Compensation and Incentive Structures: A Perspective Paper
The seemingly simple questions of what and how to compensate employees form the core of how employees and indeed the firms and economic systems perform. They are also at the intersection of human nature (what motivates various stakeholders?), economics (the demand and supply of talent), game theory (negotiation for services under conditions of uncertainty), leadership and culture (how to build healthy psychological contracts), theory of firm (objectives of the firm), legal and regulatory/tax imperatives (disclosures, conditions for certain incentive payments and tax treatment of income), corporate governance and trajectory of desired economic activities (entrepreneurship and social investment) in the broader economic system. As major economies transition into their next stage of evolution, compensation structures are likely to have higher prominence in terms of direct and formal expectations (such as, gender pay, pay ratios between top and low, and say on pay) and indirect and social concerns (such as higher economic and income inequities; and nature of public investments).
The purpose of this paper is to encourage reflections on compensation design and structures to align them with the emerging social economic context and organizational choices. This paper focusses mainly on compensation for leaders, who have a significant influence over organizational performance and outcomes.
1.0 Evolution of Compensation and Incentives
In general, the evolution of compensation structures reflects the economic context and academic frameworks in which “compensation mystery” is explored and sought to be addressed.
Classical economics addressed the compensation question through the concept of marginal revenue product, which essentially suggests that the pay rate should be equal to the value of the extra product produced for a given unit of time spent. While it provides a good theoretical start point, it presents two challenges: It is not easy or even practical to do such calculations, and secondly compensation is influenced by a broader set of factors besides marginal costs and revenues. These challenges hold good at any level, but apply even more for leadership roles, which have an open and strategic remit with long term performance horizons. The core – and traditional – compensation challenge in a typical organizational context was that it was largely understood and practiced as a zero-sum game between a firm’s desire to pay less (or on the productivity and output) and an employee’s need for fair and high pay.
From a compensation perspective, the concept of equitable distribution has multiple implications. It could refer to whether the relative compensation differences between internal or external roles (or role incumbents) are justified – a process referred to as ensuring internal and external equity, and used by consultants, industrial engineers, data providers, and trade unions/industry associations. Equitable distribution also refers to distribution of profits (dividends) vs bonuses (compensation) between shareholders and top managers and rest of the employees. These “distribution” challenges are more difficult to address, if compensation is considered as distribution under a zero-sum game; however, if there is a compensation framework that allows more compensation to be paid for more “performance”, it could lead to a win-win situation. This core idea, manifested differently in various compensation structures, led to the popularity of incentive pay and subsequently to pay for performance through equity-based compensation at senior levels of management.
The rise of various equity-based forms of compensation, most notably options and restricted stock, influenced the growth and trajectory of entrepreneurship and new industries (e.g., IT and dot.com firms, and currently AI firms). For the senior managers, the question of what and how to compensate was partially addressed through equity-based compensation design. Compensation depends on how much shareholders’ wealth or firm’s valuation increased, and managers received bulk of their incentives using the same construct (equity-based compensation). Stock-based compensation gained currency, as it seemed to create wealth, introduce “skin in the game” and also presented the optics of a win-win, non-zero-sum game.
Though the above dealt mostly with the top management compensation, their priorities and behaviour had an influence over how rest of the organization “performed”, got compensated and how the pay context itself was constructed and worked. It is perhaps intuitive to infer that senior management priorities reflect what they are paid for, and rest of the organization embraces same priorities and get rewarded on similar principles, even if the mechanics, process and pay-terms were different.
2.0 Perspectives on Compensation Challenges and Context
While the concept of incentive pay worked better in the context of manufacturing, and to some extent service sectors, where the nature of work was closed-ended, it was not without its challenges when applied at senior levels and when used with equity based compensation constructs, such as options and shares. Few major concerns, in the context of CEO and possibly other senior levels, included the level and structure of compensation, transparency with respect to pay determination, the “measurability” of performance, reliability of shares price as performance measure, ability to assess talent, and difference between expected and actual pay[1]. There were other challenges as well, and they included option accounting, re-pricing, timing of managerial reporting, and narrow pursuit of goals (e.g., measure directed towards share price).
Another challenge, at the macro-level, was relationship between CEO pay amounts and economic growth. As Dorff writes in the context of US economy,
“The trend in CEO pay amounts bears no apparent relation to real growth in the U.S. economy. In fact, there is almost an inverse relation between the growth rate of the gross domestic product (GDP) and the growth of CEO pay. While the CEO pay was stable in real terms during the three decades from 1940s to 1969, real GDP growth averaged a little under 5%. During the 1970s, as CEO pay began to rise, average GDP growth shrank to 3.3%. GDP growth continued to average only a little over 3 percent during the 1980s and 1990s, while CEO pay skyrocketed. The 2000-2009 period saw a different pattern, with much slower GDP growth, about 1.8 percent, and some declines in CEO pay” (Pp. 25)[2]
This rise in CEO compensation since 1970s in the US context was marked by corresponding rise in the performance-based pay using equity compensation constructs, such as options and restricted shares. CEO pay largely consisted of salaries and short term bonuses until 1970s, which were 93% in 1950s and 87% in 1960s of the CEO package (Pp 6).[3] (Note: In contrast, an international study covering CEO pay in 37 countries during 1996-2004 found that 57% had less than 10% of equity in CEO’s total pay[4]). There are many reasons for this rise in CEO pay presumably fuelled by equity-based compensation, which increased its share of total compensation for senior managers of US Corporations from 20% (in 1990) to 70% (in 2007)[5]. These include CEO level job market, board’s desire to hire the best CEO, legal and practical difficulties in challenging CEO pay (though this is slowly changing with “Say on Pay”), rising stock market[6], changes in the financial sector – particularly rise of Alternate Investment firms such as Private Equity and Hedge Funds[7], and theoretical support through the agency theory. Regulatory changes in US context in 1992 and later are also cited as reasons for the rise in CEO pay[8].
Dorff [9] posed the question of rising CEO pay in terms of two main questions. While these questions apply to CEO compensation, they have varying relevance for other leadership roles as well – managers that Piketty referred to as “super managers” earning “super salaries”[10]. These questions are:
- Does CEO determine the performance of firm?
- Does tying CEO compensation to performance of firm motivate the CEO?
Dorff also addressed a set of other related questions, such as the Board’s ability to identify the best CEO whilst making a hire decision, assumption of market efficiency in making compensation decision, stock market as barometer of firm’s performance, and the role of regulation in compensation matters.
The 2008 financial crises brought to the fore additional challenges: High level of incentive compensation was targeted as contributor to the excessive risk-taking by bankers and having contributed to making the economic systems riskier. It also focussed attention on how equitable and fair the pay was in broader organizational and economic contexts. The financial crises shifted the attention from “pay for performance” to “pay for risk-adjusted performance” and led to regulation-led prescriptions (for the in-scope financial services in the European Union context) that covered compensation and incentive decisions for a category of employees called “Identified Staff”. Identified Staff refers to employees that have a material risk impact on the legal entity. This risk impact was identified using a set of qualitative and quantitative criteria. It is hard to say how far regulation has succeeded given that the changes took place in a muted economic context, which was hardly conducive for the compensation related “animal spirits”.
The compensation dynamics takes place in an eco-system with a variety of moving parts making it particularly difficult to establish the right compensation a priori. The experience of the last three decades (in particular dot.com and 2008 financial crises) with performance-based compensation, particularly relying on equity components in compensation, shows that it is also difficult to assess compensation and incentive decisions ex-post. The rise of high compensation, primarily through equity-based constructs, also led to other unintended consequences, such as rise in pay inequities (as evidenced by the rise in top to average compensation or similar ratios), imprudent risk-taking behaviours, crises in corporate governance, and emerging debates[11],[12] on the limited usefulness, if not harmful behaviours, of the theoretical frameworks, such as shareholders primacy and agency theory. There are also questions on the assumption, whether high compensation motivates a CEO[13] towards organizational performance, and therefore on the need to over-emphasise it?
3.0 Compensation Frameworks: Choices and Consequences/Costs
The search for an alternate perspective on compensation needs a relook at few fundamental premises that with the experience of last three decades look questionable – as discussed in the last section. While it is generally, though not always as explained later in this section, accepted that compensation should be performance based, perspectives differ on what actually is performance and how to measure it. This also leads to deeper questions, such as performance for whom, over what time-horizon, why of performance and performance for what purposes. These questions, in turn, depend on the purpose of organization and the means to accomplish them. There is also a secondary set of questions, as to how much does high pay motivate leaders in their highly complex and cognitive roles[14] generally do, how strong is the connection between performance (outcomes) and efforts, and whether the commonly accepted ideology of equity-based compensation, whether in options or restricted stock, is relevant in the emerging economic context.
The challenge for any compensation framework, particularly for senior leadership, is that simple performance matrices, such as stock performance or sales volume, are influenced by myriad of factors many of them are outside the control of leaders, and “real” performance matrices, such as technological leadership or customer value, are complex and subjective to measure. While the use of frameworks, such as Balanced Scorecard, mix of performance matrices and assessment of both “what” and “how” of performance, recognise that leaders perform a multi-dimensional long term role, the selection and/or assessment of matrices remain subjective and process tends to be complex.
While compensation frameworks rely on quality of performance assessment, they also make two main unstated assumptions on what leads to performance and measurability of performance. That is, firms make assumptions on whether:
- performance and compensation need to be individual-centric, “star” focussed based on a “tournament” model of career progression, performance and incentives;
- it is possible to reliably distinguish between luck (and context) and skills while assessing a given performance (or outcomes).
The extreme versions of above assumptions mainly lead to two “pure” compensation frameworks: star-focussed, free-agent model and value-creation focussed, capability building model.
A free-agent model (relying on star culture emphasises directly or indirectly value extraction) is strongly correlated with and is similar to pay for performance model. Capability building model mainly relies on collectivistic and holistic view and focusses on value creation. These two models, in their “pure” forms are discussed below.
3.1 Free-agent Compensation Model
Free-agent compensation model involves an individual focus on compensation, which could be an outcome of bargaining, market forces, and optimal use of performance signalling. The model, in essence, works on the pay for performance ideology. Under this model, the organization may choose to pay its star performers a high proportion of compensation money in return for high performance. Though this model is generally seen as “default” model, particularly in high pay industries, it relies on the assumptions that performance is entirely due to skill set and expertise, it is replicable, and it is possible to predict future potential based on past track record.
The research on star performance is not entirely supportive of these assumptions. In a study of research analysts, it was found that 46% of ‘star’ performers did poorly after job change, their performance dropped by average of 20% after job change and did not improve to old levels even after a period of 5 years. The research suggested that both individual competencies as well as organizational capabilities contribute to an executive’s performance[15]. Similarly, in a study on difference that right CEO candidate can make, Gabaix and Landier[16] found that “a company that hired the best CEO instead of 250th best would increase its market capitalization by 0.016 percent” (Pp 177). While this still could be a high amount for a firm with large market capitalization, there is still an assumption that it is possible to know the ‘best’ candidate. In a 2003 roundtable, in response to rise in CEO salaries for celebrity CEO hired from outside as opposed to stay-at-home CEO, Warren Batts observed that “I’d bet that since 1980, the number of CEO selected from outside has increased substantially. But most do not make it – over half the CEOs hired from the outside are fired within the first three years”[17].
Desai[18] observed in the context of financial markets that “various analyses have shown that individual managerial skill in financial markets is exceedingly rare …In short, we have come to evaluate and compensate managers on both sides of the capital markers as if the market could precisely disentangle skill from luck. Professional sports provide a common and convenient metaphor…But distinguishing skill from luck is relatively simple in sports.” It is possible to build this further and argue that it is possible to create a compensation design, which does not rely on high pay and star players, even in professional sports, as exemplified by the analytics driven pay-model used in Moneyball[19].
The rationale for the free-agent model is that an individual takes a part of the total value created, and hence it represents a win-win strategy. It is also referred to as “eat what you kill” pay philosophy. This rationale fails when the performance and risk horizons of performance differ, and, as in banking, an individual may get rewarded high pay on the basis of ‘excellent’ performance while the costs and risks appear over time. Such considerations, inter-alia, led to regulations in the banking sector in EU, where pay for identified staff (risk takers) is deferred over a number of years, and subject to assessment when the deferred tranches are released. Other EU financial pay-design features include part payment of incentives through stock, and clawback and malus provisions. Though these features of regulation discourage reckless risk-taking, there are unintended consequences. The overheads and resource requirements on performance assessment reinforce the point previously made that ‘real’ performance is complex and difficult to assess. The compensation design relies on paying a minimum amount of incentive in stock-based instruments, though the stock as a barometer of performance and indeed the agency theory is increasingly under critical debate[20].
Perhaps, an important reminder of the limitations of pay for performance – a logical implication of the free-agent, star model of compensation – comes from the famous HP experiment in early 1990s, when HP executives implemented multiple pay for performance programs at multiple locations at the request of local managers, covering blue collar workers (where the cause and effect relationships between effort and outcomes are relatively unambiguous). “Yet, within a year, all the local managers had cancelled their programs. They derided them as time-intensive, expensive, and, worst of all, ineffective”. (Pp 125)[21]
That high pay would motivate CEOs to perform better and lead to better firm level performance is also being increasingly critiqued. In an European study into the remuneration of CEOs in 861 listed companies, it was found that “better performing companies do not pay their CEOs better…proportion of variable remuneration is relatively lower” and there is “less leverage in the bonus (difference between target and maximum bonus”[22]
In their article, Dan Cable and Freek Vermeulen[23] argued, on the basis of several studies, for abolishing pay for performance for top managers altogether and replacing it with fixed pay. They cited multiple reasons, such as contingent pay works for routine tasks (though the above cited HP example raises doubts about that as well), fixation on results weakens the performance, intrinsic motivation crowds out extrinsic motivation, contingent pay leads to cooking the books, and all measurement systems are flawed”.
The above research findings and observations align with insights in the classic article, “On the folly of rewarding A, while hoping for B”[24], where Steven Kerr argued that “numerous examples exist of reward systems that are fouled up in that the types of behaviours rewarded are those which the rewarder is trying to discourage, while the behaviour desired in not being rewarded at all” (Pp 7). He identified the causes as fascination with an “objective” criterion, overemphasis on highly visible behaviours, hypocrisy, and focus on morality or equity rather than efficiency. Kerr drew up examples of fouled up systems from various contexts, such as politics, war, medicine, universities, consulting, sports, government and business.
The free-agent model also has a cultural impact on the firm, as it introduces performance or ‘star culture’ and its unintended consequences include depletion of compensation money for remaining employees. In addition, there are important morale implications when free-agent model is used excessively. An important principle for the success of compensation is that it should recognise the procedural and distributive fairness. Free-agent model risks it. At the firm or business level, high pay for few ‘stars’ means low pay for others introducing a zero-sum game.
3.2 Capability Building Compensation Model
The Capability building model relies of collectivist approach to organizational outcomes and focusses on value creation as opposed to value extraction. While the free-agent model is “eat what you kill”, the capability building model is ‘eat what you farm’.
At its core, the capability model for compensation means that employees are paid for building and contributing to a set of purpose-driven capabilities (such as customer service, cost efficiency or innovation). It is the role of leadership and strategy to translate these capabilities into financial success. Organizations pay to get the threshold level of skill or experience, and unlikely to pay beyond a threshold compensation benchmark to get additional skills or to reward stand-out performance. In this model, the compensation rates are ‘determined’ operationally by job evaluation, job architecture and pay ranges, and institutionally by perceived value in relation to internal pay relativity and organizational pay capacity. Under the capability building model, the emphasis is on culture, and an individual’s skill set, and experience is seen as contributing to the organizational eco-system of capabilities and culture.
At an intuitive level, capability model seems like a good compensation framework to follow – it does not believe in paying high compensation for expected ‘star’ performance (which may or may not materialise), or to reward performance (which may or may not be reliably assessed and reflect excessive risk taking). Having equitable pay also likely to lead to a more collegial culture. That said, the capability building model has its limitations, and it requires certain conditions to be most effective.
- Capability building is an evolving and complex process, and it requires various HR processes, such as recruitment, talent development, performance management, and leadership to be well-aligned in a robust employee proposition, of which compensation is an important, but one part. Further, it requires certain stability in purpose, values and strategies. If organization is changing its business model frequently, capability building model, which takes time to bed in and depends on consistency, may get disrupted or even worse could lose credibility;
- Capability building with its leaning towards collegial culture is prone to free-rider problems, and that talented employees, therefore, may prefer to move out at some point, if they perceive the compensation process to be unfair. Capability building model also runs the risk of becoming a bureaucracy, as various processes, which are intended to make organization less people dependent, could instead make the firm excessively process dependent, which is a risk in itself.
It is however useful to look into what the capability model seeks to address either implicitly or through its practices. In theory, capability model is focussed on the organization or business as one coherent system as opposed to specific individuals (as in free agent model, which gives primacy to individuals over system). Capability model therefore answers compensation questions differently, and in some cases answers different compensation questions.
- It does not seek to prevent attrition of a particular employee, when it entails high cost, beyond established norms of retention; what it does seek to do over a long run is that organization will not have serious talent crises, when employee, including ‘star’ employee, leaves;
- Capability model does not seek to motivate employees through a potentially high – and unknown – incentive upside; what it does is add value to the employees in different ways, so that contract with employees is psychological instead of purely transactional. The value added to employees through experience, roles and projects creates overtime superior pay options externally, if compensation becomes an important factor to an employee;
- Finally, it does not seek to make compensation open-ended to hire any specific hire; rather, it seeks to encourage and tests the managers to make the most of the best talent they could get for a given money.
Capability model, therefore, does not stress over the particular (employee, event, etc.); instead it focusses on the overall strength, resilience and stability of the compensation process. It does not mean that it does not recognize individual employee; only that it does not do it at the cost and risk to the system as a whole, and that its primary aim is to recognise the overall purpose and capabilities first in a way that there is a non-zero positive game in compensation matters.
4.0 Implications
The free agent compensation and capability building compensation models represents two opposite ends of compensation frameworks. The purpose was present them as ‘ideal types’ and it is recognised that in practice there are variations, and many firms may have mix of two types with them. This section outlines the implications for practicing managers as well as future research.
4.1 Testing the Pay Assumptions
Tradition pay context and its techniques (such as job evaluation, pay benchmarking, performance measurement) rely on assumptions, which are increasingly under challenge as business contexts and economies become more complex, inter-connected, unpredictable, and technology driven. Few such assumptions are that roles are static, standardised and comparable within a given industry for pay purposes; roles are plug and play, and skills are transferrable, and; performance and value created can be reliably assessed and attributed to individual’s performance. As business models and economies become more complex, roles increasingly become atypical and less comparable; performance is less transferable; pay may not be reliable indicator of past or future value-add; and outcomes are not entirely based on performance, skills and efforts. As organizations seek to address pay challenges, it is a good compensation-risk management strategy to test these assumptions in a more active manner.
4.2 Choice of Compensation Design
In the modern context of compensation, particularly at senior levels, when the performance and risk horizons are not aligned and it is difficult to disentangle skill and luck, compensation choices are not limited to how much to pay, but also to how, when and why to compensate. In short, the compensation design itself needs to be sound and organizationally aligned, so that value is created in the right way for the organization and its stakeholders. The EU regulation post financial crisis has tried to address it in the financial services sector (within EU) for the in-scope firms and employees with its own prescriptions. Though regulation in the field of executive reward has had its share of unintended consequences and EU regulation itself had its learning curve, it serves as a useful reminder that compensation is a not about level of pay alone (though that too is important), but also how, when and why it is paid.
4.3 Assessing the Reward Mandate
Traditional pay context is substantially influenced by the agency theory and the underlying theory of firm, which stipulate the maximisation of shareholders wealth as the goal of firm. It provided the inspiration towards the pay for performance and equity-based compensation for CEO and other senior levels, which in turn influence the broader pay context. Though this theory is increasingly under challenge, its popularity indirectly focused the attention towards the “value-extraction” as opposed to “value-creation” model of business strategy. This had similar implication towards reward strategy, which also focused on value extraction (free-agent, star focused performance pay) as opposed to value creation (focus on collective capability building and resilience). This could potentially explain few practices related to pay, such as zero-hour contracts, pay inequities, and gender pay gaps. It can be argued that while they save money and possibly add to flexibility, they do not buy commitment and institutional advantages. As institutional norms evolve and expectations from firms change, a major reward challenge will be on how to operationalise the reward mandate in a way that is fair, equitable and at the same time ensures pay competitive and efficiency.
References and Notes
[1] Dorff, Michael B (2014) Indispensable and Other Myths: Why the CEO Pay Experiment Failed and How to Fix it. London: University of California Press.
[2] Ibid
[3] Ibid
[4] Stephen H. Bryan, Robert C. Nash, and Ajay Patel, (2006) “The Structure of Executive Compensation: International Evidence from `1994-2004” , http://ssrn.com/abstract=891207, as cited in Dorff (2014).
[5] Desai, Mihir (2012) The Incentive Bubble. Harvard Business Review. March 2014.
[6]Observation by Joe Bachelder in a roundtable moderated by Charles Elson (2003). What’s Wrong with Executive Compensation? Harvard Business Review.January 2003. (https://hbr.org/2003/01/whats-wrong-with-executive-compensation).
[7] Desai, Mihir (2012) The Incentive Bubble. Harvard Business Review. March 2014.
[8] Stout, Lynn, as cited in Eavis, Peter. “Executive Pay: Invasion of the Supersalaries”. The New York Times. 12th April 2014.
[9] Ibid.
[10] Piketty, Thomas as cited in Eavis, Peter. “Executive Pay: Invasion of the Supersalaries”. The New York Times. 12th April 2014.
[11] Spotlight series on Managing For The Long Term. Harvard Business Review. May-June 2017.
https://hbr.org/2017/05/managing-for-the-long-term#the-error-at-the-heart-of-corporate-leadership.
[12] Ghoshal, Sumantra (2005), Bad Management Theories Are Destroying Good Management Practices. Academy of Management Learning & Education. Vol 4. No 1. 75-91.
13. This was examined in Dorff (2014). In addition, anecdotally speaking, Chief Executive of Deutsche Bank, John Cryan was quoted as saying, “I have no idea why I was offered a contract with a bonus in it because I promise you I will not work any harder or any less hard in any year, in any day because someone is going to pay me more or less.” In “Bankers still overpaid, says German bank chief” by Sean Farrell in The Guardian (24th Nov 2015). https://www.theguardian.com/business/2015/nov/24/bankers-still-overpaid-says-top-banker-john-cryan-bonuses-deutsche-bank.
[14] Dorff (2014)
[15] Groysberg, Boris., Nanda, Ashish., and Nohria, Nitin. (2004). The Risky Business of Hiring Stars. Harvard Business Review. May 2004. (https://hbr.org/2004/05/the-risky-business-of-hiring-stars).
[16] Gabaix, Xavier and Landier, Augustin (2008) “Why Has CEO Pay Increased So Much”, Quarterly Journal of Economics, 123 (2008): 50 (as cited in Dorff, 2014; Pp 177).
[17] Observation by Joe Bachelder in a roundtable moderated by Charles Elson (2003). What’s Wrong with Executive Compensation? Harvard Business Review.January 2003. (https://hbr.org/2003/01/whats-wrong-with-executive-compensation).
[18] Desai, Mihir (2012) The Incentive Bubble. Harvard Business Review. March 2014.
[19] “Sports Lessons – Pay, Performance, Tournaments Lecture 22 I Unexpected Economics (Course number 5657) I Taylor, Timothy I The Great Courses. Accessed 11th November 2019. https://www.thegreatcourses.co.uk/courses/unexpected-economics.html
The description on Moneyball approach was summarised between 6.40 and 8.34 minutes in the 22nd Lecture (ref. as above) of this video course. The course access is behind paywall.
[20] Spotlight series on Managing For The Long Term. Harvard Business Review. May-June 2017.
https://hbr.org/2017/05/managing-for-the-long-term#the-error-at-the-heart-of-corporate-leadership.
[21] Beer, Michael and Cannon, Mark D. (2004). “Promise and Peril in Implementing Pay-for-Performance”, Human Resources Management, 43: 7 (as cited in Dorff, 2014; Pp 125).
[22] https://www.vlerick.com/en/research-and-faculty/knowledge-items/knowledge/the-best-performing-companies-pay-their-ceo-s-relatively-less. The Best Performing Companies Pay Their CEOs relatively less. Vlerick Business School.
[23] Cable, Dan and Vermeulen, Freek (2016). Stop Paying Executives for Performance. 23 Feb 2016. https://hbr.org/2016/02/stop-paying-executives-for-performance.
[24] Kerr, Steven (1995). “On the folly of rewarding A, while hoping for B”. The Academy of Management Executive. Feb 1995. 9,1; Pp 7-14.
