25 April 2008

Paying for non-performance?

In a commentary dated 15 December 2007 on “money not enough?” the issues of pay for performance were explored. As discussed, compensation of chief executives and senior management of private enterprises have been under scrutiny by stakeholders. Stakeholders are utterly disgusted at the manner senior managers reward themselves regardless of company performance.

Although the westernised idea of paying for performance has been embedded as the reward strategy in many organizations, the question of paying for whose performance is pertinent. Are we paying company directors, chief executives and senior managers of organizations for their performance such that we may ultimately be “rewarded”? Or, are senior managers paying themselves handsomely for their own “performance”, even to the extent of behaving fraudulently to satisfy their greed addiction.

One need to go no further than to examine the classic case of Enron to understand why pay for (whose?) performance led to the collapse of the organisation. More recently, the collapse of Opes Prime in Australia wiped out millions of dollars of pension funds; First Capital suffered similar fate, and most recently, Victorian stock broking firm in Geelong, Australia has allegedly been behaving badly.

As the economy is flushed with more money and ready credit, greed had consumed some of us, allowing us to be extremely creative in feeding our greed addiction. As an example, the work performance of a loan officer is measured on the amount of credit that is booked for a given period. To secure higher book value, a bank credit officer may resort to unconventional means of earning performance bonus by offering higher credit to its customers, often ignoring their ability to service loans. Hence, many of us have continually been seduced by financial institutions offering pre-approved increases on credit cards limit, or re-financing homes with subsequent mortgages without much effort or difficulty.

For many years, organizations embrace pay for performance as the panacea for driving desired behaviours towards cash and more cash, often ignoring behavioural integrity, ethics or legal considerations. Edward Lawler III, an authority in compensation management once argued against the effectiveness of pay for performance in “why is pay no longer an incentive to better job performance".

Another commentator, Michael de Beer suggested that careful efforts to design an incentive system to make pay contingent on performance may be misguided, and raised questions on the worldwide trend towards the use of more executive incentives. However, many organisational practitioners are still paying extraordinary attention to pay for performance.

Perhaps, it is the idea of pay for performance, but whose performance? Are practitioners familiar with the notion of pay for non-performance?

The notion of performance based pay is rather complex. There are research conducted on pay and performance and on the causation between risks and rewards; the higher the risk, the greater the rewards.

For an economist, pay for performance is grounded on the theory of incentives known as the agency theory. Agency theory, also known as the principal-agent model presupposes the association between time and effort. The employee may influence the amount of work accomplished, by exerting himself, but he cannot control output entirely, because his work performance may not entirely under his control.

Under the agency model, the employee is assumed to be averse to both effort and risk. If an employee is effort averse, then incentives must be designed to get the employee to exert himself. As the employee is also risk averse, the question of tradeoffs between an employee and the employer sharing the risk is pertinent. Risk is in the balance.

As work performance may be beyond the control of the employee doing the work, pay for performance may perhaps be labeled appropriately as pay for effort. Hence, we find ourselves in a flurry of activities, as we are measured on the amount of noise we generate, and not on work related performance.

From a principle-agent perspective, the moral hazard of pay for performance is pertinent. Moral hazard is defined as the ‘‘actions or in-actions carried out by the agent that are unobservable by the principal’’ When the actions of the agent are unknown and cannot be evaluated by the principal, the principal’s ability to enforce the agency contract is hampered. Senior managers control organizational resources and know most about the organization’s activities; this allows them to act opportunistically to the detriment of shareholders.

Because of their superior information and shareholders’ lack of full observation, managers can take actions that will maximize their rewards; but their actions may harm organizational performance in the long run and result in losses to the principals.

In the words of Gordon Gekko, “greed is good, greed is right, greed works, greed clarifies, cuts through and captures the essence of evolutional spirit”. Based from the collapses of organizations involving billions of dollars, is greed really good especially if pensions are wiped out almost completely overnight. Fortunately, the Central Provident Fund of Singapore manages pension of Singaporeans. At least, our superannuation are bolted under lock and key. Otherwise, we may suffer the same fate as the Australians that invested with the likes of Opes Prime et al. Trust is definitely in the balance.

Perhaps, pay for performance may actually be misguided as it will fuel more corporate collapse.

Should we continue to pay for non-performance?