February 25, 2019
The Three Flaws of Subjective Performance Metrics
– Liz Dunshee
At about a quarter of S&P 500 companies, CEO incentives are tied (at least in part) to qualitative criteria. There’s a chance that figure will rise now that a company’s tax deductions aren’t tied to whether pay is “performance-based” – but probably not, since proxy advisors and shareholders disfavor plans that give a lot of discretion to the comp committee. This recent study finds that those misgivings might be warranted – company performance is negatively associated with the use of qualitative or subjective metrics in CEO bonus contracts.
As summarized in this CFO.com article, that’s because of these three shortcomings (meanwhile, this 2017 Pay Governance blog gives some ideas for overcoming these hurdles):
1. Qualitative performance criteria are ill-defined, providing the CEO with limited guidance regarding what exactly needs to be achieved going forward. For instance, the 2017 annual bonus of David Zaslav, CEO of Discovery, was based 50% on the accomplishment of six qualitative goals – e.g. “further develop and integrate [the company’s] overall digital and ‘over the top’ strategy” and “develop robust succession plans for key operational roles, while continuing to attract, retain, mentor, and reward exceptional talent.” Although those qualitative goals relate to important aspects of business (e.g., developing human capital), they involve a great deal of ambiguity.
2. Qualitative criteria and related performance targets are likely to be selected arbitrarily. No systematic supporting evidence can be collected and presented by compensation consultants and committees because of the idiosyncratic nature of the criteria under examination. In contrast, relevant data can be collected and tested regarding various quantitative criteria used in CEO bonus contracts.
3. Whereas assessments based on the same quantitative data always lead to the same outcome, this does not hold true in the case of qualitative assessments. The subjective nature of such assessments may induce bias into performance evaluations, possibly reducing the effectiveness of the CEO’s incentive plan in driving better firm performance.