Many governance discussions in the boardroom about executive pay over-emphasize the precision of the selected key performance indicators (KPIs). Which three KPIs will really drive performance in the year ahead? This level of granularity is largely meaningless and detracts attention from the more important aspects of performance metrics, what they are, how they are used, and why they are chosen.
The Problem With Chasing the Wrong Numbers
For a long time, earnings per share, a number easily goosed by share buybacks funded by cheap debt (made possible, it shouldn’t have to be said, by earnings), was the dominant metric used to assess executive performance. Manipulating its denominator (the quantity of shares outstanding) takes downright scant effort and certainly less strategic skill than growing a business.
Manipulating its numerator to the downside doesn’t require much more. Buy back those shares and lo and behold, profit growth goes up. Lose a little on synthetic index funds, make a lot of better-than-free money on your stock.
It’s equally easy to puff EPS by cutting research and development that won’t show results for three years or expanding your manufacturing capacity with the help of Trump’s corporate tax giveaway, only to lease it back to yourself to produce the parts needed for your share increase.
It’s simple to cut your depreciation charges by a quarter when you start running late on Wall Street engineers who lack protective headgear and will inevitably have to write the machine off as a complete loss. Buy back those shares and lo and behold, EPS growth is goosed.
Over the last fifteen years, at least, EPS has been a useless metric that still gave the appearance of informative precision.
Transparency and Defensibility Go Hand in Hand
Boards that approach Executive Remuneration design as a competitive exercise, i.e. benchmarking against peer companies to ensure you’re offering market rates, are only doing half the job. Market positioning matters for retention risk, but it tells shareholders nothing about whether the performance hurdles are sufficiently rigorous.
The say-on-pay process, and the influence of proxy advisors like ISS and Glass Lewis on institutional investor votes, has made remuneration report transparency a governance imperative rather than a nice-to-have. What shareholders consistently object to isn’t high pay in isolation. It’s pay that looks disconnected from outcomes, or where the targets were set so low that vesting was near-certain from the start.
Transparency about how hurdles are set, and why, builds more lasting trust than any PR effort after the fact. If the board can explain clearly why a given ROIC threshold represents genuine stretch performance in the context of that industry, most sophisticated investors will engage with it on its merits.
Short-Termism is a Structural Problem, Not a Character Flaw
When an executive’s compensation is overwhelmingly made up of Short-Term Incentive Plans (STIPs), the incentive time-horizon is automatically reduced to 12 months. Despite the existence of Long-Term Incentive Plans (LTIPs) with three-to-five-year vesting periods being specifically designed for this exact ‘healthy’ counter-balancing purpose, this will only be true if those LTIPs constitute a large enough portion of the total pay package to make a difference.
It’s not that a CEO’s myopic if the only option available to them in the face of an investment opportunity that would ding this year’s EPS but boost next decade’s free cash flow is the kind of flimsy “we’re playing the long game” justification that cashes out in share sales the quarter after they retire. The CEO is clearly incented to manage earnings in such a way that hitting this year’s target doesn’t come at the expense of next decade’s free cash flow.
If that’s the situation that the board created, they have only themselves to blame. The same principle applies to any sort of value-destroying M&A pursued in the name of hitting short-term EPS targets in order to max out the STIPs while knowing they won’t see the back end of an angry shareholder demanding a re-do on that decision because their biggest stock trades were announced within three fiscal quarters of their departure.
Building a Framework That Reflects What the Business Actually Owes Stakeholders
Financial key performance indicators (KPIs) can’t tell you if a business is being run sustainably. But customer retention tells you something about how well a company is serving its customers; employee turnover rates shed light on the way it treats its people; supply chain risk and carbon footprints provide insights into its resilience and its environmental stewardship. These metrics are the messy stuff of actual operations. They are both critical to long-term viability and challenging to monitor and report on publicly.
However, 75% of FTSE 100 companies now include at least one ESG target in their executive incentive plans. That may not yet revolutionise the way they approach everything from capital expenditure to acquisition due diligence, but it’s becoming a factor in a boardroom near you. The reason is simple: at some level, investors understand that non-financial risks eventually leak into the financial ones. A business that is badly governed isn’t well-run, it’s also a business that’s financing its operations on a going-concern basis with shareholder value.
A structural response with a good deal more to recommend it than it often receives is the “gatekeeper” measure. This is a ‘metric’, by which we mean either an ethical or a health and safety standard, breaches of which mean that no bonus is paid, no matter how many financial or non-financial goals an individual hits.
If your business had a bad safety year and there was a fine by a court or a regulator for a material breach of any compliance obligation, you simply don’t open a bonus pool. That’s not administering punishment (although it may deter some in the future); that’s declaring that you simply don’t negotiate around certain outcomes.
Pay as Strategy, Not Just Compensation
The most effective pay systems are not those that “pay for performance,” or even those that pay executives “fairly.” Rather, they are pay systems that facilitate the types of actions and decisions that are consistent with the company’s long-term strategy. This often requires a significant misalignment between executive pay and current performance, particularly in companies pursuing strategic shifts that will involve a few years of investment spending before they produce bottom-line results.
Compensation only works to drive long-term value when the system is designed to ensure that the priorities of the employees, management, and stakeholders are well aligned.
