I am grateful to the energetic strategic thinker Paul Barnett for highlighting that management guru Peter Drucker’s famous quote is actually much more interesting in its full version:
“What gets measured gets managed — even when it’s pointless to measure and manage it, and even if it harms the purpose of the organization to do so.”
Yet we measure and measure, whether or not it is a helpful thing to measure, and we tie pay to these measurements. No wonder a sense of fairness rarely seems to arise from this misguided process.
Bob Emiliani of the Lally School of Management and Technology, mounts an entertaining attack on the whole concept of what gets measured. He claims to prove that it is a falsehood because business is always more complex than any simple promise indicates. He highlights the tendency of executives — from senior management to junior staff — to game any system they are presented with. Certainly, shareholders consistently worry that a focus on specific financial performance measures drives negative behaviours; the current row about share buybacks being driven by earnings targets and executive share options being just the latest public manifestation of this ongoing concern.
And it is not just shareholders that worry about the possible unintended consequences and perverse incentives embedded in the performance metrics of executive pay. One FTSE 100 chair of my acquaintance tells the story of a frustrating meeting with a fund manager who was insisting on the inclusion of an EPS target in executive pay. There was no coherent answer given when the chair pointed out that an EPS target made no sense because any EPS result could always be manufactured by tweaking investment or marketing spend, in effect harming future performance for the sake of near-term numbers. The history of recent business seems littered with companies that have indeed underinvested in their future — perhaps in part because executives were encouraged to over-deliver earnings in the near-term.
It’s odd that this myth of the value of measures and measurement persists with such vigour. During the Vietnam war, US Secretary of Defense Robert McNamara demonstrated that using things that were measurable to judge success was a mistake. He ensured that available metrics were captured — metrics such as the enemy body count — and was happy to find these demonstrate ongoing success. What those metrics did not capture was the impending US defeat. Assessments that might have revealed the extent of US military failure were much less readily captured, and so the potentially useful information was ignored. Yet 50 years on the business world does not seem to have learned from what is known as the McNamara fallacy.
For some, merely setting targets drives short-termism. Harvard’s Robert Merton as long ago as 1936 (and claiming to build on the foundations of a remarkably diverse group of thinkers including Machiavelli, Adam Smith and Engels) argued that the measurement of performance automatically means the measured succumbs to “the imperious immediacy of interests” — in the less florid language of our own days, short-termism. He found that the “paramount concern with the foreseen immediate consequences excludes consideration of further or other consequences”. He went further: “strong concern with the satisfaction of the immediate interest is a psychological generator of emotional bias, with consequent lopsidedness or failure to engage in the required calculations”. In other words, target-setting blinds us even to our own best interests.
As indicated in Resentments and Rents, it is not enough just to talk about problems, we also need to consider what sorts of performance metric we should be applying to executive pay. This discussion is an attempt to respond to that challenge. Thus far, I have highlighted the dangers of narrow financial measures but I haven’t offered positive solutions.
Merton’s challenge is a substantial one: he doesn’t just raise the risk of gaming of targets but says we even trick ourselves and fall into a form of voluntary enslavement to any given performance metric. If this is right, and it certainly is easy to recognise the risks, we need to escape from the false precision of target-setting and need to assess performance in a much more rich sense. This is what happens in the rest of business, but oddly not at the top of organisations.
So our challenge is to uncover the McNamara fallacy in business — so that we no longer use metrics just because they are available but apply intelligent judgement such that we assess what is actually worthwhile.
Given that the job of the CEO is to drive the long-term success of the business, not simply to make the numbers next week, measuring a richer set of measures of the health of the organisation has some attraction. This may require assessments of the extent to which stakeholder relationships have been built, business culture has been advanced, new businesses or products developed or fostered. This needs to be not an excuse for paying up in spite of weak current performance — jam today for the CEO on the promise of jam tomorrow or in some years for the shareholders and other stakeholders in the business would not be fair. But remuneration committees need to be bolder in their approach to the challenge of assessing performance and agreeing executive pay. And shareholders need to be more flexible.
The solution lies in judgement. Merton is right that any performance metric embeds some degree of perverse incentive, some pressure towards short-termism. Indeed, it could be argued that the major attraction of TSR (total shareholder return) as a performance metric is because it introduces the fewest possible perverse incentives, provided it is measured over a long enough time horizon. To avoid, or at least limit, these perverse incentives we need remuneration committees to apply judgement and to assess whether the targets have been delivered without having given rise to negative consequences. This will mean that remuneration committees need to move away from what another investor representative has called the standard board approach to their CEO:
Brilliant, brilliant, brilliant, fired
Even the best CEO is not brilliant, and is unlikely to deserve 100% of their available incentive. So we need a richer and more honest discussion of performance. This does require a brave step, and it requires trust. Trust by executives of remuneration committees, that they will genuinely display fair judgement to deliver an appropriate level of reward, and trust by remuneration committees that their appropriate judgements will win approval from shareholders. We need to acknowledge that the process of shareholders looking over the shoulders of remuneration committees is not yet driving the right behaviours. It is not helping reinforce appropriate business-specific judgement by remuneration committees but instead seems to be herding them into the safety of a few approved metrics and structures. This has happened because we shareholders tend to lack trust in the judgements of remuneration committees.
So our underlying challenge is to build trust: trust between remuneration committees and senior executives; and trust between shareholders and remuneration committees. Only in this way can we unlock the tyranny of the McNamara fallacy.
McKinsey Quarterly recently published a paper which may open a window on how this might be done. Talking about pay structures in companies more generally, it highlighted declining trust in those systems, and discussed ways in which trust may be reawakened. Their answer is to generate clear and apparent procedural fairness in pay systems: not only fairness of treatment but also the expectation of fairness of treatment. The article suggests three key steps to make pay more procedurally fair:
- transparently link employees’ goals to business priorities and maintain a strong element of flexibility
- invest in the coaching skills of managers to help them become better arbiters of day-to-day fairness
- reward standout performance for some roles, while also managing converging performance for others
Considering these same themes in the context of senior executive pay may help us to unlock the spirit of fairness, and so build the necessary trust between the parties. Certainly #2 above may require more active dialogue between remuneration committees and management about the underlying drivers of long-term business success. This would be no bad thing in itself, and may be necessary in order for us to see pay linked to a rich sense of long-term prosperity rather than the narrowness of the current performance metrics that we typically employ.
Drucker also said “because knowledge work cannot be measured the way manual work can, one cannot tell a knowledge worker in a few simple words whether he is doing the right job and how well he is doing it”. Not only can we not say it in a few simple words, we shouldn’t try to measure it in a few simple numbers.
We in business forget this at our peril.
I explored some of the ideas in this post further in: Money is not the answer
The false promise of what gets measured gets managed, Bob Emiliani, Management Decision 38(9) [Nov 2000]
The Unanticipated Consequences of Purposive Social Action, Robert Merton, American Sociological Review, Vol 1, No 6 (Dec 1936)
Dysfunctional Consequences of Performance Measurements, VF Ridgway, Administrative Science Quarterly 1(2) [Sep 1956]
The fairness factor in performance measurement, Bryan Hancock, Elizabeth Hioe, and Bill Schaninger, McKinsey Quarterly, April 2018