ‘you get what you pay for’ thinking.
14. Performance pay can lead to ‘excessive’ remuneration that attracts bad press. Chief executives in most organisations, even in the not-for-profit sector, are comparatively well paid. When, on top of an apparently generous base remuneration, it is publicly disclosed that a chief executive has received a ‘bonus’, public reaction is typically negative. This can be a major distraction from other more critical issues.
It is understandable, in the light of conventional wisdom about performance pay, that a board might seriously consider adopting (or retaining) a substantial incentive payment to support achieving a particular business objective.
However, the logic and much of the evidence do not favour this. The board should consider a wider range of fundamental issues in the partnership between the board and its chief executive and the organisation’s overall ability to fulfil its purpose. A key question is what, if anything, stands in the way of achieving improved organisational performance. If motivating its chief executive may be a significant variable, a board needs to understand what will really motivate him/her to achieve the board's objectives.
Notes
[1] Graeme Nahkies and Terry Kilmister. ‘The Emperor’s New Clothes: Testing the ‘Fabric’ of Performance-based Remuneration for Chief Executive.’ Good Governance No. 69 (May-June 2009)
[2] Alfie Kohn. ‘Why Incentive Plans Cannot Work.’ Harvard Business Review. September-October 1993
[3] Alfie Kohn. Op cit
[4] Jeffrey Pfeffer and Robert I Sutton. Hard Facts, Dangerous Half Truths and Total Nonsense: Profiting from Evidence-Based Management. Boston, Harvard Business School Press. 2006. See Chapter 5 'Do Financial Incentives Drive Company Performance?
[5] Which was how performance pay for senior public servants in NZ originally operated. Rather than a bonus system, sums to which an individual would otherwise be entitled were deducted for assessed under-performance.
[6] Alfie Kohn. Op cit
[7] See, for example, the Australian Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (2017-19).
[8] Alfie Kohn. Op cit
