From the June 2010 issue of Investment Advisor • Subscribe!

The Business of Advice: Paying to Fail

How to get what you pay for, and more, when it comes to human capital and motivating employees

Everyone has heard the old adage "you get what you pay for." Applying this maxim to an advisory firm leads to the conclusion that more highly compensated staff equals greater skill and better performance. Is it really that simple? No.

Work behavior does not necessarily improve just by paying more, whether it is in the form of more salary or more incentive pay. While offering a greater level of compensation helps to attract and retain more talented staff, ultimately it is not what you pay that matters most. How you pay with regard to the structure of compensation is the key factor behind motivating desired work behavior. At best, a poorly designed compensation system will create a drag on the productivity, efficiency, and profitability of a firm. At worst, the wrong pay structure can be catastrophic for the firm, its culture, and its clients.

According to a December 2009 Harvard Law School study--The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008--performance-based compensation provided the top five executives at Bear Stearns and Lehman Brothers with cash flows of about $1.4 billion and $1 billion, respectively, during the eight years leading up to the collapse of these firms in 2008. Unlike others who held shares of these firms from 2000 to 2008, the executives' net payoffs during this period were dramatically positive. The authors concluded that "performance-based compensation based on short-term results provided them with undesirable incentives--incentives to seek improvements in short-term results even at the cost of an excessive elevation of the risk of large losses at some (uncertain) point in the future."

Paying to fail isn't just limited to Wall Street. The practice extends to mainstream America as well. In the early 1990s Sears, Roebuck and Co. introduced a production-based incentive plan throughout its nationwide network of automotive centers. According to government investigators, the compensation system led Sears personnel to deliberately mislead customers and recommend unnecessary work in order to generate higher revenue. In addition to severely damaging the firm's brand, lawsuits cost Sears millions in fines and several million more in lost business.

Our point is not that compensation, and performance incentives in particular, don't matter--they do. The problem is that employees have the capability to respond just as strongly to a badly designed compensation system as they do to a good one. The solution lies in assuring compensation aligns the interests of employee, employer, and the client alike and that when incentives are paid out in full all parties win.

To help firm owners "get what they pay for" and then some, we turn to the 2009 FA Insight Study of Advisory Firms: People and Pay, sponsored by TD Ameritrade Institutional. This comprehensive human capital study, produced through a marketing partnership with Investment Advisor, provides the backdrop for our discussion of the best practices regarding paying for performance. This article is the third of our four-part Human Capital series of articles that draw from the findings of this industry-leading study.

Similar to our past articles, we look to the industry's Standout firms for additional insight into the habits of the industry's most successful firms. The People and Pay study identified a premier group of Standout firms based on two key indicators consistent with building sustainable value--growth and income. Based on annual revenue growth and owner income, the top third of all participating firms within each of our four stages of firm development were considered Standout firms.

Across nearly all firm stages and all position groups, Standout firms are making greater use of incentive pay. Chart 1: Paying for Performance Pays Off (below), for example, displays the higher proportion of professional compensation that is incentive-based among Standout firms at each stage. Based on the superior overall performance of these firms, it's safe to assume that unlike the firms in our introductory examples, our Standout advisory firms are leveraging incentive compensation to motivate desired behaviors that are aligned with the firm's strategic vision.

Incentives Reward Above-and-Beyond Performance

The first lessons for firms to apply in order to make best use of performance-based incentive pay is to recognize that incentives are not about rewarding team members who are merely "doing a good job." Meeting the expectations of the position is what an employee's base salary is intended to reward. Incentive pay should motivate above-and-beyond performance, encouraging team members to perform beyond the baseline responsibilities of their roles. For some firms this will require a dramatic shift in thinking for owners and their teams. As the bar is set higher, a new level of expectation must be created. Let's be clear--achieving exceptional firm and individual performance will not be possible if firms aspire to and reward for mediocre performance.

Many performance measures should be considered as a given and not subject to additional reward. For example, upholding the firm's core values should be an expectation of all the firm's team members. While adhering to values can be an effective requirement for qualifying for consideration to receive incentive pay, this behavior on its own should not be considered sufficient for receiving incentive pay.

Specific and Measurable Objectives Drive Reward

Linking incentives to above-and-beyond performance is a necessary but insufficient requirement for an effective incentive plan. The plan must also incorporate specific and measurable objectives that are linked to the strategic vision of the firm. Incentive pay is never discretionary--discretionary incentives most often fail to motivate desired behavior and fast become perceived as entitlements. For each position, firm managers, in consultation with staff members, must create clearly defined and assessable performance measures. The performance measures developed should enable ready evaluation of those behaviors the business requires to be successful, benchmarked to where the firm and its staff need to progress in order to realize the strategic vision of the firm.

Given the varying levels of direct influence each role type can have on a firm's financial results, it's interesting to see from the People and Pay results that the primary drivers of performance-based pay across all roles are mostly the same. As shown in Chart 2: Top Three Drivers of Incentive Pay (middle chart, above), firm profit and revenue are most used to determine individual incentive compensation across all position types. We would advise that revenue and profits hold heavier weight for professional or management positions that have the most direct influence on revenue or profit.

The People and Pay study indicates that all firms have the opportunity to better link performance incentives to the areas of the business that each role directly influences. The best incentive plan should combine overall business performance measures such as revenue and profit with an individual performance rating determined by the achievement of specific role-linked objectives.

With appropriate objectives decided for individuals and their roles, the next set of questions a firm must resolve relates to the proportion of an individual's compensation that will be fixed salary versus variable incentive. A firm must also decide whether to put in place minimum firm thresholds to trigger any type of incentive payout. Managers will want to ensure enough money is at risk to matter and motivate performance and behavior. Positions that can make a greater impact on revenue generation should typically receive more of their compensation in incentive pay.

As for thresholds, FA Insight always advocates setting a minimum profit or revenue level before team members are eligible for incentives. This is for two reasons: 1) it better assures, particularly if profit is the threshold, that the firm has the ability to pay; and 2) it encourages all team members to make the overall success of the firm a first priority over their own individual success.

Structure Bonus Pay to Performance

Using a structured performance management process to clearly tie incentive pay to performance is the final critical component of an effective incentive pay program. Without performance management, an incentive compensation plan becomes discretionary and is largely ineffective. A formal process further ensures the right work behavior by increasing transparency and minimizing the potentially harmful subjective and discretionary elements of awarding incentives. As a result, staff members have greater clarity concerning what is expected of them, what they need to do to meet those expectations, and how they are progressing toward their achievement.

In Chart 3: The Performance Management Process (bottom chart, above), we outline the key steps of a performance management process beginning with strategic planning--the launch pad for setting individual objectives. A proactive and formal process is then set in place to track individual performance and provide regular feedback in order to support the achievement of individual performance objectives. This approach to performance management will often require firms to make an additional investment of time and effort, but, if implemented effectively, the rewards to the firm will far outweigh the time invested.

Money Motivates

In summary, the fact that money motivates is fundamental to our economic system. Pay is a powerful incentive that can work constructively or destructively, depending on the effectiveness of a firm's compensation plan. Our research strongly supports the notion that the ability of Standout firms to pay smartly is a key differentiator for success. By rewarding above-and-beyond performance, setting well-defined performance objectives, and using a structured performance management process to further facilitate achievement of these objectives, firms can truly get what they pay for--and more.

Click here to read all of Investment Advisor's People and Pay coverage.

A special 30% discount is available to readers who wish to purchase the full People and Pay study at FAInsight.com: enter IAREADER as your discount code when ordering. To participate in the 2010 FA Insight Study of Advisory Firms: Growth by Design--and to get exclusive data and analysis for yourself and your firm--please visit the FA Insight home page at www.fainsight.com.

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