The root causes of perverse incentives often hide (in plain sight) in the most common variable compensation structures, which include payout floors, thresholds, payout caps, and stretch goals.
The seeds of the Epipen scandal, for example, were planted when Mylan’s management became eligible for millions of dollars of a one-time bonus payout if they hit 90 percent of their cumulative earnings target. Such threshold performance levels are a feature found in most incentive plans. But this particular element meant that management stood to lose out on millions of dollars if they merely achieved 89.9 percent of their goal.
What would you do if your team were $89 million toward a $90 million threshold with just a few weeks to go? What would you do for that last million? The last $100,000?
A large segment of all corporate scandals in the last couple of decades have been associated with steep incentive plan thresholds. What makes them landmines is not just their ubiquity, but that they are invisible until the company steps into the wrong circumstances.
Think of them as compensatory cliffs. If management comfortably soars beyond the threshold, nobody notices the peril below. If performance is looking well below threshold, with no chance for awards, the cliff is too far to be seen. But what happens when businesses find themselves perilously close to the cliff, which is the area just short of threshold performance. In other words, almost at the finish line.
It might be that a manager never had to face the temptation created by a steep payout cliff. And because organizations can live with these dangerous features for so long without incident, they are lulled into thinking that the plan structure is sound. But when they find themselves facing that cliff, certain behaviors that they would have condemned as shortsighted, such as channel stuffing, accounting manipulation, or bribery, suddenly seem worth considering. It’s the moment of “what does everyone really want,” success or compliance, because “now I can’t deliver both.”
The good news is that steep thresholds are almost always avoidable. While an oft-used compensatory practice, companies can significantly reduce or eliminate these unnecessary features without any loss of motivation or accountability. A simple proportional payout to plan targets can eliminate the risk. Even if you wanted to ramp up incentives as the goal gets closer, let’s call it a “hockey stick” payout, that still has less behavioral hazard than an all or none “cliff.”
Beyond the threshold, “high leverage” plans — whereby incrementally higher performance results in very high additional rewards — encourage a focus on performance with a sense of urgency; that is the intended effect. The sooner you make plans, the sooner the higher payout structure takes effect. But this can also encourage behavior that is riskier than the company would prefer.
It also encourages significant dishonesty during the planning process, as leaders will try to “sandbag” their goals as much as possible to get to the next level of payout. Thus, organizations would be well advised to look at scenarios during the planning season in order to identify where incentives may need to be de-leveraged, in order to create a better balance between motivation and risk.
In the next post, we’ll continue the hunt for compensation landmines that can sink a compliance program and wreck a company’s reputation.
Richard Bistrong is a contributing editor of the FCPA Blog and CEO of Front-Line Anti-Bribery LLC. In 2010 he pleaded guilty to a conspiracy to violate the FCPA and served fourteen-and-a-half months at a U.S. federal prison camp. He now consults, writes and speaks about compliance issues. In 2015 he was named one of Ethisphere’s 100 Most Influential in Business Ethics. He can be contacted by email here and on twitter @richardbistrong.
Marc Hodak is Partner at Farient Advisors, an independent executive compensation and performance advisory firm. He has taught corporate governance as a professor at NYU’s Stern School and as visiting lecturer at the University of St. Gallen in Switzerland. He can be contacted here.
This post was adapted from an article that appeared in Compliance Week “Is It Time For An Incentive Mine-Sweep?” by the same authors.