A recent study highlighted in CFO.com finds that companies that incorporate “subjective unstructured” qualitative criteria into annual incentive plans for CEOs experience lower performance compared to companies who do not use such measures. The study looked at annual incentive plans of CEOs at S&P 500 companies outside of the financial services and utilities industries in 2007, 2010 and 2013. It found that companies where the CEO’s annual incentive included one or more qualitative metrics such as strong leadership, mentoring other executives, employee engagement, key talent retention, organizational development, diversity, and succession planning
- decreased employee and asset
- lower capital
- lower future stock returns measured over one and two
- greater upward earnings management.
The qualitative criteria did not impact operating income nor operating cash flow.
The authors argue that certain qualitative performance criteria have the following
- They are ill-defined, providing the CEO with limited guidance regarding expected
- “Qualitative criteria and related performance targets are likely to be selected arbitrarily” because of the lack of comparable
- Performance assessment may be biased “possibly reducing the effectiveness of the CEO’s incentive plan in driving better firm performance.”
It does not appear from the descriptions and examples provided that the research targeted all qualitative metrics. Rather it focused on those it termed “subjective and unstructured”. Some qualitative metrics, such as customer satisfaction, safety, and efficiency are measurable and comparable. It is also clear that the researchers were limited to the descriptions provided in proxy statements, so they were unable to determine whether companies had measurable criteria for the qualitative metrics that were not disclosed (e.g., for competitive harm reasons). Further, shareholders expect boards to exercise their judgement about key areas of senior executive performance.
Perhaps the most questionable flaw in the analysis is that only 22.9 percent of total pay for the sample CEO’s is in the form of annual incentives, and since only 20-25 percent of STI is generally based on non-financial factors, many of which are not weighted and may be subjective, the study suggests that if 5 percent of total pay is based on subjective criteria there is a statistically significant impact due to the use of such metrics. It is hard to conclude that that is the case. However, the findings may encourage further research on the effectiveness – broadly defined – of linking such metrics to incentives.