Why Performance-Related Pay Isnt

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FEATURE:WHY PERFORMANCE-RELATED PAY…ISN’T
required to operate PRP in any organisational role, worth the trouble? The research evidence is far from supportive. Looking at chief officers first, payments under simple bonus schemes are quite closely associated with firm performance. But of course, that is because in such senior roles, firm performance usually determines them. It is not evidence that bonuses cause or are necessary for superior performance. Ironically, there is now a strong trend towards complex bonus schemes, partly to incorporate more non-financial performance measures for a longer-term view. This move is motivated by the right principles, but complex bonus schemes are less sensitive to actual performance. Long-term incentive plans (LTIPs) don’t fare any better. There is evidence that their design is easily and regularly manipulated6 and that they handsomely reward average performance7. Executive share options (ESOs) might be expected to avoid all these problems. After all, they are surely very directly linked to the performance of CEOs and their top teams. Here, a different problem and interesting irony crops up. The more senior an executive, the more he or she is considered responsible for firm performance, having the remit to manipulate an extremely wide range of organisational variables. However, it is precisely the control over these variables that empowers executives – where they are so inclined – to make self-serving decisions at the cost of the company. We tend to forget, when granting share options (a ‘long-term’ incentive) that very often the executives receiving them will still be in control of the important levers when these options mature and tempted at that point to make short-term decisions to maximise personal rewards. It is often the dysfunctional behaviour that is delayed, as well as the reward. For example, the use of share buy-back schemes, which increase share prices (but not long-term shareholder return8), has increased in line with the use of ESOs and there is evidence that such incentive schemes affect stock repurchase decisions9. Just to add to the confusion, many executives receive share options based on a multiple of salary, so at the

How PRP produces the illusion of control and thwarts strategy implementation Andrew MacLennan explains...

There can be few more intuitively
appealing ideas in management than linking pay to performance. It conjures up all the right notions – leading edge, logical, wise, prudent and equitable. Plenty of organisations seem to agree. Over 80 per cent of the UK workforce is eligible for some form of performancerelated pay (PRP) – a figure that is growing fast1. PRP is being introduced to an increasingly diverse range of jobs. Its introduction for teachers is a recent highprofile example of the public sector catching up with the trend. Not only is PRP becoming more widespread but organisations are also relying upon it more than ever before – especially for the most senior roles. A recent survey reported that the annual 28

bonuses of executive directors and senior executives now average over 40 per cent of salary2. The corporate governance movement has fuelled the drive towards PRP. The Greenbury and Hampel committees both recommended that incentive compensation be closely aligned with performance3. These recommendations followed the concern, backed by considerable evidence, that the relationship between executive pay and company performance was very weak4. Indeed, chief officers’ pay appears to be far more closely associated with the size of firms than the returns they generate5. So is the widespread enthusiasm for PRP justified? Is the complex apparatus and sensitive stakeholder management

time of the award, a lower share price translates into a greater number of shares. This diminishes the incentive for early share price increases. Moving away from chief officers, what about everyone else? Can organisations make PRP work for those in less...
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