In a year where political focus has been on the possibility of a royal commission into banking, it is not surprising that a number of Boards have been considering the use of non-financial performance indicators under their bonus plans.
Indeed, ASIC Chairman Greg Medcraft has been prolific on the topic of culture, presenting a number of speeches on the topic and stating that it would like to have the power to hold Directors and senior management to account when the culture of their company deteriorates.
Diversity has been another hot topic, with a significant amount of pressure being applied from certain quarters for Boards to incentivise management to hire a gender, culture and age diverse field of candidates.
Remuneration report votes at the AGM season, on the other hand, have clearly shown the dangers of introducing additional non-financial performance measures to bonus plans without careful consideration.
AGL Energy recently faced a protest vote from Shareholders over CEO remuneration, in part due to the use of non-financial performance measures or KPIs in assessing performance pay outcomes. Other companies, including the Commonwealth Bank, have also incurred the wrath of investors and proxy advisers over bonuses awarded to CEOs and KMPs based in part on performance criteria seen by some as soft or ‘flaky’.
Culture and diversity are only some of a broad web of non-financial performance measures that can be found in the incentive plans of major organisations. There are three major categories of non-financial measures:
- Customer measures such as customer satisfaction and growth
- Internal Business Process measures like quality control and production efficiency
- People Development measures like safety, productivity and succession planning
Also increasing in prevalence are measures related to effective risk management, sustainability and the environment.
Such non-financial measures are being seen in performance appraisal and reward systems, as elements of the original Balanced Scorecard methodology are increasingly adopted and incorporated into corporate performance management and reward frameworks.
Some prominent examples include:
The case for non-financial performance measures
The argument for including non-financial measures in assessing CEO and KMP performance in relation to their annual incentive payment is twofold:
- Identifying and Rewarding Underlying Value Drivers
The Balanced Scorecard methodology that originated with Kaplan & Norton identifies lead and lag measures of performance and groups these into four distinct areas:
Financial measures typically include Profit, Return on Capital and Earnings Per Share type measures and are usually outcomes or lag indicators of performance.
The drivers or lead indicators of performance would include measures relating to customer satisfaction, internal business process efficiency and people development.
By measuring and rewarding non-financial lead indicators, CEOs and KMPs are encouraged to focus on the underlying drivers of financial performance, which, when properly implemented, lead to increased value for shareholders in the long run.
- Alignment with Societal Norms and Values
The second argument for including non-financial KPIs in measuring and rewarding performance is to ensure organisational alignment with important broader societal goals and norms. Evidence suggests a direct link between these goals and the organisation’s reputation in the market, which in turn affects how customers perceive and value the brand and the company’s products or services. In labour intensive industries Health and Safety is normally accorded a material weighting in performance measurement whilst in other industries KPIs relating to the environment or people development and culture might be included.
Successfully implementing non-financial incentives
There are a number of considerations when deciding to implement non-financial incentives.
- Relationship to remuneration.
Should performance against the KPI impact directly on remuneration via annual or long term incentives, or indirectly impact remuneration by affecting the executives’ career prospects and accountability levels or by acting as a factor in fixed remuneration decisions?
If it is decided that the KPI fits best within the annual incentive plan, in what way should it impact the annual incentive? The non-financial measure could:
- Determine whether a proportion of the incentive is awarded. For example, 80% of an executive’s bonus might be determined by financial measures, while 20% might be determined by non-financial measures. Generally, single non-financial measures will only be worth between 5% to 20% of the total award.
- Modify the amount of an incentive that is awarded. The proportion of the target incentive that vests is determined by financial KPIs. Performance against non-financial incentives might act as a multiplier, for example, between 1 and 1.5 that adjusts the actual incentive amount paid.
- Act as a gateway. The proportion and amount of the incentive that is awarded is determined by financial KPIs, while the payment will only be made if performance objectives against key non-financial KPIs have been met.
Non-financial measures that are considered crucial might be implemented as gateways (for example maintaining zero fatalities) while less important indicators could be implemented using either one or a combination of the other two approaches.
Where too much weight is placed on non-financial KPIs, particularly in years where financial performance is less than stellar, criticism will invariably be invited from activist shareholders and proxy advisors.
Where not enough weighting is afforded non-financial KPIs, it is unlikely that CEOs or other KMPs will give them sufficient attention to warrant their inclusion in the performance management and remuneration process and as such their impact as a behaviour and outcome modifier is diminished.
Of the top 500 companies by market capitalisation that disclosed the proportion of the incentive that is determined by financial measures, the average award governed by financial measures was 60%.
Proxy advisors and institutional investors generally prefer that at least half of an annual incentive award be determined by financial outcomes. The preference may make non-financial gateways or modifiers more attractive for certain organisations.
- Identification and Definition
In essence a good KPI is one that complies, inter alia, with the following key selection criteria:
- Alignment – KPIs are in line with the business objectives
- Definitive – KPIs are well defined and accurately measure the desired outcome
- Objective – KPIs are measured objectively using available substantiating data
- Measurable – All KPIs are measurable i.e. the required data / information exists or can be easily obtained and then also on a repeatable basis
Ultimately executive incentive plans should reward CEO and KMP actions that generate sustained improvements in shareholder value creation in a manner acceptable to all relevant stakeholders. It is the Board’s duty to identify the correct remuneration approach to support this objective and then communicate that approach to all stakeholders.
Where non-financial KPIs are included, the linkages to value creation must be well understood and the weightings correctly applied at the various levels of the organisation. There should also be no ambiguity or unintended subjectivity in the measures used or in their calculation or subsequent interpretation.