Comp Targets That Work

by Radhakrishnan Gopalan, John Horn, and Todd Milbourn

SETTING EXECUTIVE PERFORMANCE targets is one of the main responsibilities of any board of directors. Unfortunately, it’s a task boards struggle with. From 2006 to 2014 nearly all of the 1,000 largest U.S. firms by market cap completely changed the metrics in their CEOs’ pay-for-performance contracts at least once, and almost 60% changed them more than once. In some cases, of course, the revisions reflected shifts in strategic imperatives, but in many others they were attempts to fix problems that the metrics themselves had created.

The troubles associated with executive performance targets are well known. Most often they encourage short-termism. Cutting research and development to increase quarterly profitability or earnings per share, for instance, may compromise an organization’s ability to introduce innovative products and services. Managers can also game the metrics—by, say, lowballing budgets and forecasts to set themselves easily achievable goals. And some executives manipulate performance numbers by accelerating revenue recognition or postponing discretionary expenditures.

What companies need, then, is an incentive structure that makes it easier to meet targets by creating actual value than by gaming the system. New research, in which two of us participated, points the way. (See the sidebar “About the Research.”) The study, which analyzed data from the proxy statements of more than 900 large U.S. firms over 15 years, examined the link between the behavior of executives and company performance. We have drawn on its findings to identify four principles for designing incentive packages that encourage managers to deliver real, sustainable value.

Principle 1: Use Multiple Metrics

Many firms like to set simple targets for their executives and so assess performance against a single metric that they believe will capture a multitude of behaviors. The logic goes like this: If a CEO has only one metric to focus on, every decision will enhance it, so all you need to do is pick the one that will deliver the results you want. We find that many companies are deeply wedded to this thinking. When companies change a CEO’s performance criteria, 40% of the time they simply choose another single metric.

But even metrics that encompass a broad range of activities can produce dysfunction when used alone. Consider EPS targets, which are very popular. If a strategic choice hurts revenue growth or delays new product launches but nevertheless improves EPS, then a CEO who has an EPS target will always be tempted to make that choice to increase his or her chances of earning a payout.

This problem goes away if you set multiple targets, such as EPS and revenue growth and new product introductions and R&D investment level (say, as a percentage of sales). It’s very hard to game multiple interconnected targets simultaneously, and it becomes more difficult as the number of targets rises. Senior executives just don’t have the time to do it. This was, in fact, what our data showed: Executives who had to achieve multiple goals to receive their bonuses were just as likely to miss a given target as they were to exceed it. Statistically, this is what you’d expect to see if no manipulation has taken place. In contrast, it is highly unlikely statistically that executives will just overperform most of the time. Such results are an indication that they are actively managing to their targets.

It’s important to include a purely revenue-based target in the basket because that’s harder to fudge than a profit target. It’s easier to bridge a 10% profit shortfall than to bridge a 10% revenue shortfall by manipulating your sales. Let’s say your revenue is $100 million and your total costs (assume they’re fixed, for simplicity) are $90 million. A 10% profit shortfall would be $1 million, so you would have to find only an additional 1% of sales to close the gap. On the other hand, to meet a 10% sales shortfall, you’d have to come up with an extra $10 million.

It’s also easier for senior executives to control costs than to control revenue. Consumer reaction to price cuts (or increases) is inherently uncertain and may take time to become apparent. But cost reductions often can be calibrated with enough precision to ensure that earnings (and EPS) meet the desired targets. This is especially true for the costs that senior executives most often focus on when adjusting to make EPS numbers: R&D and sales, general, and administrative expenses.

When you set multiple targets, make sure they aren’t too closely correlated. Don’t choose both earnings and EPS as key metrics, for example, because it will be as easy for the CEO to hit both targets as it would if she had to clear only an EPS hurdle. A better combination would be cash-flow growth and EPS, or revenue growth and earnings.

There is no magic number of targets to choose. Ultimately, it comes down to which metrics reflect the corporation’s strategic objectives. A good rule of thumb, however, is to aim for three to five, because using just two could still create opportunities to manage to the targets while more than five can create confusion about where the organization should focus.

Principle 2: Increase Payouts at a Constant Rate, Adjusting for Risk

In most companies payouts for performance don’t increase at a steady rate. Typically, executives don’t receive one until some minimum threshold has been crossed; then their rewards rise steeply until a target is reached, after which the rewards tend to increase at a lower rate. Consider the incentive plan that one large U.S. technology company spelled out for its CEO in its 2017 proxy statement. The minimum threshold for the CEO was operating income of $295 million; at that point he’d receive 50% of his payout. His incentives rose sharply until operating income hit $328 million, at which point he’d receive 100% of the payout. Beyond that target, the payout for improved performance grew much more slowly. (See the exhibit “The hidden disincentives in performance plans.”)

This type of compensation structure encourages performance gaming. There is less incentive for a CEO to push beyond the target, since additional performance improvement doesn’t have the same incremental impact on his or her bonus. The data seems to bear this out: At companies where payout rates tapered off beyond a given target, CEOs tended to deliver results at or just above the target and seldom much beyond it.

For this reason we recommend that boards increase payouts at a constant rate relative to performance. When companies do this, actual results are less likely to bunch around the target. Of course, you don’t want to encourage senior executives to take excessive risks to achieve higher and higher payouts, which means payouts should be capped at some maximum performance level. But you should be very explicit about why you are setting that cutoff point.

The board must also ensure that payout rates reflect the riskiness of a given target. Targets for EPS and return on equity, for example, can be achieved by increasing leverage at the company—perhaps to repurchase shares. To counter this, a board should adjust payouts on these metrics downward if the firm’s capital structure becomes weaker or other risk factors increase during the performance period. The overall compensation plan, as well as the underlying strategy that it mirrors, must reflect the risk the company is willing to accept.

For example, a bank CEO’s return-on-equity targets should be calibrated to the level of capital the bank maintains. Achieving a 10% ROE with a 12% capital ratio may be easier than achieving it with a 15% capital ratio, so the targets should progressively increase as the capital ratio falls.

Principle 3: Reward Performance Relative to Competitors

Most compensation packages set absolute goals, meaning that the CEO must hit a specific number to receive a bonus. In fact, the use of absolute goals has become increasingly pervasive over the past decade. In 2006 the payouts of 82% of CEOs and 89% of all top executives were pegged to them; by 2014 those numbers had risen to 93% and 98%, respectively.

It’s certainly an easy approach. The board can just use analysts’ forecasts to determine a goal, and the CEO gets a clear number to measure progress against. If you’re feeling bold, the next time you’re in a senior executive’s office, ask whether his or her computer has a ticker active on it that tracks the company’s stock price.

But absolute goals don’t necessarily lead firms to reward performance. Say the board decides the appropriate target is 2% revenue growth. With an absolute metric, it would reward a CEO who grew revenue 2% while the sector overall grew 7%, but not a CEO who grew revenue 1.5% while the sector shrank 3%—even though the latter CEO did a better job.

By switching to relative targets, boards can avoid that kind of problem completely. Relative targets also make gaming far harder because the performance of competitors isn’t known until they release results, which often happens weeks or months after the end of the performance period. Senior executives can’t go back and manipulate numbers at that point. The best way to beat the competition, then, is to continually strive to improve the corporation’s performance. The research confirms this: When CEOs had relative targets, company performance was either slightly greater than or slightly less than the relative target with equal likelihood, which is what you would expect in the absence of gaming.

Absolute targets let managers stay in their comfort zones, focusing on things they can more easily control, like R&D spending, SG&A spending, or landing a large contract. They have no incentive to look beyond that. Relative metrics, by contrast, encourage an outward focus: To outdo competitors, executives must also study them closely and find ways to create differentiated positions. Although there’s a risk that the focus on rivals will cause some companies to rely too much on benchmarking, this will be balanced by the fact that at least one of them will always be innovating. And if the CEO wants to hit the relative targets in her contract, she can’t merely copy those innovations—she’ll have to create a distinctive advantage.

In setting relative targets, you need to think carefully about which competitors to follow. This comparison group should also be based on the firm’s strategy. If the company is a major player in a mature industry, it will want to use its large competitors as the primary benchmarks. If the corporation is expanding into a new area as the core of its strategy, it should benchmark against smaller, newer rivals in that sector. The sweet spot will be more than one or two (which makes it too easy for the CEO to benchmark against others) and fewer than 10 (since the competitors’ performance will have to be aggregated into one number for comparison).

Of course, the exact number of benchmarked competitors will depend on how many publicly owned companies are in the industry, and it’s OK to pick bigger or smaller companies, provided you adjust the relevant benchmarks to account for differences with your corporation. For example, if you’re a small player going up against a large conglomerate, you can use the results in the specific areas in which you compete with it as your benchmarks (if its results are broken out that granularly) or estimate what portion of its overall performance is accounted for by the division you compete with.

Principle 4: Include Nonfinancial Targets

Our final recommendation is to incorporate targets that are not directly related to sales and profits in any CEO performance contract. Although the research we base this article on didn’t explicitly measure the effects of nonfinancial targets, it’s clear that many of them are hard to game. To begin with, it often takes a significant amount of time for the results of decisions related to them to become apparent. Investments in employee training, for example, may not translate into employee productivity for a while. Additionally, many nonfinancial metrics, such as brand, reputation, and sustainability rankings, are set by outside agencies and so are hard for managers to manipulate.

What measures should you consider? Metrics like customer and employee satisfaction levels (as determined by broad-based surveys) are valuable because they provide leading indications about the long-term viability of an organization’s strategy. If customers and employees aren’t responding to the core value propositions the company is offering them, it will be hard to sustain revenue growth and profits or create an engaged workforce. Alaska Air Group, for example, has rated its CEOs on customer satisfaction, while Campbell Soup has included employee engagement in its CEO metrics. Visa ties executives’ individual performance to “deep partnerships” and being “the employer of choice.”

In our view it’s important for every board to consider including a metric on how much a CEO respects and embodies the corporation’s values. If top executives are not living up to these, it’s quite possible the rest of the organization will follow, which could have disastrous effects on performance.

Probably the best way to assess adherence to values is through 360-degree feedback from peers, direct reports, board members, key customers, external partners, and other company stakeholders. ScottsMiracle-Gro applies to its executives’ performance payouts a personal multiplier based on “a subjective assessment of effective leadership qualities such as team development, embodiment of the company’s culture, and personal development and growth,” according to its 2017 proxy statement.

Finally, nonfinancial metrics on environmental, social, and governance performance are top of mind for many boards. In many corporations there is a strong link between short-term ESG goals and long-term financial performance. A reputation as an environmental steward, for example, may improve customer loyalty and enable premium pricing. In such situations tying part of compensation to ESG metrics is a great way to get the CEO to focus on the long term. But compensation committees should be alert to the risk that CEOs may massage ESG metrics to surpass their targets so that they can justify receiving a bonus if faced with a shortfall in current financial performance.

Creating a compensation package that adheres to the four guiding principles is not easy for a board. Directors need to debate multiple metrics (financial and nonfinancial alike), align them with the company’s strategy and values, calibrate them with the risk appetite of the firm, and select an appropriate peer group to use as benchmarks. But this is ultimately what a board is there to do. If it uses executive compensation packages as a way to reinforce the company’s competitive strategy and manage its risks, so much the better. Not only will it be more effective at communicating the strategy and rationale for top management pay with shareholders but it will also ensure that senior managers execute against the right objectives. Remember: Executives will do their best to hit whatever goals are set. So set targets that work for the corporation.

Originally published in September–October 2017. Reprint R1705H

The Case Against Long-Term Incentive Plans

Alexander Pepper spent 27 years at a large accounting firm helping client companies devise ways to compensate CEOs and other senior executives. Starting in the early 1990s, pay packages have typically included long-term equity incentive plans aimed at aligning managers’ and shareholders’ interests. But over time Pepper grew disillusioned. “I began to realize that the people we were putting the packages in place for didn’t necessarily like them very much, and the plans didn’t do what they were intended to,” he says. In the early 2000s Pepper went back to school, eventually earning a DBA; he teaches at the London School of Economics. Today he researches why pay-for-performance plans don’t work. “I was part of the system that I’ve subsequently come to say is not very effective,” he says.

Since 2013 Pepper has published four academic studies based on in-depth surveys with 756 senior executives across 40 countries. He sought to measure how well the executives understand and value the components of their pay plans and how their pay affects their behavior. Although compensation practices differ dramatically from country to country—CEOs in the U.S. earn far more than their counterparts elsewhere, for instance—Pepper finds that regardless of region, executives have the same general misperceptions about pay. He identifies four reasons why pay-for-performance incentives don’t work as well as proponents expected.

Executives are more risk-averse than financial theory suggests

Would you rather have a 50% chance of getting a $90,000 bonus, or a guaranteed payout of $41,250? In theory, the rational choice is the risky payout, since its “expected value” is $45,000, but 63% of executives chose the sure thing—and when asked similar questions involving stock option payouts, they consistently showed a preference for less risky choices. Someone who’s risk-averse assigns less value to dicey propositions, which suggests that executives see the at-risk portions of pay packages as less valuable than economic theory would predict. In interviews they attribute this attitude partly to how “extraordinarily complex” and even “arbitrary” equity plans are. Pepper says that if people view something as not worth very much, more of that thing is needed to make it meaningful—and this dynamic inflates the value of pay plans.

Executives discount heavily for time

Would you rather get a $1 payout today or a $2 payout in a year? The rational choice is to wait, because you’ll earn a 100% return during the interval, but behavioral economists have found that many people choose the early payout—a phenomenon called “hyperbolic discounting.” Pepper’s studies show that it applies to executives’ thinking about pay: A long-term incentive package that may be worth a lot in three or four years is valued very little today. (His data suggests that executives discount distant payouts at the remarkable rate of 30% a year—about five times the discount economic theory suggests.) One executive in the study summed up the situation this way: “Companies are paying people in a currency they don’t value.”

Executives care more about relative pay

Consider a simple question: Would you rather earn $50,000 or $100,000? Now consider the same question with some added context: Would you rather earn $50,000 in a society where the median income is $30,000, or $100,000 in a society where the median income is $125,000? Assuming that prices are the same in both settings, you should choose $100,000—it lets you buy more, regardless of whether it’s more or less than what other people make. But economists have long known that people are highly sensitive to relative earnings and prefer to outearn others even if it means a lower absolute income. Pepper’s research shows that this holds for executive compensation. The executives surveyed were less concerned with absolute earnings and more focused on (and motivated by) how they were paid in relation to their peers, both inside the company and at rival firms. Fully 46% indicated that they would prefer a lower pay package if it was higher than those of counterparts. One said, “The only way I really think about compensation is, ‘Do I feel fairly compensated relative to my peers?’” If everyone asks that question, the resulting arms-race mentality drives pay packages higher.

Pay packages undervalue intrinsic motivation

People work for all sorts of reasons, but executive pay packages tend to discount nonmonetary motivations. Pepper’s research shows that achievement, status, power, and teamwork are all important incentives; in answering survey questions, executives made it clear that extra-large pay packages don’t necessarily create stronger incentives. “I do not believe, nor have I ever observed, that $100 million motivates people more than $10 million or $1 million,” said one company chairman. Executives said they would willingly reduce their pay packages by an average of 28% in exchange for a job that was better in other respects.

How should companies use these findings? Given that executives dramatically undervalue long-term incentive pay, Pepper believes that companies should eliminate that component and increase others. “My research suggests, somewhat perversely, that companies would be better off paying larger salaries and using annual cash bonuses to incentivize desired actions and behaviors,” he says. Additionally, they should require leaders to invest those bonuses in company stock (or should pay the bonuses in the form of restricted stock) until a certain share of leaders’ net worth, or some multiple of their annual salary, is invested. As long as executives hold substantial equity, Pepper says, their interests will be aligned with those of shareholders—and this arrangement would achieve that aim without the confusion and inefficiencies of long-term incentive plans. Some companies, including Berkshire Hathaway, already have plans structured along these lines.

Pepper and other observers recognize that companies looking to implement such changes will face headwinds. In the United States, for instance, salaries above $1 million are not tax deductible, and in most countries the notion of pay for performance is so ingrained that big salary increases could draw criticism. However, Pepper says that like fashion, executive pay tends to go through cycles, and he believes that the long-term incentives in vogue for the past quarter century may soon fall out of favor. “My argument is that pay for performance makes the problem worse, not better,” he says. “You can pay executives considerably less in total—but do it in a different way.”

About the Research

Pepper’s studies, conducted with the University of Bath’s Julie Gore, are described in his book The Economic Psychology of Incentives: New Design Principles for Executive Pay (Palgrave Macmillan, 2015).

Originally published in October 2016. Reprint F1610A