Thursday, 8 March 2012

Solving the performance pay problem

There is a growing consensus that performance pay for directors is not working as advovates had hoped. There are a number of possible responses to this. For some, the focus ought to be on better carrot design, maybe tying carrots to the achievement of positive goals for example. For others, radical simplification is the answer. To me the latter approach seems best, I'd scrap as much of it as possible. But is there another way?

There was an interesting paper published last year by PwC on the psychology of incentives. This is an important battleground, because there is quite a bit of compelling evidence from psychological experiments that financial incentives are at best a limited tool. PwC admitted as such, and even pointed out that certain reforms (such as bonus deferral) might undermine the value of incentives.

They suggest that incentives need to be seen as fair, relatively simple (as complexity may deaden the incentive effect) and relevant to the recipient. They also stress the need for regular payouts:
The human propensity to remember bad news over good means that each year a plan doesn’t deliver has a disproportionate effect on perceived value. But of course if incentives pay out regularly, this needs to be recognised in total compensation – that is the trade: greater certainty in exchange for lower maximum reward levels.
I've though about this and come up with my own solution. My proposal is a simple cash reward. It would reviewed regularly, say, annually, with an uplift applied in certain circumstances. This would ensure that the fairness test is met. There might even be an opportunity to re-jig relative rewards between recipients if one is seen as doing particularly well.

In order to meet PwC's point about regular payouts, the payment of the award would be staggered throughout the year, my preference being monthly chunks. In order to meet the simplicity test it would clearly set out as one single figure that the recipient could expect to receive in the course of the year. This would result in the greater certainty PwC advocate.

I'm calling my proposal a Seasonally Assessed Long-term Adjustable Reward Yardstick. If it works in the boardroom, I could envisage it being rolled out to all employees.

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