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The credit crunchThe credit crunch

Russell Connor

The scale and impact of the credit crunch and the subsequent devaluation of assets worldwide will be so damaging that the BBC’s Business Editor, Robert Peston, and other informed commentators believe that a “new capitalism” is likely to emerge from the rubble. What is clear to Robert is that the system cannot stay as it has become over the last 30 years. He holds out the hope, among the loss of capital and gloom of massive job losses, that “the system’s salvation may require it to be kinder, gentler, less divisive, less of a casino in which the winner takes all”.

This may be rather too rosy a view. What is absolutely clear is that those running our biggest financial and commercial businesses will have to be more visible. They will have to manifest not only a genuine understanding of their employees but taxpayers too. Those chief executives who succeed will be those that imbue their organisations with very simple common sense standards of decency. And they will almost certainly be paid less for doing it.

This article deals with issue of how to pay and remunerate the business leaders of tomorrow.

Market-related pay and pay for performanceUp until the late 1980s internal equity was a guiding principle of pay and its guardian was a myriad of often highly complex job evaluation schemes. Then, as liberal capitalism, the free flow of money around the world and light-touch regulation came to be the dominant modus operandi, these schemes were demolished in favour of more flexible person-based pay. This person-based approach knelt at the foot of market forces.

Unfettered by issues of internal equity, headlines related to fat-cat salaries soon appeared and have been regularly spotted in the media for more than a decade. Despite some limited curtailing of executive compensation under shareholder pressure, packages have continued to rise to levels undreamt of even five years ago.

This is reflected in the compensation plans of most senior executives in FTSE100 companies. Royal Bank of Scotland (RBS) is a good example to reference. Not because it is particularly different, but because the pay and pension of its most famous CEO, Sir Fred Goodwin, did rather come under the media spotlight. Sir Fred was paid £3,996,000 as stated in the 2006 accounts of which, £2,860,000 was bonus-related. The deferred payment in the form of pension pots and potential lump-sum payments were not referenced in the accounts. However, they did make much of the long-term incentive plans which were largely geared to total shareholder returns (TSR) and increases in earnings per share (EPS).

Using TSR and increases in EPS as the main planks of incentive schemes are common practices in a range of financial and non-financial organisations. Lauded as objective market-related data, they provide the means to pay large bonuses to a range of people — based on performance of course!

However, there are serious flaws with using such measures.

TSR and EPS compare companies’ performance via share price movements and these become a proxy for value-creation. However, the link between share price and value creation is not direct or linear due to the fact that:

The future value of an organisation is already embedded in the share price now. The share price can over-estimate the future value creation potential or underestimate it. Compensation schemes that measure executives based on actual short-term stock prices or comparative stock price movement such as total shareholder return are being rewarded for the value that the market expects them to create — whether they are doing so or not.

The credit crunch: You get what you pay for and other important lessons

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The credit crunchThe credit crunch

Markets move in sometimes mysterious ways especially viewed over short timescales.

In summary, a range of executives, and not just those in RBS, were incentivised by using metrics that can be easily manipulated in the short term. What is more, the measures do not necessarily reflect the creation (or destruction) of longer-term intrinsic value of the enterprise (eg economic profit and market-value added).

When there is a lack of understanding of what constitutes value creation, proxies get taken for the real thing and perception becomes reality.

As mentioned, RBS’s compensation practices were by no means unusual. Undoubtedly, expensive advice and benchmark data had been received and the remuneration committee would have been satisfied that it was introducing best practice schemes. Indeed, the 2006 accounts made much of the fact that advice had been received from international pay and benefit consultancies. These were the very same organisations that were closely monitoring (and very probably advising on) the spiralling amounts of money paid to executives in hedge-funds, private equity firms and investment banks.

It is clear, with the benefits of 20/20 hindsight, how a simple ratcheting up of the pay of all business leaders was explained away by the corporate mantra of market-related pay and pay for performance.

Raising the phoenix from the ashesThe reconstruction has started. Quantitative easing, recapitalisation of the banks, and incentivising consumers to begin spending again all seem to be necessary. However, in order to ensure that we do not repeat the mistakes, lessons have to be learnt. Business people and governments need to:

understand the difference between profit and value reward executives in line with value generation.

Fortuitously, sound principles regarding value generation, organisation design and reward have been around for more than 30 years. We just have to start using them!

The framework underlying the basis for the sound principles is called levels of work. Levels of work has its origins in the work of Elliott Jaques and the Tavistock Institute.

This work concluded that all jobs can be allocated to a limited number of levels each with their own theme and core contribution. The growing body of knowledge based on these ideas also incorporates related research on organisation design and “felt-fair” pay. Felt-fair pay is addressed through a concept known as pay equity multipliers (PEMs).

PEMs have great value when used as an internal measurement tool. Over the last 25 years, starting with the work of Elliott Jaques, more than a dozen research studies have investigated the relationship between differential pay, position in the corporate hierarchy and the “time-span of discretion” of

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The credit crunch

a particular role. Time-span of discretion relates to the time it takes for the consequences of a decision to become clear. These studies, involving over 1000 participants in the US, Canada and the UK, all indicated that pay is felt to be fair if the pay equity multiplier increases by a factor of two for each genuine increase in work level.

PEMs focus on internal equity.

Based on the incentive plans in RBS, Sir Fred’s pay in 2006 was some 200 times bigger than that of a bank cashier. Was this fair and equitable? With the opening up of a vast black hole of debt, this disparity is clearly seen now as highly distorted.

If PEMs had been utilised during the growth of the pay bubble it would have clearly shown how skewed executive pay had become.

The challenge aheadThe so-called “masters of the universe” practised alchemy for a while. It seemed that it was possible to go on forever turning a negative factor (debt) into real value and as a consequence reward yourself with riches beyond the dreams of avarice.

Now it is revealed that the alchemy was an illusion and we have to live with the real lesson that money borrowed has to be paid back.

With the realisation that long-term real value is not generated by financial engineering comes an equally stark understanding that we are going to need the finest minds and best talents to build a new economy if we ever want to live the lifestyle that we were becoming accustomed to. The question is, how are we going to reward them?

Implications for HRThe loudest message an organisation can give about what it values most is to pay for it. Given this, an organisation’s remuneration structure and philosophy must be based on its values and culture.

The HR function needs to help the organisation determine what it values and to construct ways to pay for this. While this is a simple statement, the means of achieving it are by no means clear for many.

It seems that as the downturn deepens, the orthodoxy of market-related pay and pay for performance is being called into question. However, it is very unlikely that many HR leaders will be reintroducing the complex pay and evaluation structures that existed in the 1970s and 1980s.

A new way forward needs to be found. This is likely to involve an integrated approach to HR and the best organisations are attempting to create an integrated approach to managing people. However, they often lack the fundamental framework that makes this

possible. Levels of work provide just such a framework and enable jobs and organisation to be designed and people to be paid in accordance with sound principles.

An integrated approach undoubtedly has to involve a structured way of evaluating jobs and to rewarding their incumbents based on the real contribution that they make

Semi-analytic job evaluation systems that avoid the bureaucracy of older approaches have been developed based on a levels of work framework. These can be used to:

establish a system for pay management rather than for setting pay levels of every job

help clarify the value-add of jobs and the person requirements

provide the basis for internal equity and equal pay for equal value

ensure sensible organisation design facilitate career development and mobility.

ConclusionThe lesson that you get what you pay for is beginning to sink in.

Fortunately, this lesson has a positive aspect and through a thoughtful development of a compensation system based on sound principles that reference more than competitive pressure and market forces it is possible to attract, retain and develop just the sort of people who will build a positive sound economy.

Points to ponder• How much does your organisation’s reward system

favour only short-term performance over longer-term results? How could a better balance be struck?

• To what extent do employees feel that the reward system is fair? How do you know? What can be done to address any issues of perceived inequity?

ReferencesMark Van Clieaf and Janet Langford Kelly (May/June 2005): The New DNA of Corporate Governance: Strategic Pay for Strategic Value. Corporate Governance Advisor, Volume 13, Number 3.

Duncan Brown and Brian Dive (January 2009): Level Pegging (People Management).