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The closer you tie a senior executive's fate to the organisation's fate, the better the decision making is going to be. Executive compensation must match organisational performance, writes Ian Williamson, associate professor, Melbourne Business School.
Research clearly shows that the old axiom 'you get what you pay for' is true when it comes to employee behaviour.
If you want a one-year turnaround, you should give your executives a one-year bonus. If you want five-years of sustained growth, give them five years of at-risk incentives and you'll get your growth.
If you have trouble with this concept, take it out of the elite executive suite and think about motivating lower level employees. For example, tell managers they'll get a 30% raise if they reach their quarterly mark. They'll do it.
But tell them that their financial remuneration and performance evaluations will be determined by whether their departments reach certain levels of growth over three years and you will get completely different behaviours. The managers will think about the importance of developing talent, investing in R&D, and forming long-term customer relationships rather than simply cutting costs.
Poorly implementing a pay for performance strategy can create several negative outcomes in organisations. The first is whether managers focus on what's best for the organisation or whether they focus on what's best for them.
In the case of the executive suite, the party most responsible for addressing these so-called agency concerns is the board of directors. Research shows that if you have a weak board or a board that's not paying attention, you can create a situation where executives are being paid big bonuses despite the fact that that company is under performing or even losing money in the long run.
An example of this is the current situation in the US with Lehman Brothers, American International Group (AIG), Fannie Mae and Freddie Mac—all well known financial organisations who from 2003 to 2007, paid their top executives a total of US$1.4bn. In 2008 they were all bankrupt or close to it.
You're less likely to see this where you have some independent board members who have not been nominated by the top executive team and when the board engages in a high levels of monitoring behaviour.
A second negative concerns the motivational aspects of paying a non-performer excessive compensation. Decoupling the link between rewards and outcomes can create all types of cascading problems. The executive starts to believe the bonus is an entitlement and they are less likely to take market feedback about what they are doing wrong, seriously.
For example, consider the US-based auto-makers who are currently seeking federal funding from the US government. Concerning these requests US-president-elect Barack Obama recently noted: "What we haven't seen is a sense of urgency and the willingness to make tough decisions. And what we still see are executive compensation packages for the [US] auto industry that are out of line compared to their competitors, their Japanese competitors, who are doing a lot better." He later added that if the US auto manufactures are going to get support, perhaps not all of current executives need to be there to see it.
So why would organisational leaders provide excessive rewards to executives despite poor organisational performance? One major motivation is a concern for retaining or attracting top executive talent. Board members may believe that because it is so hard to get a good CEO, they should just pay to keep the one they have. If they fire (or lose) all their top executives, who is going to run the company while a new team is found?
However, boards need to understand that this action just masks poor monitoring behaviour or succession planning in the past. If these issues are not fixed it is likely that the organisation will be in the same situation down the line, even if new executives are hired.