Should a CEO’s Bonus Be Based on Financial Performance Alone?

On November 9, 2016, the shareholders of Australia’s largest company, and the world’s tenth-largest bank, revolted. The Commonwealth Bank’s shareholders were reacting to the board’s annual Remuneration Report, which contained a recommendation that the CEO be granted a bonus based on what critics saw as “soft” measures. Other firms have ventured down this path, including the conglomerate Wesfarmers, with its 200,000-plus staff, and the global hospital operator Ramsay Health Care.

Should CEO performance be assessed only on “hard” measures? Should soft measures be part of a CEO’s scorecard? Is there a framework that might assist you to tackle the CEO appraisal task?

CEO incentives have traditionally been evaluated against objective data — also labelled “hard.” Take, as an example, the world’s largest mining company by market capitalization, BHP Billiton. Its Remuneration Committee employs several key performance indicators (KPIs) to guide the compensation of senior executives. According to its annual report, those include financial metrics such as “attributable profit; underlying EBIT (earnings before interest and taxation); and total shareholder return (share price and dividends which are assumed to be reinvested).”

What has emerged more recently is the use of nonfinancial, but still objective, KPIs. In BHP’s case, these are total recorded injury frequency and greenhouse gas emissions.

Corporations are now taking a further step beyond objective metrics, which can be financial and nonfinancial, to include subjective measures — tagged as “soft.”

In 2012 the Commonwealth Bank restructured its evaluation system so that 75% of CEO incentives came from the bank’s total shareholder return (TSR), relative to a set peer group, and 25% from customer-satisfaction results, benchmarked against another peer group. When this award structure reached the end of its four-year performance period, on June 30, 2016, in response to the ethical scandals within the bank’s life insurance arm, the bank’s board took yet another step to include even more subjective measures. Specifically, to help modify the bank’s culture to match its stated values, the Remuneration Committee and Board recommended a change to the reward split: TSR 50%, customer satisfaction 25%, and people and community 25%. The latter was concerned with “measuring long-term progress in the areas of diversity and inclusion, sustainability, and culture.” Now a full 50% of the assessment was subjective. This proved to be a step too far for some shareholders, precipitating their revolt in November 2016.

Boards around the world find themselves in a bind. For the last 20 years they’ve gone down a path forged largely by U.S. corporations and global remuneration consultants. They now find themselves dissatisfied with the result, recognizing that they can’t simply rely on financial measures in assessing corporate performance and in distributing rewards to CEOs and senior executives. But they don’t really know what to do instead.

As a consequence, companies are firing off ad hoc responses rather than approaching performance measurement in a comprehensive way. The Commonwealth Bank appeared to shareholders as simply putting out a fire. “Well-intentioned but not well designed” was how Ian Silk, the CEO of Australia’s biggest industry superannuation fund, AustralianSuper, assessed the bank’s attempt.

The future of corporate reporting lies in an integrated approach. Here’s the framework I employ with boards and CEOs. I recommend using it in developing a corporate performance scorecard. It produces both objective and subjective measures:

• Recognize, as company law dictates, that a board’s primary responsibility is to look after the best interests of the company — not only those of shareholders.
• Develop a corporate scorecard focused on the relationships that the company has with its stakeholders, including customers, employees, shareholders, and suppliers.
• Acknowledge that the relationship between company and stakeholder is a two-way street.
• Develop measures on both sides recognizing that measuring performance is measuring relationships and that shareholder returns are driven by effective relationships with other stakeholders.
• Appreciate that those much-sought-after leading indicators are often those soft, subjective measures.
• Implement a short list of KPIs recognizing the cause-and-effect relationship between soft and hard measures.

A recent study by AMP Capital observed that “incentives linked solely to financial metrics risk fuelling negative culture and conduct.” As a result, it noted: “Companies are increasingly focussing on setting non-financial targets alongside financial targets.” The Commonwealth Bank is one among many firms around the globe that is forging new ground. You might expect that the board, under its new chair’s leadership and following the kerfuffle, would back away from the issue. It has no intention of doing so. Instead, indications are that it will provide shareholders with additional context and logic on the thorny issue of soft measures as part of CEO assessment. That points to an additional step that firms can take: proactively preparing their shareholders to accept a different way of doing business.

This blog first appeared on Harvard Business Review on 05/25/2017. 

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