Using the right incentives to deliver better results
Top company CEO’s earned $18.9m on average in the US in 2017 (Economic Policy Institute). This means that CEO’s earned more than 300 times as much as their workers. Often this compensation was paid in stock and stock options. There are similar situations of excessive pay in many other nations.
In 1965 company leaders earned only around 20 times their employees.
Quite often executive pay overall has little relationship to the performance of the companies involved. Our elected leaders around the world have called current salaries unreasonable and even potentially an abuse of capitalism. LP
But we can both reduce excesses and put upward pressure on minimum wages with two simple changes, all the while improving the chances of better company profits.
Paying senior managers generously is on some level necessary — the pressure is high, the workload large and with billion dollar revenues you want the best people. For someone to take on the task, management compensation must ensure that executives are motivated to deliver. But how best to ensure this?
Huge pools of retirement savings are held in publicly listed companies. Getting the best results from these companies is critical for many. So, pay incentives need to be aligned to deliver the best interests of shareholders. There are also some underlying management personal goals that we may want to avoid. For example, egotistical managers may take on too much risk through takeovers and aggressive strategies that often destroy shareholder value. We have sadly seen this all too frequently.
At the moment, we have senior executive incentives related to a range of things. These can include dependencies on a company’s share price, on improvements in the cost base, on improvements in customer satisfaction, or on increases in overall revenue. The problem with these types of incentive is with the outcome that they encourage. Managers are smart and driven and like most people will do whatever it takes to achieve the best financial outcome for themselves and for their families. If you incentivise managers merely to reduce cost they will do so, often at the expense of delivery or at the expense of customers’ experience. If you incentivise revenue then this can be achieved for example, by reducing margins. If you incentivise net earnings, then the business can be grown through takeovers or high risk moves at the expense of a shareholders’ real earnings per share. Incentives not tailored directly to the best interests of a company’s long term strategy will deliver the wrong results for shareholders.
Any incentive based on future share prices — even if option based — is less effective, since share market valuations are often more dependent on macro factors and overall market sentiment. A CEO cannot realistically affect short term or even medium term share prices. Many incompetent CEO have simply been in the right place at the right time.
We must have incentives for the right business outcome, not individual metrics.
What matters most to shareholders is only one thing — the long term growth in a company’s earnings per share (EPS). That is, how much income does each share produce. The underlying driver of long term share price growth is long term earnings per share growth. It is the metric used by the best in the business to value shares. Company net profit matters less, since it can be easily manipulated through acquisitions and/or capital initiatives.
Management incentives must then be aligned simply to increases in earnings per share. It is then up to the company executives to determine how to achieve this — it could be partly through reducing costs, it could be through increasing revenue, it could be through investing for the future, or all of the above. But management incentives must be aligned to best benefit shareholders, and good managers will then work hard to achieve this goal. With a large part of a manager’s salary dependant on simple earnings per share, a manager will be driven to improve not just the company’s overall earnings and revenue, but the earnings for each shareholder’s shares.
It is also the wrong incentive to have bonuses being dependent on an individual year’s results, since this can be easily manipulated by moving costs and investments between years. It is no good for a CEO to be tempted to write off enormous losses in one year and to decimate that year’s earnings, just so that the profits and bonus will be larger in the next year. We have seen what happened with the global investment banks’ bonuses prior to 2007/8. Employees incentives were set up to reward risky deals, which produced enormous individual bonuses in the current year. The deals however increased overall firm risk in later years. Staff profited with enormous bonuses in the short term, but the risks destroyed banks’ assets in later years.
An incentive system for executives should then be based on the average growth in earnings per share over the long term. It would also be best to have incentive payments paid over a 3–10 year period, to ensure long term growth. This type of incentive system could apply to the vast majority of profitable companies. Any other incentive system is derivative, would encourage the wrong behaviours, and would contain inherent risk especially if applied in isolation.
In the companies that I own, I want a manager who is driven. I want a person who comes into work knowing that her success is dependent on the long term success of the company. One who knows that she will not earn multi-millions unless she materially improves the company’s earnings for shareholders. For mine, a base salary pays your living expenses. So, for a company executive, a base salary of an absolute maximum of about ten times that of the company’s poorest workers, seems eminently reasonable. Performance based incentives should then form the bulk of any further earnings.
If a company executive is not willing to back themselves to make a difference, then we should find an executive who is. If an executive can materially improve the company’s earnings per share average over 3, 5 and 10 years, then it would seem reasonable for them to be potentially paid accordingly. Sure, there are quite a few other bonus complexities that must be considered but this is a great starting point from which to drive better results for shareholders.
If the bulk of a CEO’s earnings are derived from increases in a company’s earning per share, those leaders will want to hire the best executives available. There is less incentive for “jobs for the boys”, since this will potentially impact the take home pay of the person at the top. There is less incentive to hire “yesmen”, since an executive will want real feedback on the effectiveness of leadership, or it will cost them money. Leaders will then want to employ those people best able to deliver an increase in their own pay, and hence company earnings.
Publicly traded companies are already regulated to protect shareholder interests. We mandate that they produce standard and regular company reports and updates. We mandate that they follow defined accounting standards. We mandate company boards and a basic company structure. Why not also mandate some minimum requirements for company executive pay conditions?
It would seem reasonable for publicly traded companies to have the minimum parameters of their pay schemes controlled. We cannot leave these decisions solely to often conflicted and self-interested company boards (the composition of which is a separate issue worth addressing). Regulations should mandate that company CEO performance bonuses must be primarily driven by increases in average long term earnings per share (where possible). Regulations should also mandate the maximum amount for base salaries – which would also deliver better incentives. Mandating a maximum ratio between company leadership’s base salaries and their employees’ salaries would even potentially encourage pay rises for lower paid staff. Until lower paid employees got paid better, then company executives could not. Getting the right incentives to drive performance should surely be at the heart of capitalism.
Management incentives should make a huge difference to the drive and motivation of company executives. They should make them want to get out of bed and perform each day. They should make up a significant proportion of their total income. They should be based on the key long term company outcome so that long term goals influence each and every decision. Reasonable base salaries, set at no more than ten times the lowest paid worker’s earnings, and bonuses primarily dependent on average increases in earnings per share over the long term, regulated accordingly. A company with that incentive scheme is a company that I want to own.