Why ‘Pay For Performance’ Is a Sham

When Peter Drucker published his first major book, The End of Economic Man, in 1939, the median compensation for chief executives of the biggest companies in America stood at about $1 million a year (in today’s dollars).

The median pay was still at roughly $1 million, in inflation-adjusted terms, when Drucker’s 1954 landmark, The Practice of Management, came out. Executive compensation was at the same level when his Managing for Resultsappeared in 1964. Ditto when Drucker’s Management: Tasks, Responsibilities, Practices was released in 1973.

But why? Were CEOs suddenly playing a role worth many times more than their predecessors had for five decades? Are the CEOs who sit atop the U.S. auto industry today really deserving of far fatter salaries—on an apples-to-apples basis—than what, say, Alfred Sloan of General Motors pulled in during the 1930s?

Most certainly not. Yet to hear some tell it, more and more CEOs are now being properly remunerated because they are “paid for performance.” Last week, The Wall Street Journal highlighted the trend, noting that more than half of the compensation awarded to 51 CEOs last year was tied to their companies’ financial results or stock price. That was up from 35% in 2009, according to Hay Group, a consulting firm.

But this also raises a question: How is “performance” being defined? Linking a CEO’s pay to a company’s bottom line or the trajectory of its shares is, arguably, better than having no measure in place at all. Still, as has become abundantly apparent in recent years, this approach carries its own risks, especially if it prompts executives to think too much about goosing earnings in the short term at the expense of the long-term health of the enterprise.

“You have to produce results in the short term,” Drucker asserted. “But you also have to produce results in the long term. And the long term is not simply the adding up of short terms.”

Beyond that, though, something far more fundamental is at play: Meeting financial targets, while obviously vital, is an awfully narrow way to think about executive performance. Indeed, Drucker believed that there were at least four other criteria that should be used in creating a “scorecard for management.”

First, he said, executives should be evaluated on how successfully they’ve invested capital. “Most managements spend an enormous amount of time on capital appropriations decisions,” Drucker wrote. “But amazingly few managements pay much attention to what happens after the capital investment has been approved.”

“To be sure,” Drucker added, “if the new multimillion-dollar plant falls behind schedule or costs a great deal more than was originally planned, everybody knows about it. But once a plant is ‘on stream,’ there is not too much attention paid to comparing its performance with the expectations that led to the investment. And smaller investments, though in their totality equally important, are barely ever looked at once the decision is made.”

Second, Drucker said, management should be assessed on how effective it has been in hiring and promoting people. There is no part of an executive’s job, after all, that is more essential than steering the right talent into the right spots in the organization.

“Yet, while admitted to be crucial, the area is usually considered to be intangible,” Drucker wrote, while quickly making clear that this attitude is little more than a cop out. People decisions can’t necessarily “be quantified,” he explained, “but surely they can be judged—and fairly easily.”

Third, Drucker called for appraising how management has fared when it comes to innovation. “What is expected from a research effort, from a development effort, from a new business or a new product?” Drucker asked. “And what then are the actual results—one year, two years, three years, five years later?”

Admittedly, achieving success here can be difficult. “Even the most competent management probably bats, at best, around .300 in the innovation area,” Drucker pointed out. “Innovation is chancy. But surely there is a reason, other than luck, why some managements—a Procter & Gamble or a 3M, for instance—have done consistently so much better in product development and product introduction than most others.”

Finally, Drucker advised, management should be held accountable for its business planning. “Did the things predicted in the plan happen?” he wrote. “And were they the truly important things? Were the goals set the right goals, in light of actual development, both within the business and in the market, economy and society? And have they been attained?”

Drucker decried the surge in CEO pay—a topic I’ve explored before and alsocommented upon to the Securities and Exchange Commission. He thought that, among other problems, it undermined the spirit of the organization.

But Drucker also would have frowned on the formulas being used to justify such outsize compensation. Unless companies do more than track financial metrics when rewarding their CEOs, “pay for performance” will continue to be a misnomer.

By Rick Wartzman, from: http://www.forbes.com/sites/drucker/2013/03/26/pay-for-performance-is-a-sham/