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Seven sins of executive
performance measurement
- Limited metrics, uniformity, oversimplification, balanced
scorecards, ‘me too’ approaches and a lack of objectivity
damage incentive programmes
- Organisations must address key issues in incentive
programmes in light of recent executive remuneration failings
Mercer, a leading global provider of consulting, outsourcing and
investment services, has outlined the flaws in the current approach
used by major companies, including financial services organisations,
in measuring and rewarding the performance of their executives.
Mark Hoble, a principal in Mercer’s executive remuneration team,
said: “Developments over the past six months have heightened the
focus on incentive plans and the measures for setting targets and
rewarding performance. Despite increased scrutiny of rewards for
performance, many companies continue to struggle with defining and
managing their performance measurement system. Most apply a standard
approach to executive performance measurement, but what works for
one company might fail for another.”
Common performance measurement sins
According to Mercer, the following are the seven sins that companies
commonly commit when deciding their performance measurements:
1. Earnings per share (EPS) is the main driver of shareholder
value
As one of the most common metrics used in discussing corporate
performance, EPS is easily understood by executives and investors
and is generally reported by the press as an indicator of the
success of a company. But EPS can be affected by changes in
accounting policy and does not account for the cost of capital and
the capital structure of the business. It also yields growth
percentages that can be misleading or meaningless when calculating
growth from a small base or from negative earnings.
EPS also highlights the difficulty of determining the validity of
one-time, non-recurring and extraordinary items. Most importantly,
actual EPS performance (as opposed to performance against
expectations) may not always be well correlated with creating
long-term shareholder value.
2. Total shareholder return (TSR) is the only performance metric
required
TSR allows objective benchmarking of performance against peer
companies but the relationship between executive behaviour and TSR
results is less direct. TSR is affected by factors outside
management’s control or influence, including macro-economic factors,
broad market trends and specific sector competitive issues. It also
represents actual performance and expectations of future
performance, so rewarding for TSR means rewarding for results that
have not yet been delivered. Participants, particularly those below
the most senior executive level, cannot meaningfully affect this
measure, given the number of possible drivers of share price.
The most effective incentive programmes should include metrics that
are linked directly to the business strategy, provide a clearer line
of sight to executive behaviour, and measure outcomes, not
expectations.
3. A balanced scorecard is the best framework for measuring
performance
Scorecards measure results against a range of factors and are used
to paint a more holistic picture of performance outcomes than can be
captured by one or two metrics. They recognise the trade-offs in
decision-making, such as maximising returns today versus investing
for future growth.
Yet “balanced” scorecards, which typically place equal weight on
financial objectives and a host of other operational and strategic
objectives, may not appropriately reflect business priorities. Some
business goals are more important than others, and using too many
measures dilutes executive focus. Scorecards are often more
effective if they are “unbalanced” as they provide greater
flexibility to reflect the business strategy as it evolves, and can
concentrate on fewer metrics – sending a clear message to executives
regarding business priorities and holding them accountable for the
most important dimensions of performance.
4. If a competitor or peer uses this measure, our company must
use it too
Performance metrics should be selected based on a variety of
internal and external factors. Simply adopting metrics used by peer
companies may cause organisations to fail due to differences
inherent in their business. Growth-related metrics usually play a
more prominent role in performance measurement in younger companies,
for example, while profitability or return-based metrics tend to
become more important as a company matures. Performance metrics
should also support an organisation’s unique business strategy.
5. To be effective, your performance measures must be commonly
accepted and well understood by everyone
The simplest measurements are often adopted because companies fear
over-complexity will make incentive plans too difficult to
communicate and administer. However, more complex metrics include
additional information that more accurately captures performance
results. Some complexity may be necessary to deal with specific
business measurement challenges such as performance in a cyclical
industry, a merger or acquisition, or ensuring the profitable use of
capital. Simple performance measures may make plan administrators
happy, but an overly simple plan is unlikely to deliver the results
that shareholders expect. Ideal performance programmes should be
designed and then the simplification of administration and
communication should be undertaken.
6. Your budget and strategic plan is your performance target
In European companies, incentive payments are often linked to
company performance compared to the planned budget. While these may
seem common-sense standards for assessing performance, using only
internal measures often leads to under- or over-calibration of
performance and a misalignment of incentive payments. For example,
executives may be under-rewarded for achieving target results in the
case of a stretch budget and over-rewarded if the budget is
conservative. Companies that set goals based purely on their own
historical performance are likely to build incentive payments into
their budget even in poor years.
Creating targets from a number of different perspectives – rather
than relying solely on the strategic plan and budget – will more
accurately assess performance. Providing a more objective basis for
evaluating performance and breaking the link between incentive plans
and the budget helps to maintain the integrity of the budget-setting
process, and it reduces the tendency of executives to underestimate
the company’s future potential.
7. All senior executives should be rewarded using the same
performance measurement programme
Most companies reward all executives using the same performance
vehicles and plan metrics, as common goals encourage collaboration
and team-work. Yet large, more diversified organisations often
require more differentiation as business units can have different
strategic priorities or may be in very different stages of business
development. Differences in talent needs – driven by either business
characteristics or geographical factors – may also present unique
performance measurement challenges. Companies must balance the
objective of fostering collaboration and team work with the need for
customisation. For senior executives, at least a portion of the
incentives should be tied to overall corporate performance to ensure
proper alignment with shareholder interests.
Performance measurement virtues
Mercer’s executive remuneration team recommends a number of virtues,
or best practices, to ensure companies incentivise and reward their
executives only for good performance, to help them beat the
competition and generate sustainable profits:
- Identify what you need to accomplish to beat the competition
and generate sustainable economic profits. Then design your
performance measurement system around those factors.
- Pick internal and external performance measures that
accurately reflect the behaviours and outcomes you want to
achieve, given your company’s current strategy and stage of
development. Revisit these as your priorities change.
* Consider using standard performance measures such as EPS
and TSR, if helpful – but don’t rely on just one or two metrics
to assess performance.
* Create a robust target-setting process. If your industry
offers a viable number of comparable peers to allow for relative
goal setting, consider setting incentive targets based on how
your company performs on specific measures versus those of your
competitors.
* Make sure that your goals and incentives are clearly defined
and applied across business units and that they encourage the
appropriate balance between collaboration and accountability.
* Build sustainable, long-term performance into your
measurements to ensure payments are not made, for example, on
the basis of one year’s good performance that could be
overturned in subsequent years.
* Ensure your short- and long-term incentive plans are aligned
to avoid paying twice for the same performance – or paying high
annual incentives year after year without ever reaching your
long-term goals.
* Be clear about what specific behaviour you want to encourage
and what measurable outcomes you want to achieve – and follow
through with clear, consistent communication to help
participants understand exactly what’s expected of them to
achieve their incentive targets.
Mercer is a leading global provider of consulting, outsourcing
and investment services. Mercer works with clients to solve
their most complex benefit and human capital issues, designing
and helping manage health, retirement and other benefits. It is
a leader in benefit outsourcing. Mercer’s investment services
include investment consulting and multi-manager investment
management. Mercer’s 18,000 employees are based in more than 40
countries.
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