Monday, November 30, 2009

Strategic Planning Analogy #295: Bonus Backlash

Many years ago, I was working at a company that was having mediocre (at best) performance, yet paid its top executives quite well. I complained about the high pay relative to the performance and was told, “You have to pay a lot to get this caliber of management.”

My reply was, “Are you saying that if I pay less I can get a better caliber of leaders?”

My point (half in jest) was that if a company pays too much money to top management, they will attract people who are primarily there to satisfy their personal greed. Pay less and that caliber goes away, replaced by people who are more motivated by doing a good job for all the business stakeholders.

Before throwing me overboard as a heretic, consider an article published today in the Wall Street Journal in collaboration with the MIT Sloan Management Review. The article advocated eliminating the executive bonus, using words which echoed some of my assessment. In particular, the article said,

“It has been claimed that if you don’t pay [bonuses], you don’t get the right person for the CEO chair. I believe that if you do pay bonuses, you get the wrong person in that chair. At the worst, you get a self-centered narcissist. At the best, you get someone who is willing to be singled out from everyone else by virtue of the compensation plan.”

This article was not written by some young anti-capitalist revolutionary. It was written by Dr. Henry Mintzberg, a long-time business professor at McGill University.

While I disagree with Mintzberg’s ultimate conclusion to eliminate bonuses, I agree that the current system is a bit broken. And my biggest concern is not about the greed. A little greed can be a useful motivational tool. My key concern is that compensation influences action, and long-term strategic actions tend to get little emphasis when the compensation plan is created.

The principle here is that people act based on how they are rewarded. Therefore, if you want leaders to act in the best interest of the strategic plan, make doing so a key part of the reward plan.

Now some might argue that long-term strategies are already well baked into most executive compensation plans. After all, most of them have a large component tied in some way to stock price. Doesn’t a rising stock price represent some sort of approval of long-term future strategic performance?

The problem is that there are a large number of causes for rising/falling stock prices which have virtually nothing to do with implementation of a strategic plan. These causal factors can include everything from short-term financial manipulations (that have nothing to do with strategy) to stock buybacks to macro-economic factors outside a company’s control. Given all the factors which impact a stock, it is virtually impossible to isolate how much the price fluctuation has to do with strategy implementation (or lack of implementation).

In fact, there can often be a negative correlation. By cutting back on investments with more strategic, long-term impact, one can make the near-term results look better, which can temporarily increase stock prices. Of course, this is like saving money today by eliminating automotive maintenance, only to have a longer-term disaster when the engine eventually blows up due to lack of maintenance.

At best, stock is a weak indicator of strategic success. At worst, it is a false indicator which only corrects itself after it is too late and the damage is already done.

A good strategic plan is a roadmap to the future. It shows your desired destination and an action plan of steps to get there. If you want to give incentives for strategic success, then reward achieving those particular actions elaborated in the plan.

For example, your strategy could outline specific action plans similar to the following:

1) Shifting the product portfolio mix in a particular direction (less of some types of products, more of others).
2) Shifting the customer mix in a particular directions (less of some types of customers, more of others)
3) Shifting the way particular work is done, so that it is more productive.
4) Shifting the perception of the company’s position in the marketplace.
5) Entering particular new businesses, geographies, or customer segments.
6) Exiting particular old businesses, geographies, or customer segments.
7) Gaining market share from a particular competitor.

These are actions that can be measured—did you accomplish them or not? If yes, you get rewarded; if no, then no reward. Action-based compensation is more closely aligned with strategic plans than near-term financial outcomes or today’s stock price.

Step #1: Have Actions Written Into Your Plans
Of course, this assumes that your strategic plan includes concrete and specific action steps/goals. If it does not, then I question the value of your strategic planning process. Therefore, the first step is to make sure your strategy is linked to actions. Just providing a vague platitude like “We will be great corporate citizens while providing our shareholders with an adequate return” is not enough.

Somewhere in the strategic plan one needs to explain in broad terms what actions must be accomplished. And remember, numbers are not actions. Saying “We will increase profits by 50%” gives no strategic insight into how to bring this idea to reality. One needs to explain how this is to come about—what needs to be done.

Step #2: Put Actions into Compensation
Now, assuming we have actions described in our plans, the next step is to get those actions into the compensation program. Setting compensation is not just the responsibility of the Human Resources Department or the Compensation Committee of the Board of Directors. If you want people motivated to accomplish the strategic plan, then take responsibility for getting that accomplishment rewarded in the compensation program.

The idea is to reward if the action is accomplished and not reward if the action is not accomplished.

Step #3: Watch Out for Cheaters
No matter how a compensation system is set up, employees (including top executives) will try to find a way to exploit the rules to their advantage. For example, if my goal is to expand into bio-technology, I can do so very quickly if I am willing to acquire a bio-tech company for 1,000 times what it is worth. I got the task done, but in a way that could bankrupt the company by paying too much.

No compensation system is 100% free from cheaters. Loopholes can always be found. But at least with an action-based system cheaters need to at least accomplish something related to the plan.

Some safeguards can be put into the compensation system to ensure that the actions are not blatant abuses of the system. Approvals will need to look at the quality of the action, not just the quantity. Limits need to be placed on how many resources you use as inputs in order to get those outputs, to ensure that there is a positive return on investment.

This should stop a lot of the abuse. And if a habitual cheater still regularly abuses the system, then maybe the problem is not the system, but the person.

Step #4: Properly Size the Prize
If a bonus is too large a percentage of total compensation, then you are increasing the likelihood for abuse. You are also increasing the likelihood that you will be attracting people motivated by excessive unproductive narcissism, rather than people looking out for all of the various stakeholders.

Therefore, make the bonus a minority of total compensation—enough to incent the right strategic behavior, but not so much that it creates unbalanced behavior.

Bonus systems are effective at providing an incentive for action. If set up wrong, they can provide an incentive to do the wrong things. They may even provide an incentive to attract the wrong people. However, if managed properly, bonuses can create the incentive to accomplish your strategic plan. This requires: a) Putting Actions into your Strategic Plan; b) Giving Rewards when those Strategic Actions are Accomplished; c) Putting in Safeguards to Slow Down Blatant Abuse of the System; and d) Making sure that the Size of the Bonus is kept below a level which Distorts Greedy Behavior too Much.

Next time you hear someone say they are “results driven,” ask them what they mean by that. Does it mean they are driven to achieve a number on an income statement regardless of how much strategic damage is done in the process? Or does it mean they are driven to get the right tasks accomplished in the right way?

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