DESIGNING EFFECTIVE REWARD SYSTEMS

1 DESIGNING EFFECTIVEREWARD SYSTEMSBy Wim Van der StedeThe attached article was published in the October 2009 issue, , of Finance & Management, the monthly magazine of the ICAEW s Finance and Management faculty supports chartered accountants working in online at FROM CHRIS JACKSON, HEAD OF THE FINANCE AND MANAGEMENTFACULTY, ICAEWI hope you enjoy this the year, the faculty publishes similar material to help you do business with find out more, please contact Caroline Wigham on +44 (0)20 7920 8508 or join online at banking industry has been criticised for rewardingexcessive risk-taking with its bonus culture . At thesame time the downturn means that manyorganisations will be reviewing their pay-for-performance plans. The question then is, how can thisbest be done?

2 I propose that organisations scrutinisethree elements of their REWARD SYSTEMS : incentive strength; incentive type; and incentive strength consider weak(er) incentivesIn an earlier article about the pitfalls of pay-for-performance1, I argued that incentives have theindisputable effect of focusing employees on what isrewarded. What you measure is what you get , thesaying goes but does it always work as intended?Strong incentives would be just fine if what youmeasured, and rewarded, matched what theorganisation wanted. But that is hardly ever the casedue to measurement problems and problems examples of measurementproblems are not hard to find. Schools want to improveeducation, but they measure improvements in testresults. Hospitals want to improve health care, but theymeasure treatment costs.

3 Firms want to enhanceshareholder value, but they measure annual profits. Ifwhat is measured is what is rewarded, organisations arelikely to see progress in measured performance, eventhough measured performance may not match intendedperformance. Worse, organisations may seeimprovements in measured performance to thedetriment of intended , teaching to the test a possible unintendedconsequence of rewarding teachers for improved testresults should not be equated with improvededucation. Equally, focusing on treatment costs inhospitals the measured performance may divertattention away from prevention, which might (albeitperhaps with delay) reduce the need for, or improve theeffectiveness of, are also a number of ways in which for-profitfirms may increase annual profit without creating long-term value, or worse, while destroying it.

4 For example,managers can push employees into overtime or hiretemps at the end of a measurement period so that moreFEATURE: MANAGING PEOPLEHow can a business design REWARD SYSTEMS appropriate for the currenteconomic crisis? Wim Van der Stedeproposes constructive ways toimprove incentive October 2009 FINANCE & MANAGEMENT6 DESIGNING EFFECTIVEREWARD SYSTEMS product can be shipped and higher revenues and profitsreported. But if product quality suffers, customersatisfaction may diminish, the cost of customer returnsmay increase, and some employees may becomedisgruntled and disengage or leave. Goodwill that hadbeen built up previously may be lost. So the effects ofsuch measurement imperatives are counterproductive. As these examples show, incentives work in that theyfocus employees attention on what is measured andrewarded.

5 But it is only when measured performanceadequately captures what is intended for improvementthat strong incentives will have good effect. When that match between measured and intendedperformance is incomplete, then strong incentives willonly stimulate unintended or perverse behaviours. Putbluntly, when incentives are misdirected due to poormeasurement, they only take the organisation offcourse, faster. Thus, when measurement is likely to beproblematic, organisations are better advised to weakenincentives rather than strengthen hard as it is for any measure tocompletely, or sometimes just adequately, captureintended performance, it is just as hard to define jobs even seemingly simple jobs by a single dimension interms of what is desired by the employee for performingthe job effectively.

6 That is, most jobs are multi-dimensional: they require multi-tasking2. For instance, banks may have thought that the job oftheir mortgage personnel involved generatingmortgages (indeed they often motivated theseemployees by paying straight commissions on the facevalue of the mortgages sold), but what good does it doto have bad mortgages on the books (as many bankshave pitifully found out)? In fact, generating good mortgages involves not just selling the highest numberof loans at the highest possible face value but alsoassessing the creditworthiness of the borrowers, amongother things. Commission-type incentives based on theface value of the mortgage are likely to crowd out suchconcerns, thereby reducing what is essentially a multi-tasking job (one that involves trading off loan amountvs.)

7 Risk; current business vs. future profitability) into asingle-tasking focus, which it is not. Conceptually,employees respond to what is signalled by the incentivesystem as being important (what is measured) and whatthey are rewarded for (what is incentivised). But whenwhat is measured is incomplete, the incentives attachedto it are likely to lead employees to devote less, orsometimes no, attention to important-yet-unrewardedactivities that are just as critical, sometimes even morecritical, for success. The incentive system is imbalanced,with strong incentives on one dimension crowding outthe desired attention by employees to other importantdimensions of their providing strong incentives on all of the importantdimensions is likely to prove unfeasible and too costly,so it follows that providing weaker incentives that is,incentives that are proportionally smaller relative tosalary might be the best option available to preventthe imbalance from getting out of addition to reducing the incentive strength on anyone dimension, another way to address the incomplete-measurement problem, and to keep incentives balanced,is to consider subjective performance type consider subjective performanceevaluationsWhen subjective performance evaluations are used.

8 Part(or all) of a bonus is based on subjective judgementsabout performance: this allows organisations to utiliseany relevant information about an employee s7 FINANCE & MANAGEMENTO ctober 2009 PEOPLEWhen incentives are misdirecteddue to poor measurement, theyonly take the organisation offcourse, fasterWim A Van der Stede is CIMA professor ofaccounting and financial management at theLondon School of Economics and Political that arises during the period. Of course,subjectivity, if used, needs to be contractually authorisedin the bonus plan. This is not just for legal reasons. Ifemployees do not understand the key elements of theirbonus plan, it is unlikely to generate the desiredmotivational key focus here, however, is that subjectivityallows for the rebalancing of incentives, such as toimprove multi-task incentives3.

9 For example, if amortgage sales rep is deemed to have beenperforming below standard, then that employeewould miss out on all or part of the eligiblediscretionary bonus. In other words, subjectivity canbe used to REWARD (punish) employees for value-enhancing (value-destroying) efforts that areotherwise too complex or too costly to quantify inthe formula bonus contract. In so doing, theorganisation signals that the other dimensions of thejob at least receive some weight, thereby possiblymitigating otherwise narrow or perverse the subjective evaluation processes are done welland kept honest, and when the judgements aresubstantiated, such discretionary bonuses can be farsuperior to mute aggressive bonus cultures that arepredicated on generating short-term results, regardlessof the horizon keep focus on the long termA final problem with incentive SYSTEMS is illustrated bythe recent banking crisis: namely, that in many of thebanks the vast bulk, if not all, of the incentive pay wasbased on short-term performance, particularly at levelsbelow the most senior executives.

10 When it becameapparent that in some cases the stratospheric short-termprofits were unsustainable in the long term, the bonuseshad already been paid and there seemed no way to clawthem this demonstrates, again, is that incentives work ie, when they focus on profits measured inshort periods, then employees tend to be highlyconcerned with increasing monthly, quarterly orannual profits. When employees orientations to theshort-term become excessive, however so that theyare more concerned with short-term profits than withlong-term value creation they are said to be can incentives be designed to mitigate myopiaand encourage employees to have a long-term focus,or better still, to balance their concerns for both short-term profitability and long-term sustainability?