We have been pioneers in showing how unintended incentives can destroy companies. In 'Deconstructing failure - Insights for boards' we went on to discover that it was a root cause of failure in 40% of cases, 60% in the financial sector.
But Anthony Hilton's latest column discusses how bonuses can distort national and corporate growth and probably will. The piece is based on based on Andrew Smithers' latest book "The Road to Recovery: How and Why Economic Policy Must Change". If you haven't heard of Smithers, he is one of the rare economists who "can reasonably claim to have predicted the financial crisis in its full gruesome detail long before it happened".
The central point is that the design of most bonus schemes has two effects on the C-team's behaviour.
- First, sacrificing greater long-term growth by not investing now produces bigger and more certain bonuses in the short term. So that is what too many C-Suite teams do.
- Second, if you have a cash pile, the most reliable way to a bigger bonus short-term is buying back shares in an attempt to increase earnings per share - though it doesn't always work.
This behaviour makes sense to CEOs who understand about discounting cash flows on large future bonuses - and the grim statistic that the average CEO tenure is usually below 4 years. It is the obvious route to the probability of larger bonuses under many bonus schemes.
But don't blame the C Suite. They are only human and are behaving just as all humans can be expected to behave. The risk that they will respond to bonuses in this way is a ubiquitous, if largely unrecognised, board vulnerability.
So who is to blame? The answer lies between Remuneration Committees, who set the bonuses, the professional remuneration advisers who advise Remuneration Committees and Institutional Investors who fail to challenge Remuneration Committees that set flawed incentives. (I have left Chief Risk Officers and Risk Directors off the list because whilst they might have the know-how to see the risk, their hierarchical status below the C-suite makes it impossible to raise the subject without putting their careers in jeopardy.)
The largest part of the blame, however, probably attaches to remuneration consultants. How many have taken the time to explain to Remuneration Committees how short term bonus schemes risk generating short termism in the C-Suite? And which remuneration consultant has explained how larger bonuses actually seem to work. As Dan Ariely has discovered, bigger bonuses seem to produce worse performance, not better, when it comes to mentally demanding work (as opposed to mechanical or manual tasks).
This is part of a bigger problem, the hole in the "three lines of defence" approach to risk control. The name has a reassuring ring about, but the concept isn't designed systematically to find, let alone deal with, risks related to how humans actually behave. Nor is it a remotely suitable concept to deal with board-level vulnerabilities. No-one below board level can deal with them.