The Empty Promise of ‘Pay for Performance’

Pundits and pols love to blast windfalls that go to corporate CEOs who ‘fail.’ But windfalls for CEOs who ‘perform,’ research suggests, ought to worry us far more.

Leo Apotheker, the just-axed CEO at computer giant Hewlett-Packard, appears to have become the latest “poster child” for everything haywire in America’s corporate executive suites.

Apotheker spent all of 11 months as HP’s top executive. Over the course of those 11 months, HP shares dropped over $40 billion in value. Not good. Last month the HP board gave Leo the ax. His exit package: nearly $25 million in bonus, stock, and assorted perks.[pullquote]Compensating by predetermined performance criteria is driving our corporate compensation chaos, not solving it.[/pullquote]

Also not good. Corporate America, critics are howling, is once again rewarding CEOs “for failure.” Corporate boards, the rant continues, have to start shaping up. They “need to choose,” one top CEO pay expert told Fortune last week, “clear performance measures and set concrete goals to align pay for performance.”

If corporations did this “pay for performance” aligning, the conventional wisdom holds, CEO compensation would cease to be an eyesore. “Pay for performance” would restore basic business common sense to corporate executive pay.

This conventional wisdom currently dominates America’s mainstream discourse over reforming executive pay. To end CEO pay outrages, the standard argument goes, corporations need to get serious about paying for “performance.”

But this conventional wisdom has a bit of a flaw. Major American corporations are already setting “concrete goals to align pay for performance.”

At Hewlett-Packard, for instance, Leo Apotheker was working under an HP “Pay-for-Results Plan” first introduced in 2005.

“The fact of the matter,” Robin Ferracone told Corporate Board Member magazine last week, “is that most executive incentive plans today are driven largely, if not entirely, by objective and quantifiable goals.”

Ferracone should know. She runs one of America’s premiere performance advisory firms and has authored a basic performance pay text, the 2010 Fair Pay, Fair Play: Aligning Executive Performance and Pay.[pullquote]Executives devote inordinate energy and time to manipulating performance criteria.[/pullquote]

We seem to have somewhat of a contradiction here. How can anyone claim “pay for performance” as an antidote for our outrageous CEO compensation status quo when we already have “pay for performance” in effect?

Industry insiders like Ferracone, for their part, see no contradiction. They simply refuse to define the current CEO pay status quo as outrageous.

“Most people believe that CEOs are significantly overpaid,” as Ferracone put it to Corporate Board Member last week, “but the reality is that that the majority of CEOs are not overpaid.”

Not overpaid? CEOs last year, the latest Institute Policy Studies annual executive pay study reports, averaged $10.8 million, a take-home 27.8 percent higher than their 2009 compensation — and 325 times more than the pay of average U.S. workers. A generation ago, American CEOs averaged only 30 to 40 times more than average U.S. workers.

“Pay for performance,” given these realities, doesn’t seem to be doing much to fix our broken executive pay apparatus. And that doesn’t at all surprise two of the world’s top corporate pay experts, Bruno Frey and Margit Osterloh.

Compensating by predetermined performance criteria, these two University of Zurich analysts suggested last week, is driving our corporate compensation chaos, not solving it. Their latest look at the business research on “pay for performance” crushes the widely held contention — in executive suites — that “performance-based” pay helps enterprises succeed.

In reality, the research shows, pay-for-performance plans end up encouraging employees — at whatever level — to obsess over “those areas covered by the performance criteria” and give short-shrift to everything else.

Executives with millions riding on how well they fulfill performance criteria don’t just obsess over the criteria. They devote, note Frey and Osterloh, inordinate energy and time to manipulating these criteria in their favor.

“The wage explosions observable in many sectors of the economy,” the two analysts observe, “can at least partly be attributed to such manipulations.”

But the problems with “pay for performance” run deeper than incentivizing executives to game the performance-measurement system. Pay for performance, Frey and Osterloh point out, “tends to crowd out intrinsic work motivation” — “the joy of fulfilling a particular task.”

Healthy enterprises — and societies — need to nurture this intrinsic motivation, this pleasure that comes doing from a job well, for its own sake. Intrinsic motivation, Frey and Osterloh note, “supports innovation” and encourages people to achieve tasks that go “beyond the ordinary.”

Enterprises that revolve their compensation around “pay for performance,” by contrast, end up with executives fixated on making as much as possible, as quickly as possible. These execs “exhibit no loyalty.” They jump ship to whoever might pay them more. The inevitable result? High turnover, inefficient operations.

“Pay for performance,” Frey and Osterloh freely acknowledge, certainly seems an “attractive concept.” And top corporate execs have certainly done well by it.

But the rest of us, if we truly want to end executive pay excess and promote more enterprise effectiveness, are going to have to stop genuflecting before anyone who solemnly intones we have to “pay for performance.”

Sam Pizzigati, the co-editor of Inequality.Org, also edits Too Much, the online weekly on excess and inequality published by the Washington, D.C.-based Institute for Policy Studies. Read the current issue or sign up here to receive Too Much in your email inbox.