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New thinking on how to link executive pay with performance.

A Rappaport1

  • 1Northwestern University's J.L. Kellogg Graduate School of Management, Evanston, IL, USA.

Harvard Business Review
|July 1, 1999
PubMed
Summary

Executive compensation, particularly stock options, needs reform to better link pay with performance. Proposed changes include index-tied options and unit-based performance metrics to reward superior achievement across all corporate levels.

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Area of Science:

  • Business Administration
  • Corporate Governance
  • Executive Compensation

Background:

  • Executive pay, especially stock options, has significantly increased since the mid-1990s, comprising a large portion of CEO and senior manager compensation.
  • Current stock option practices can reward even below-average performers during market upswings, creating a disconnect with actual achievement.
  • The link between incentive pay and superior performance is often weak, necessitating reforms in compensation strategies.

Purpose of the Study:

  • To propose reforms in executive and employee compensation practices.
  • To align pay-for-performance with higher levels of corporate achievement.
  • To ensure that compensation accurately reflects value added at all organizational levels.

Main Methods:

  • Recommending the replacement of conventional stock options with those tied to a market or peer index for top managers.
  • Advocating for performance metrics at the business unit level that measure value added, rather than solely relying on company stock price.
  • Suggesting the use of specific value indicators to assess the contributions of frontline managers and employees.

Main Results:

  • Index-tied stock options would reward superior performers and not penalize companies during market downturns.
  • Measuring value added at the business unit level provides a more accurate assessment of managerial performance.
  • Implementing reforms can strengthen the link between incentive pay and superior performance, motivating employees at all levels.

Conclusions:

  • Reforms in compensation schemes are necessary to ensure pay truly reflects performance.
  • Shareholders are likely to support changes that enhance corporate value creation.
  • A multi-level approach to compensation reform is crucial for motivating superior performance throughout the organization.

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