The Salary Sage

The ESOP I Love and the ESOP I Hate (Part 1)

Unless I miss my guess, ESOPs are going to make a comeback soon. Just as toadstools sprout from the mud after a steady rain, ESOPs surge after economic slowdowns. What are ESOPs? That depends on whom you ask. There are actually two distinct types, a fact that leads to considerable confusion. This confusion is enhanced by the fact that both types are very complicated. And now we know, if we know nothing else, that complicated financial instruments can lead to big problems. Fortunately, with ESOPs, these two types are radically different, one in my view to be avoided at all cost, and the other extremely beneficial (although not overly common).

THE TOADSTOOL

The toadstool that I referred two is one of the two types of ESOPs -- namely, the Employee Stock Option Plan. These are the programs whereby employees are granted the option to purchase shares in their company at a discounted price ("strike price") and can redeem them later for a payout if the value increases.  As a rule, employees pay nothing for these shares when they are granted, then after some period of time when the value of the shares have increased, the employee sells them and realizes the gain associated with the difference between the strike price and the market value at the time of the sale. The intent is to align employee interests with those of the shareholders by providing employees with motivation the behave in ways that will boost the company's stock price.

The reasons that I consider this type of ESOP to be a toadstool are almost too numerous to list, but I will attempt to do so, beginning with the one that relates to their popularity in financial downturns. ESOPs are viewed by companies as a way to compensate employees without spending real cash. And real cash is something companies don't have much of right now. This is why I am anticipatinga surge in ESOPs. I suspect employees may start to hear their leaders say "we can't pay you back the money you lost in recent salary cuts, so we are going to issue options." If this happens, a lot of people are going to experience the downside of options. So what are those downsides?

• First of all, let's face it, the value of a share of stock has about as much connection to the value of a business as a bet at the crap table has with a passbook savings account. So the inference that employees who own stock will be better employees is about as sensible as saying that gambling helps you save money. Sensible action on the part of employees rarely has any connection whatsoever to share price. So rather than encouraging right action, stock options create an intense fixation on something completely outside employees' control.
• In addition, by their nature, stock options create the illusion of extreme value. Sensible people who would never expect their salaries to double over-night, naturally assume their shares will. Ask anyone who owns a pile of stock options valued at $1 per share what those shares will be worth in three years and you will be shocked at what you hear. For every person who says 50 cents, there will be 100 who will say $20. And where do they get this idea? Often not from themselves. They get it from management.
• Stock options are the perfect vehicle for managers to create (consciously or unconsciously) the illusion of future wealth for their employees. This illusion can be used to great advantage to secure increased loyalty and extra effort. If employees can be convinced that their options will make them wealthy, they will attempt to move mountains.
• To encourage this perception, companies grant huge sums of stock. They do this in order to make the grants appear more valuable than they actually are. Case in point -- rather than giving an employee 1 share of stock valued at $5,000, they will grant 50,000 shares wort 10 cents. By doing this, they are manipulating human nature. They know that a person can more easily be imagine a 10 cent investment becoming worth $10 than they can imagining a single $5,000 share suddenly being worth a half million dollars. But the ratios are the same.
• What happens when reality settles in (as it always does) and stock options fail to live up to employees' expectations? Disappointment, resentment and betrayal are sure to follow.
• The reality of options is that real wealth, as in so many other things, if it is to be had at all, falls into the hands of a select few (usually high level executives and investors) not the larger employee group.

All of this, coupled with the fact that administering a company-wide ESOP program is breathtakingly expensive and complicated makes it, in my view, one of the most flawed forms of compensation ever conceived. In fact, of all the companies and people I have known involved in ESOPs (and there have been hundreds), the only person I know who consistently sings their praises has spent his entire career at Exxon. Over the last 30 years his stock has steadily increased in value and has made him a wealthy man. But for every person like that, there are thousands who worked for companies like Enron and AIG who have a very different story to tell.

THE BOTTOM LINE

If you find yourself talking to a company about a new job, and management starts discussing stock in lieu of cash, beware. Your pocket is about to be picked.

In the next entry of this three part series, I will provide additional details on more pitfalls and problems with Employee Stock Option Plans.

Bonuses Continue to Get Hammered in the News

A couple of months ago I described why all the hysteria about management bonuses was a smokescreen and a red-herring (pick your annoying anachronistic metaphor). Now, I am compelled to weigh in again in light of recent developments.

This time, the spotlight of shame has shifted from the ex-Merrill Lynch CEO (John Thain) to the villains at AIG. Their decision to pay $165 million in bonuses, most if not all of which will come out of TARP funds, has cast them in a very poor light. And as often happens when hysteria permeates public opinion, people aren't interested in being confused with facts when it is so much more fun to vilify and accuse. After many months of being blamed for all the problems, Congress is thrilled to have someone else to blame. Listening to them pontificate about waste and excessive spending is as comical as it is pathetic. Policymakers can always, it seems, be counted on for meaningless posturing when serious action is needed. And the public will respond in kind, fixating on inconsequential and superfluous details

How best to summarize this mess? Well, consider this. Incentives are not extra pay, they are merely another part of pay. And they happen to be the part that a person actually has to earn. Unlike base salaries which are paid merely because a person is able to fog a mirror, you actually have to do something to earn an incentive.

Now if you believe that AIG's incentives were paid to individuals who did nothing to deserve them, then your beef is with the people who designed the incentives, not the people who received them. Conversely, if you believe the recipients of the incentives did something worthwhile, then your beef should be with all the other people who did nothing to deserve a bonus and got paid anyway. Get the point?

So rather than vilify incentives, we should be begging for them. Incentives are contracts that only pay out when the recipients deserve them. Rather than guaranteeing 80% to 100% of a person's pay in the form of a base salary and paying it out for nothing, shouldn't we be guaranteeing far less and demanding performance for far more? Imagine a world where executives and managers received 20% of their pay in the form of a guaranteed base salary, and had to deliver specific measurable results to earn the remaining 80%. I am willing to bet that the same AIG employees who earned $165 million in incentives, earned close to a billion in base salary over the same period. They had to do something to earn the $165 million. They did nothing to earn the billion.

So now congress, in its infinite wisdom, is capping salaries at $500,000 and taxing incentives at 90%. Consider what this means. The executives that the taxpayer is counting on to dig us out of this mess show up to work every day guaranteed to earn $500,000 whether they perform or not. Wonderful. And if someone actually wants to link their pay to actual results, there is no way to do it. Not even the circus would make such a foolish mistake -- at least the lion tamer has a little bag of treats he can give to the animals to keep them from chewing his head off.

My great fear is that incentives will take such a PR hit from all this bad press, that boards and CEOs will shy away from them in the future. This would be a grave mistake.

So, as I said back in February:

...while government regulators clamor for caps on executive earnings and the abolition of incentives, don't get caught up in the hysteria. If the people who are saying these things knew what they were doing, they would never have let this mess happen in the first place. Instead, remember that well designed incentives are a key part of the solution, not part of the problem. They provide clarity and transparency by revealing what a person is expected to do, and what they will earn when they do it. They protect against windfalls and focus on outcomes that are controlled and influenced by each individual. So, when you hear that incentives are being abused and misused, blame the leadership teams and Board Compensation Committees who created the incentives, not the incentive plan itself. After all, if someone walks up to your car and smashes your windshield with a hammer, do you blame the hammer?

MEASURE OF THE MONTH -- Leadership Effectiveness

Not long ago I wrote what turned out to be a very popular blog entry detailing some of the characteristics of ineffective leaders. I followed that up with another entry on the type of leader progressive companies are after. I am now adding to the discussion an incentive plan measure on Leadership Effective found in Incentive Plan Builder.

DEFINITION

The ability to attract, retain, develop, and motivate others to achieve results that contribute to the company's overall success.

CALCULATION

This measure is frequently selected without much consideration as to how it will be measured. It is essential when selecting this measure to clarify in advance the desired improvement, how they will be measured,and who will do the measuring. For a more complete description of how to do this, see Even If you Can't Measure It You Can Still Use It.

WHEN TO USE THIS MEASURE

Use this measure when you have a manager who has leadership potential but has not yet realized their full potential. If you use this measure, expect to give regular feedback and coaching. Do not just create the measure, drop it onto an incentive plan, and forget about it until the year ends. This will lead to frustration and ultimately failure. This should be considered a discretionary measure in that it will not be measurable but it will be observable. Success will be determined by the participant's manager, perhaps with input from others.

HOW TO USE THIS MEASURE

Consider using some or all of the following elements:

• STRATEGIC THINKING -- Takes a broad business perspective and creates effective plans and strategies for accomplishing critical objectives.
• KNOWS THE BUSINESS  -- Understands the complexities and key factors impacting the business.
• COLLABORATES -- Builds effective trusting relationships with staff and co-workers. Models proper behavior for others to follow in how to work as a team. Resolves disputes rapidly and effectively.
• LEADS CHANGE -- Supports company direction and effectively communicates this direction to staff.
• ENGENDERS TRUST & RESPECT -- Emphasizes the importance of ethical decisions and actions. Goes beyond self-interest for the good of the group.
• HIGH PERFORMING TEAM -- Recruits develops coaches and manages staff to high levels of performance. Helps team members understand how their performance effects the business. Quickly addresses issues that are inconsistent with the company's vision and direction. Makes good hires and selects candidates with appropriate skills and qualities.
• INSPRITES AND MOTIVATES -- Articulates a compelling vision of the future, builds confidence that goals will be achieved, talks optimistically and realistically about the future.
• DEVELOPS PEOPLE -- Helps staff identify areas of improvement, unique needs, and aspirations. Works closely with them to achieve these goals. Approaches performance management as an important ongoing day-to-day process that involves regular feedback reward and recognition. Provides constructive specific feedback (both positive and negative.) Takes time to provide one-on-one coaching.
• LEADERSHIP INTEGRITY -- Demonstrates ethics and integrity adheres to a core set of values and holds staff accountable to same. Consistently models behaviors that are in the Company's best interest. Follows through on commitments to others. Is honest and forthright. Accept responsibility for mistakes.
• BREAKTHROUGH THINKING -- Encourages others to look at problems from various angles, challenges assumptions, seeks and provides differing perspectives.
• RELATIONSHIP BUILDING -- Develops effective relationships and alliances within the company as well as outside the organization. Gains collaboration and support from others.
• ACCOUNTABILITY -- Takes personal responsibility for driving outstanding business results. Sets challenging but achievable goals for self and others. Maintains commitment in the face of obstacles and frustrations. Accepts responsibility for the quality and integrity of work. Demonstrates a strong sense of urgency about solving problems and achieving goals.
• MANAGES DIFFERENCES -- Creats an environment that recognizes the value of differing points of view, incorporates cross-cultural and diversity concepts into everyday business activities.

This should be considered a discretionary measure in that it will not be measurable but it will be observable. Success will be determined by the next level manager with input from others.

WHO IS THIS MEASURE BEST SUITED FOR?

This measure is useful for any person who has leadership potential but has not yet realized their full potential.

RELATED MEASURES

• Employee Development
• People Management & Development
• Performance Reviews
• Workforce Diversity
• Employee Satisfaction
• Teamwork
• Creativity & Innovation
• Decision-Making
• Performance Management

Incentives DO Work

Every credible movement has its detractors. That comes with the territory. There is always some clever self-promoter attempting to build their career on the rubble created by destroying the foundation of something credible. In the world of incentives, this has been attempted many times.

The most famous perpetrator is Alfie Kohn. In his book Punished by Rewards, Kohn somehow managed to parlay his dislike for gold stars in elementary school classrooms into a credible philosophy of business management. His writings are more diatribes than carefully considered assessments written from experience (click here for one such polemic). In it, he cites the lack of "a single controlled study show[ing] long-term improvement in the quality of work as a result of any reward system." This he considers to be proof that people don't work for money. While academics like Kohn bemoan the paucity of controlled studies, the rest of us are building incentive plans that work.

    Another famous iconoclast is Steve Levitt (author of Freakonomics). In this video clip, Levitt pontificates about something he knows little about, incentives. It is fun to watch his brain work in response to a thoughtful question on incentives from the audience -- "Uh oh, I don't really know anything about this, but I am the expert and people expect me to answer, so let me stall with this anecdote about Christmas turkeys from my wife's former company while I try to figure out what to say. I know, I'll talk about Google. I have no idea what they do as far as incentives, but I can talk about their corporate culture for a while and dodge the question." Might have been easier to say "I don't have anything useful to say about incentives."

What I have generally found (as the Levitt clip illustrates) is that those who are opposed to variable pay either . . .

1. Are confusing incentives with bonuses (as Levitt does with his turkey example), and/or
2. Are approaching the topic from such an incomplete and/or academic/theoretical perspective (ala Kohn) that they simply don't know what they are talking about (but can convince those more naïve than themselves that they do), and/or
3. Are attempting to make the case that people don't really work for money which, if it was ever true (which I seriously doubt) is an argument holding precious little water these days.

I have never seen a person who is both credible and experienced make a seriously convincing case that well-designed incentives don't work.

Another common misconception aimed at undermining incentives is to infer that they are so complicated and difficult to design that they should be entirely avoided lest you make some egregious mistake and ruin your entire business. In response to that, as I have said repeatedly in this blog, you are much more likely to ruin your business by increasing base salaries indiscriminately than by attempting variable pay. If you make a mistake and increase someone's salary for the wrong reason, you will live with that mistake forever (or as long as they remained employed by you). Whereas, if you screw up an incentive plan, you get to start all over next year and try again. Much more forgiving.

Besides, everything looks complicated to the uninitiated. But to those who have been around the block a few times, it is all rather simple. It is not so much a question of what you do as what you don't do. Kind of like the difference between major league baseball and little league -- kids make catching routine fly balls into a real adventure, while the pros make diving catches look routine. It comes down to economy of motion.

Consider this. If you you watch an experienced sailor in a storm at sea, they don't look all that different from a novice on a placid lake. But let the novice take the helm in a gale and you will quickly see that the old salt is doing more than meets the eye. The novice will come back describing a hair-raising experience (if they come back at all) while, for the old salt, it was just another day at sea (or at the office).

Incentives are no different from any other business practice -- learn from experience, do it right, reap the rewards. Listen to amateurs, screw it up, pay the price. And above all, make up your own mind -- Don't let the pundits do your thinking for you. And if you want to get a crash course on how to build incentive plans right, check out Incentive Plan Builder.

Cutting Salaries, Bonuses, and Benefits

I was recently interviewed by a reporter for the Thomson Reuters' HR Wire (Paula Santonocito) who was researching trends in compensation; particularly those relating to companies reducing pay as a response to challenging economic times. Below are some excepts from her recently published article.

ANALYSIS & PERSPECTIVE

Implementing staff cuts is only one measure companies have taken to reduce costs. Organizations are also cutting salaries, bonuses, and benefits.

A GROWING TREND

In recent weeks, the practice has become more common. Generally, others get wind of these kinds of reductions in connection with layoff announcements. A company will release information about job cuts and provide specifics about other cost-cutting measures.

For example, when department store chain Macy's said it will slash 7,000 jobs, the retailer also announced it is eliminating executive salary increases for 2009, reducing the amount of its 401(k) contribution, and cutting its dividend.

Similarly, when announcing it would cut 1,100 jobs, upscale retailer Saks said it would suspend matching 401(k) contribution and freeze salaries.
And the practice isn't confined to the retail sector.

When announcing it will eliminate 10,000 salaried jobs worldwide, General Motors, the largest U.S. automaker, said it will reduce executive pay by 10 percent, and reduce other salaried employees' earnings between 3 and 7 percent.

Likewise, in connection with announcing it will cut 450 jobs, UK-based luxury automotive maker Jaguar Land Rover, a subsidiary of Tata Motors of India, announced that management bonuses have been eliminated and management salary increases have been deferred.

These are only a few companies that have made headlines for their cost-cutting initiatives.

Perhaps the most noteworthy example, and the one to get the most media attention, relates to bonuses. There has been much debate about whether executives at companies that take federal bailout money should receive bonuses. The argument for bonuses is that they are part of a salary package; the argument against is that these times require sacrifice.

SHARING THE PAIN

Wherever an organization chooses to cut, there should be consistency. So says Kent Romanoff, compensation consultant and founder of IncentivePlanBuilder.com, an online incentive plan design tool.

Romanoff tells HRWire the objective is to create a cost-cutting initiative, but it is also to build a lifeboat, and the message should be "we're all in this together."

However, he acknowledges there are challenges. "The term 'fair' is very much in the eye of the beholder," Romanoff says.

Just as there are different ways to increase pay, there are different ways to reduce pay, he explains. Flat dollar increases or decreases are one way.

Yet, yearly increases are typically tied to percentages of base pay. This method tends to be unfair to someone at the lower end of the scale, Romanoff says. Likewise, when you go to the other side of the equation, the salary reduction mode, you run into the same issue, he says.

Although some argue that the percentage should be the same for everybody, Romanoff disagrees. "I advocate against mindless percentage increases on the way up or down," he says. "I do believe it is mindful for executives to take a bigger hit."

Romanoff sees an "incredibly unbalanced relationship" between what executives are paid and what they actually earn. He tells HRWire we have this inequity built into the U.S. compensation arena, and there is a need to level the playing field.

Click here to view the entire article.

ABOUT THE AUTHOR

Paula Santonocito is a business journalist specializing in employment issues. She is the author of nearly 1,000 articles on a wide range of topics, such as impact of world events on the workforce, recruitment and hiring, retention, HR legal issues, benefits, diversity, changing workforce demographics, and the Internet as it relates to the workplace. Articles by Paula Santonocito have been featured in many global and domestic publications and information outlets, including Thomson Reuters’HRWire; The Wall Street Journal site CareerJournal.com; Expatica HR; AIRS News; Monster.com Office HQ; Online Recruitment Magazine; and others. In addition, her work has been posted at more than 100 web sites throughout the world, referenced in academic and legal publications, and translated into several languages. Paula Santonocitoserves as AIRS News editor, features editor of Online Recruitment Magazine (North American edition), and career editor of SingleMindedWomen.com.

Get What You Pay For -- Don't Double Dip

It's an old story. An employee has a good year and they are rewarded by a hefty salary increase and a fat bonus. The unsuspecting manager thinks s/he has done the right thing. What they don't realize (or don't think about) is a base salary is the gift that keeps on giving. How so? Because even if the employee never has another good year, they will still be receiving the money from that base salary increase for the rest of their time with the company.

To underscore the point, imagine an employee who earns a $70,000 base salary receiving a 6% increase for a job well done. That amounts to $4,200 per year EVERY YEAR for as long as they remain with the company. Multiply that by all the raises given to all the other employees, and you begin to grasp the magnitude of the problem. Then, when you add a bonus payout into the mix, things get really hairy. So in essence, paying a base salary increase and a bonus for the same performance is not merely double-dipping, it is "endlessly dipping" because that is how long you will keep paying for that one good year.

How do you break this cycle? By realizing that you should make base salary increases and incentive payments for DIFFERENT things, not the same things.

WHEN TO GIVE BASE SALARY INCREASES

Base salary is the money you invest to acquire talent in the market place. This talent is freely traded and you must pay a certain amount for certain knowledge, skills, and abilities. As the value of a particular type of talent increases over time, you must stay current or you run the risk of being outbid for that talent by your competitors. A person's knowledge, skills and abilities is the raw material they use to get results -- but it is not to be confused with the results themselves. We all know people who have all the ability in the world but get very little done. We also know people who lack certain skills but accomplish great things. Whey it comes time to grant salary increase, forget about the results a person achieved. Instead consider whether or not the person's knowledge, skills or abilities have increased (or whether their existing skills are worth more to the company or its competitors. If so, an increase is called for. Otherwise, no increase.

WHEN TO PAY AN INCENTIVE (OR BONUS)

This is where you pay for results. Unlike base salaries that should be paid when an employee acquires knowledge that is of value to the business, incentives (or bonuses) should be paid for outcomes (that is, the results achieved using that knowledge). No results, no incentive payouts. And just because some important result was achieved doesn't mean a base salary increase is called for. This is the unnecessary and costly double-dipping already mentioned.

THE PERFECT PAY PROGRAM

The good news about managing pay this way is that if you make a mistake and grant a base salary increase for the wrong reasons, you will literally be paying for that mistake forever (unless you decide to lower someone's pay which is never a good idea).

Incentives are much more forgiving -- if you pay an incentive for the wrong reasons, you get to start over and try to do better next year.

By clearly understanding and communicating when it is appropriate to raise a salary and when it is appropriate to pay an incentive, you will be using your compensation tools for the precise purpose they were intended. This will not only save you money, it will help employees understand how their skills and achievements relate to the overall performance of the business.

Should You Adjust Salary Ranges in a Recession?

Since so many organizations are skipping or delaying salary increase these days to save money and try to ride out the recession, the question keeps coming up as to whether they should also forgo adjusting salary ranges. It appears logical that skipping one is consistent with skipping the other. This is not so.

Granting raises and adjusting the ranges are two entirely separate and unrelated acts. Raising a salary is a function of an employee's performance, acquisition of new skills, and the company's ability to pay. Adjusting salary ranges is related to the external market for comparable jobs. While it is true that the economic slowdown has also put the breaks on the market as a whole, recent analysis of compensation surveys suggests that overall salaries have increased 2% to 4% in the last year and may well do so again this year (for those fortunate enough to still have a job).

Failing to adjust the range will result in your employees falsely appearing better paid relative to their colleagues in similar positions elsewhere. Over time, this could lead to them becoming vulnerable to being picked off by the competition. In addition, once you finally decide to adjust your ranges, it is likely you will need to make a large jump, perhaps as high as 10% or more depending how long you wait.

It is far better to continue in a business-as-usual manner with annual range adjustments even if you aren't willing or able to grant salary increases at this time. By communicating your intentions to employees, and explaining the separateness of the two acts, you will avoid confusion that might stem from increasing ranges in tough times.

Remember, just because you choose to ignore the market and make believe salaries elsewhere aren't increasing doesn't make it so. You are better off confronting the reality of what is happening around you and making sensible choices based on what is best for your business. Ignoring data is never a sound business practice.