This is an extract from a mini toolkit (article +E-Templates) that can be source from this link.
Performance bonuses give away billions of dollars each year based on methodologies where little thought has been applied. Who are the performance bonus experts? What qualifications do they possess to work in this important area other than prior experience in creating mayhem we currently have?
- Avoid Tying to a Future Target. 6
- Exclude Super Profits. 7
- Free from Unearned Adjustments. 8
- Apply the Full Cost of Capital 8
- At-Risk Portion of Salary Separate from the Scheme. 9
- Avoid Any Linkage to the Share Price. 10
- Make Bonuses Team-Based Rather Than Individual Based. 10
- Avoid the Annual Entitlement. 11
- Linked to a Balanced Performance. 11
- Exclude Unrealized Gains. 13
- Test Scheme to Minimize Manipulation. 14
- Avoid Links KPIs 15
Avoid Tying to a Future Target
Tying bonuses to the annual plan, turning it into a long drawn out round of politics. The AP in annual planning standing for annual politics. As we all know the numbers were wrong as soon as the ink is dried.
If you set a target for employees that depends on market performance, you can’t really know if the measure will be appropriate until the target date comes. You often end up paying incentives to management when their performance was in fact substandard. Instead, performance should be compared internally (one team against another) and externally (against the competition) rather than against a future target that will be either too soft or too hard.
Failing to set a target beforehand is not necessarily a hindrance as long as staff are given regular updates on their progress against other teams in-house and against competitors. As Jeremy Hope, says, “Not setting a target beforehand is not a problem as long as staff are given regular updates as to how they are progressing against the market.” He argues that if you do not know how hard you have to work to get a maximum bonus, you will work as hard as you can.
Jack Welch in his book “Winning” indicated that when he was in charge of General Electric (GE) that Compensation for individuals and businesses was not linked to performance against budget. It was linked primarily to performance against the prior year and against the competition. Which he stated, “Takes real strategic opportunities and obstacles into account”.
In one-year GE paid the appliances division more bonuses than the plastics even though their performance to budget was inferior. Appliances’ earnings were 10 percent below internal expectations and about ﬂat with the previous year, but their market share had increased in a difficult year. Whereas plastics’ earnings jumped 25 percent, about ten points higher than was expected from the operating plan. However, their two main competitors had earnings growth of 30 percent and 35 percent. Jack Welch got the staff in GE to look outside the company to judge their performance.
“After all, what good is beating targets you set in a windowless room? The real world has its own numbers, and they’re all that matters.” Jack Welch.
Exclude Super Profits
Super profits should be excluded from schemes and retained to cover possible losses in the future. In boom times, schemes often give away too much. These “super-profit” years come around infrequently and are needed to finance the dark times of a recession. Yet, what do our remuneration experts advise? A package that includes a substantial slice of these super-profits, but no sharing in any downside. This downside, of course, is borne solely by the shareholder.
There needs to be recognition that the boom times have little or no correlation to the impact of the teams. The organization was always going to achieve this, no matter who was working for the firm. As Exhibit 1 shows, if an organization is to survive, super-profits need to be retained. If you look at Toyota’s great years, the percentage paid to the executives was a fraction of that paid to the executives in Detroit who had underperformed.
This removal of super-profits has a number of benefits:
- It is defensible and understandable to employees
- It can be calculated by reference to the market conditions relevant in the year. When the market has become substantially larger, with all the main players reporting a great year, we can attribute a certain amount of period-end performance as super-profits
- Bonuses can be paid in loss making years out of carry forward super-profits.
When designing a bonus scheme, the super-profits component should be removed from the calculation rather than used to create a windfall gain to all those in the bonus scheme. If a bonus pool has maxed out, then staff would rather play golf than go hard to win further business.
Free from Unearned Adjustments
All profits included in a performance bonus scheme calculation should be free of all major “profit-enhancing” accounting adjustments. Many banks generated additional-profits in 2010–2013 as the massive write-downs from the Global Financial Crisis were written back when loans were recovered.
This activity is no different from many other white collar crimes that occur under the eyes of poorly performing directors. One simple step you can take is to eliminate all short-term accounting adjustments from the bonus scheme profit pool of senior management and the CEO. These eliminations should include:
- Recovery of written-off debt
- Profit on sale of assets
The aim is to avoid the situation where management, in a bad year, will take a massive hit to their loan book so they can feather their nest on the recovery. This type of activity will be alive and well around the globe.
I remember a classic case in New Zealand where a CEO was rewarded solely on a successful sale of a publicly owned bank. The loan book was written down to such an extent that the purchasing bank reported a profit in the first year that equated to nearly the full purchase price. Most of the written down loans had been repaid in full.