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Does the “Carrot” of Big Bonuses Still Lure Executives and Encourage Performance?Management December 9, 2016
Would you rather…? This is a question I am regularly asked by two, very inquisitive kids, often with very amusing options to choose from, such as, “Would you rather be rich and ugly, or be poor and good-looking?” or “Would you rather make headlines for saving somebody’s life or for winning a Nobel Prize?”
Inspired by several dinner conversations with responses such as, “Easy — I’d be rich and ugly; then I can afford plastic surgery,” and by some thought-provoking research from London School of Economics we set out to ask similar questions about executive compensation. The intent was to get a better understanding of how senior executives feel about their compensation arrangements.
Conventional executive compensation models are built on a few common principles, such as:
- Keeping fixed costs low and including an element of at-risk pay (that is, bonuses and incentives) is important, so that CEOs and executives share in pain as well as gain.
- Implementing pay-for-performance models are ideal for incentivizing executives to work harder.
- Aligning the interests of executives with those of shareholders of the company is vital.
- Offering long-term incentives (LTI or equity plans) and bonus deferrals helps retain key talent.
Although these principles are very robust and defensible, we thought it would be interesting to see how many executives actually believe in them, when they apply to their own pay.
To assess this, we tested a few “would you rather” questions with approximately 200 mid-levels to senior executives in the region. We asked these executives to take off their hats as HR professionals or business leaders, who often have to explain and defend compensation systems to shareholders and employees, and instead, answer the questions purely based on how they felt.In other words, their emotional responses were the key determinant rather than logical/defensible ones. Some of the results were equally as fascinating as “but what if I make headlines for winning the Nobel Prize for curing cancer?”
One of the first questions was, “Would you rather get (a) $1 million today; (b) $1.25 million in 12 months; or (c) $1.5 million in 24 months?” As you can imagine, the economically rational option would be (c) —after all, there aren’t too many risk-free investment options that would yield returns of 22.5% each year.
However, as we put up this question to every group, a vast majority (nearly two-thirds) chose option (a). This seemed to suggest that most executives discount heavily for time. Similarly, when asked, “What would deter you from leaving your company?” the majority of respondents opted for “(a) Regular payment of $1 million every year for three years,” as opposed to “(b) Lump-sum payout of $4 million after 3 years.”
The implications of such attitudes on executive compensation models are important. Most executive compensation plans avoid upfront gratuities and have incentive payments delayed or staggered over multiple years, partly to manage costs and risks. However, if executives truly discount so heavily for time, then we need to rethink the deferrals terms that would be meaningful.
The next question was to test the executives’ risk appetite. When asked, “Would you rather have (a) a 50% chance of getting a $2 million bonus; (b) a 66% change of getting $1.5 million bonus; or (c) a guaranteed bonus of $800,000,” nearly 80% opted for the “show me the money” option (c).
Again, the economically rational option would have been either (a) or (b) — depending on person’s risk appetite — as both options would probably be adjusted to a likely value of $1 million. Yet, most executives picked the low-risk, low-reward option.
Similarly, we asked executives, “What pay package would motivate you to perform your best? (a) Fixed pay of 1 million + 0 bonus; (b) fixed pay of 650,000 + on-target bonus of 350,000; (c) fixed pay of 500,000 + on-target bonus of 500,000; (d) fixed pay of 350,000 + on-target bonus of 650,000; or (e)zero fixed pay + on-target bonus of $1 million. Again the overwhelming majority chose either (a) or (b) — opting for the relative certainty of fixed pay.
Both these responses seem to suggest that executives may be more risk averse than we imagine. The “carrot” of big bonuses may not be as lucrative to executives, and thus, may not be as important in encouraging performance.
Finally, we wanted to test what motivates people, so we asked “Do you think you would be more motivated to do your job if you got paid $4 million versus $5 million?” Interestingly, the majority of the respondents indicated that they would not be any less motivated or hardworking if they got paid $4 million instead of $5 million.
We also asked, “What matters most to you: (a)hitting KPIs and tangible financial outcomes (e.g., profit growth); (b)creating value (e.g., share price growth or shareholder returns); (c) favorable judgment from others (e.g., performance ratings, awards); (d)building a team (e.g., coaching, mentoring, nurturing talent); or (e) learning (e.g., developing a new competency, acquiring a new skill, mastering something new)?”
Interestingly, very few people opted for (c), suggesting perhaps all the time organizations spend on performance ratings may be better spent elsewhere. Achieving operational KPI, creating shareholder value and building teams all had nearly a third each of the votes.
Current compensation programs focus heavily on (a) and (b) and may not sufficiently emphasize non-financial elements of management responsibilities. This is also a good reminder for companies to give some serious thought to refining the definition of performance and where performance truly lies.
So where does this all leave us? For starters, it certainly challenges some of the commonly held perceptions regarding effective executive pay programs. While we do not suggest that we should abandon current constructs; rather, this may prompt us to think more about our perceptions of CEOs and executives when designing pay programs. It might also encourage companies to consider alternative models.
For instance, imagine a CEO of a publicly listed company. What would motivate her (read footnote below) to perform at her best? Would she be better engaged and more committed with:
- Base pay at reasonable level, so that it doesn’t encourage excessive risk taking to maximize bonuses, or low base pay and highly leveraged bonuses to drive performance?
- Bonuses linked to a few operational KPIs that executives can control (for example, revenue growth, profit margins, returns and efficiency ratios), or incentives linked to share price growth to align interests with shareholder?
- Reward for non-financial performance (for example, delighting customers, coaching and developing people, ensuring corporate sustainability) — assuming these lead to shareholder value or reward mainly for financial performance and shareholder value — assuming that everything else is the means to this end?
- Deferring a significant portion of bonuses earned into shares that cannot be sold for a defined number of years, so as to create an ownership mindset, or having a significant carrot in the form of LTIs that would vest at end of three years for achievement of certain performance conditions?
As you can imagine, there are no right or wrong answers. The ideal model depends on the company’s compensation philosophy, culture of managing risk and reward, and executives’ perception of current pay programs.
When it comes to executive compensation, it is more important to focus on best fit, rather than best practice. Each company is different, and every company goes through different phases; it is important to tailor a compensation plan that is best aligned with the company’s business priorities.
Successful executive compensation models try to balance the economic arguments with executives’ perceptions and emotional responses. Only such balanced programs are able to achieve the desired intent of engaging and retaining executives.
A case in point: when I asked the kids, “Would you rather get $50 million today or $1,000 every day for the rest of your life?” they unanimously responded, “$1,000 every day; because then you have something to look forward to every day —and that’s much more fun!”
Author credit: Shai Ganu, Partner and Market Business Leader, Talent, Mercer Asia
Shai Ganu is a partner at Mercer and is responsible for its Talent business across Asia, covering both the Information Solutions and Consulting portfolios. Shai considers himself very fortunate to be leading a team of 200+ exceptional consultants who are trusted advisors for clients on issues relating to board and executive remuneration, workforce rewards and careers, skills frameworks, business transformation, culture and change management, workforce planning, and predictive analytics. Shai is also an author and board advisor on executive remuneration matters. The author can be contacted on firstname.lastname@example.org.
Feature image credit: efinancialcareers.com
“Footnote: In an attempt to normalise the use of female pronoun the word “she” is used here and it implies to both “he or she”. CEOs and other executives can be male or female. The author is a strong proponent of gender equity and hopes that more people write and speak using gender-neutral terms.
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