Do Not Pay for Performance

The vociferous criticisms of the stay bonuses paid out at AIG, Sallie Mae and Merrill Lynch are a reminder that bad economic times have a way of stripping out the pretensions of business. When survival is on the line, there is less room for platitudes, conventional wisdom and faddishness. “Pay for performance” as it is commonly understood is one such nicety.

How could these companies pay retention bonuses to the same individuals responsible for the collapse of these entities? Don’t these companies pay for performance and the performance was poor, right? Wrong. When the going gets tough business is forced to face up to the reality of paying for future performance (PUP).

Professional sports teams are forced to recognize the harsh realities of PUP all the time. A team signs an athlete to a long-term contract and shortly thereafter he gets injured (see the Brave’s Mike Hampton). The team still has to pay him during his contract. When the athlete’s contract is up the team has to decide whether to “punish” him for taking their money without playing – pay for performance – or to pay him based on the team’s best estimate of performance for the coming season. Whatever their view of fairness, competitive pressures force the team to recognize that it must PUP; if it won't another team will.

So why in business do we get stuck on pay for past performance and too often relegate PUP discussions about employees to a quiet corner. For one thing, it is easy. At the end of the year, you give a performance rating to an individual on how they performed against their goals. Compare that rating against a table and you’ve got your merit pay increase and bonus. The practice is easy to support legally. Formulas are applied equitably regardless of race, color, creed, etc. There is no messy business of making subjective evaluations of future value and performance.

Unlike sports, business can get away with this because the competitive market for business talent is less public and much stickier than it is for athletes. Pay a key executive less than he or she is worth and in the short-term it probably will not result in a lost employee.

A strict pay for past performance approach works okay when there is plenty of money floating around. Business can still retain those employees who might not have performed well against goals for one reason or another through discretionary bonuses and pay increases. But when money is tight, strong business leaders acknowledge that they have to make some tough choices on talent with respect to pay and those choices cannot be made solely on the basis of past performance. PUP comes to the forefront.

Say you are running AIG’s financial services division. Your division is a party to thousands of complex trades. Most of those trades are in the red which has gotten your company into its present mess. But many of those trades are in the black and the counter-parties owe AIG lots of money. Who knows enough about the details of those trades to effectively collect? The very traders who also made the bad ones. Before you fire them, you need them to stick around to unravel the good deals and collect the money. You are not paying them for their past poor judgment and greed. You are paying them to make money for your shareholders going forward: PUP in its purest form.

No doubt about it. Past performance can be a good indicator of future performance. But there are enough instances when it is not the case that we need to remind ourselves that ultimately what we are really paying for is future performance.