(extract from “The leading-edge Manager’s guide to success – strategies and better practices”. The book is available Amazon, see link on www.davidparmenter.com
By David Parmenter
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?
When one looks at their skill base one wonders how did they get listened to in the first place. Which bright spark advised the hedge funds to pay a $1bn bonus to one fund manager who created a paper gain that never eventuated into cash? These schemes were flawed from the start; ‘super’ profits were being paid out, there was no allowance made for the cost of capital and the bonus scheme was only ‘high side’ focused.
There are a number of foundation stones that need to be laid down and never undermined when building a performance bonus scheme (PBS) that makes sense and will move the organisation in the right direction. These foundation stones are:
- § PBSs need to be based on a relative measure rather than a fixed annual performance contract
- § super profits should be excluded from a PBS as they need to be retained to cover the loss making years lying ahead
- § the profits included in a PBS calculation should be free of all major ‘profit enhancing’ accounting adjustments
- § all PBS, especially those in the finance sector, should take into account the full cost of capital
- § any ‘at risk portion of salary’ should be separate from the PBS
- § PBSs should avoid any linkage to share price movements
- § PBSs should be linked to a ‘balanced’ performance
- § PBSs should avoid having ‘deferral schemes’ for unrealised gains
- § all PBSs should be tested to minimise risk of being ‘gamed’ by participants in the scheme
- § PBSs should no be linked to KPIs
- § PBSs need to be communicated with staff using PR experts
- § PBSs should be ‘road tested’ on the last complete business cycle
Be based on a relative measure rather than a fixed annual performance contract
Most bonuses fail at this first hurdle. Jeremy Hope and Robin Fraser, pioneers of the Beyond Budgeting methodology have pointed out the trap of an annual fixed performance contract. If you set a target in the future, you will never know if it was appropriate, given the particular conditions of that time. You often end up paying incentives to management when in fact you have lost market share. In other words, your rising sales did not keep up with the growth rate in the marketplace.
Relative performance targets measures are where we compare performance to the market place. Thus the financial institutions that are making super profits out of this artificial lower interest rate environment would have a higher benchmark set retrospectively, when the actual impact is known. 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 if you do not know how hard you have to work to get a maximum bonus you will work as hard as you can.
Super profits should be excluded from a PBS and retained to cover the possible losses in the future
In boom times, annual performance targets 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; yet no sharing in any downside. This downside, of course, is borne solely by the shareholder.
Exhibit 1: retention of super profits
There needs to be recognition that the boom times have little or no correlation to the impact of the teams. The organisation was always going to achieve this, no matter who was working for the firm. As Exhibit 1 shows, if an organisation is to survive, super profits need to be retained. If you look at Toyota’s great years the percentage paid to the Executive’s was a fraction of that paid to the State side Detroit ‘fat cats’, who had under performed.
This removal of super profits has a number of benefits:
- it avoids the need to have a deferral scheme for all unrealised gains
- it is defensible and understandable to employees
- can be calculated by reference to the market conditions relevant in the year. Where the market has got substantially larger, with all the main players reporting a great year, we can attribute a certain amount of period end performance as ‘super profits’.
When designing a bonus scheme the super profits component should be a deduction from the profits rather than create a ceiling for the bonus scheme. If a bonus pool has ‘maxed out’ then staff will rather play golf than go hard to win further business. The ceiling in Exhibit 1 is shown for illustration purposes only.
The profits included in a PBS calculation should be free of all major ‘profit enhancing’ accounting adjustments
Many banks will be making super profits in 2010 -2012 as the massive write downs are written back when loans are recovered to some extent. This will happen as sure as night follows day.
I remember a classic case in New Zealand where a merciless CEO was rewarded solely on a successful sale of a publically owned bank. The loan book was written down to such an extent that the purchasing bank merely had to realise these write downs to report a profit in the first year that equated to nearly the full purchase price.
This activity is no different to 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.
These adjustments do not have to be made for the loan team’s bonus calculations. We still want them motivated to turn around non performing loans.
Taking into account the full cost of capital
The full cost of capital should be taken into account when calculating any bonus pool. A trader can only trade in the vast sums involved because they have a bank’s balance sheet behind them. If this was not so, then the traders could operate at home and be among the many solo traders who also play in the market. These individuals cannot hope to make as much profit due to the much smaller positions their personal cash resources facilitate.
Each department in a bank should have a cost of capital, which takes into account the full risks involved. In today’s unusual environment the cost of capital should be based on a five year average cost of debt and a risk weighting associated with the risks involved. With the losses that bank shareholders have had to stomach the cost of capital should be set in some ‘higher risk’ departments as high as 25%.
With the current artificially low base rate, a fool could run a bank and make a huge bottom line. All banks should thus be adjusting their cost of capital based on a five year average in thier PBSs.
Any ‘at risk portion of salary’ should be separate from the PBS
In the finance sector it is traditional for employees to have a substantial share of their salary at risk. The bonus calculation has been a very primitive calculation.
I propose that the at risk portion of the salary should be paid when the expected profits figure has been met, see Exhibit 2. Note that as already mentioned this target will be set as a relative measure, set retrospectively when actual information is known.
Where the relative target has been met or exceeded the ‘at risk’ portion of the salary will be paid. The surplus over the relative measure will then create a bonus pool for a further payment which will be calculated, taking into account the adjustments already discussed.
Exhibit 2: At risk component of salary