Top executive pay should not be linked to performance as the work they do is difficult to measure and such pay may actually be damaging to companies, according to a recent article by two academics in the Harvard Business Review.

It is not unusual for 60-80% of the pay of chief executives and other senior leaders, to be tied to performance – whether performance is measured by quarterly earnings, stock prices, or something else, according to Dan Cable and Freek Vermeulen both professors at London Business School. However, they argue that when you review the research on incentives and motivation, it is wholly unclear why such a large proportion of these executives’ compensation packages would need to be variable.

They argue that most firms should pay their top executives a fixed salary. Their argument is based on five points which they say is backed by research results. These are that:

1. Contingent pay only works for routine tasks. Cable and Vermeulen write that decades of strong evidence make it clear that large performance-related incentives are detrimental when the tasks is not standard and requires creativity.
2. Fixating on performance can weaken it. The authors said that several studies have shown that when employees frame their goals around learning (i.e., developing a particular competence; acquiring a new set of skills; mastering a new situation) it improves their performance compared with employees who frame their work around performance outcomes
3. Intrinsic motivation crowds out extrinsic motivation. According to Cable and Vermeulen research shows that when financial incentives are applied to increase senior leaders’ extrinsic motivation, intrinsic motivation diminishes which is not good for company performance because intrinsic motivation is fundamental to creativity and innovation.
4. Contingent pay leads to cooking the books. The authors said that different studies have shown that paying chief executives based on stock options significantly increases the likelihood of earnings manipulations, shareholder lawsuits, and product safety problems.
5. All measurement systems are flawed. No matter what measurement you produce there will always be imperfections and they could actually the cause the chief executives or other senior executives to behave in a way that is actually damaging to the company but boosts their earnings.

The article concludes that research shows that linking pay to performance can change the behaviour of senior executives but it may not be in a positive way for the company which they lead.

Cable and Vermeulen’s paper builds on earlier work by Jaap Winter, Professor of Corporate Governance at the Duisenberg school of finance in Amsterdam. In his 2011 paper, Corporate Governance Going Astray: Executive Remuneration Built to Fail, Winter argued that substantial performance-based pay creates a blind spot for breaches of integrity, even with the boundaries of any given set of rules or agreed principles. Ultimately, despite compliance with either rules or principles, productivity and effectiveness are reduced and the very problems that alignment was supposed to address are exacerbated.  Winter concludes that  Modern Portfolio Theory and widespread portfolio diversification has contributed to a lack of engagement and so trust between shareholders and companies.

Deconstructing the myth of executive pay and performance will not be easy without non-executives taking a leadership role. In the first instance Winter recommends a focus on strategy, sustainable performance, true motivation and integrity.

Last Updated: 13 March 2016