Pay can play an important part in establishing and reinforcing a company’s values and ethics amongst the workforce and demonstrating them to the outside world: linking bonuses and other incentives to the company’s values and culture are a powerful way to promote them. Conversely, poorly designed pay structures can inflict terrible damage on a firm’s culture and reputation if they allow payouts where conduct or decisions are clearly out of line with ‘the way things are done around here’.
The financial services industry was forced to come to terms with this first in the wake of the financial crisis. The suspicion that firms prioritised short-term returns above the longer-term interests of customers and society spawned detailed regulation which required:
- a large proportion of bonuses to be deferred to encourage a longer-term focus and enable reductions for future risks;
- firms to be able to reduce future payouts or even claw back past payouts for failures of risk management, business downturn or misconduct;
- present and future risks to be taken into account when setting bonus pools;
- firms to identify and manage conflicts of interest in remuneration structures and processes (especially for bonuses paid to compliance officers, legal and other ‘control functions’); and
- redesigning commission schemes for sales teams which were explicitly and exclusively linked to the delivery of individual sales targets.
This approach has now spread far beyond the financial services industry. Shareholders, the media and other stakeholders routinely hold listed companies to account for payouts which, while meeting agreed financial or business targets, are considered to be out of line with society’s expectations.
These developments support positive behaviours and develop a strong conduct culture within firms. Any firm seeking to evaluate the drivers of business and customer outcomes must examine its people-related practices, including incentives and the overall approach to staff remuneration.
Some firms include exemplary conduct as a part of the range of performance measures to be achieved to receive an incentive. But there are risks to this:
- exemplary conduct can be difficult to define and what is considered exemplary may shift over time. A performance target cannot hope to capture all this without giving the decision-maker very broad discretions. This can blur the employee’s line of sight to the hoped-for reward, devaluing the incentive in their eyes.
- investors may be suspicious of anything which distracts from narrowly defined business or financial performance.
- it may lead to a perception that exemplary conduct is an added extra, not a core part of an employee’s role.
This points to an alternative approach: payouts can be linked to financial or business (or ESG, health & safety etc.) targets. But if those targets are met, no payout is made until the company is satisfied with how they were met. Were the decisions taken and the conduct of the individuals consistent with the culture and values of the company? This approach maintains a sharp focus on the targets while giving the company power to ensure that conduct which falls short is never rewarded.
Increasingly, incentive plans include very broad discretions for payouts to be reduced in circumstances going far beyond those required by regulators or investors. This sends a clear message about the importance of culture and gives the company tools to impose a financial penalty in circumstances where other disciplinary action may not be viable. But because those discretions operate at the end of the performance period rather than at the start, they are less likely to devalue the incentive in the eyes of the employee.
There are some legal issues to consider and companies need to have robust procedures in place to:
- clearly communicate when a payout might have to be reduced; and
- decide fairly whether to reduce and, if so, by how much.
Whichever philosophy is adopted, it is critical that firms acknowledge the potential effect that remuneration and other incentives can have on staff behaviour. Getting this wrong may put pressure on employees to act in a way which enhances the risk of negative conduct and gives rise to a risk of customer harm.
The elements of performance which attract praise and status (and conversely sanction) within an organisation are critical to the furtherance of good conduct and culture. If employees observe individuals being rewarded and promoted despite poor conduct, this message will undermine (and could even outweigh) the positive steps which are taken to communicate and educate staff on the importance of ethical values.
As firms find themselves under increasing regulatory and public pressure to make performance adjustments (malus and/or clawback) for individuals in relation to management failings (as distinct from misconduct), one can further see how remuneration decisions can be used to reinforce principles of individual accountability and to position an individual’s role within the greater context of the company and its responsibilities as a whole.