The Incentive Debate

Author's Note: This article is the second in a series presenting techniques that institutions can use to build a stronger performance culture and to link rewards—monetary and otherwise—to employee performance.   There is an ongoing philosophical debate across college and university campuses that will shape the direction of higher education administration far into the future. The genesis of this discussion does not come from the classroom, research laboratory, or student body, but rather, from the office of the president and the boardroom. At stake are how institutions will be managed in the new economy and the tenor of the performance and rewards culture for leadership.
	Richard V. Smith
	Jason Adwin

Specifically, as more administration leaders come from outside the traditional circles of academia, they are bringing with them performance and rewards principles that reflect corporate America more than the traditional, often paternalistic, policies that have been in place for years within higher education. The issue is perhaps best summarized by dividing the followers into two camps: those who think institutions of higher learning are becoming “too corporate” and those who think they are “not corporate enough.” No topic better exemplifies this debate than the use of executive incentives.

Incentive compensation for higher education executives continues to increase in prominence. A 2009 pulse survey conducted by Sibson Consulting shows that between 20 percent and 30 percent of institutions use formal, goal-based incentive plans. This is consistent with our experience in advising compensation committees at a number of prominent institutions. And the interest in incentive plans continues to grow, not only due to the aforementioned influx of corporate leaders, but also because of the growing sentiment that incentives can be mutually beneficial to institutions and executives without eroding the current culture of the organization.

Executive incentives serve two primary purposes: They 1) motivate the achievement of specific institutional goals and objectives, and 2) ensure the pay-for-performance relationship is reasonable and appropriate. The former relies on human nature and the belief that self-interest influences behavior. The latter emphasizes that incentives, when structured properly, provide the flexibility that is needed to reward leadership commensurately with an individual’s contributions to the institution’s success. Another reason incentives are attractive is that they keep fixed costs (i.e., salaries), lower than what might be possible if there were no incentive program in place.

Keys to Incentive Success

There are six keys to effective design of incentive plans.

1. Develop a compensation philosophy that defines the role of incentives. Although compensation philosophies have long been the norm in the public and private sectors, they have only recently made their way into higher education. Compensation philosophies describe how pay supports the institution’s strategic objectives, performance requirements, and talent needs. Including the role of incentives in the pay philosophy formalizes the standards against which compensation committees evaluate designs and individual pay decisions. See the figure below for the typical components of an executive compensation philosophy.

2. Benchmark market opportunities and ensure that programs satisfy intermediate sanctions guidelines. The Internal Revenue Service (IRS) is becoming increasingly vigilant in enforcing intermediate sanctions rules for disqualified executives. To create a rebuttable presumption of reasonableness, institutions must rely on comparable data that is sufficient to allow the trustees or compensation committees to determine whether compensation is reasonable. Peer-group benchmark data typically comes from published surveys and IRS Forms 990 (which provide a great deal of financial and governance information about tax-exempt and non-profit organizations). All components of compensation (i.e., salary, incentives, benefits, and perquisites) need to be included in the benchmarking, and the total opportunity must be reasonable in order to avoid excise taxes and penalties. Here, too, more institutions are adopting a corporate model by hiring an independent executive compensation advisor to conduct the study, advise the board of directors, and issue a qualified opinion of reasonableness. By first looking at peer total compensation opportunities, boards of directors can then feel comfortable establishing incentive opportunities (typically structured as a percentage of salary) that are meaningful to executives and satisfy intermediate sanctions guidelines.

3. Establish clear and objective metrics. The crux of good incentive-plan design comes down to goal setting. If the goals are too easy, the plan risks becoming an entitlement; if the goals are too difficult, the plan creates the opposite effect and becomes a disincentive. Executive incentive plan goal-setting is typically an iterative process between the president and the board of directors. Goals from the longer-term strategic plan are translated into annual objectives that are then tied to incentive opportunities described in Step 2, above. The foundational guidelines to effective goal setting create the acronym SMART:

• Strategic: Goals directly align with and reinforce institutional objectives.
• Measurable: Goals are easily measurable and tracked. Quantitative metrics are preferable, even for qualitative goals.
• Achievable: Goals are challenging, reflect reasonable stretch, and can be accomplished.
• Results oriented: Goals are directly influenced by the executive’s actions and span of control.
• Time bound: Goals are set for completion within the measurable performance period (i.e., annual objectives).

4. Keep it simple. Some incentive plans become tangled in their own design features and turn out to be too complicated to communicate and administer. As a general rule of thumb, plans should contain only three or four key metrics (no more than five), and the president should be able to describe the plan to his or her board of directors and direct reports with clarity and confidence. Keeping the design simple will focus executives’ attention on those key areas that are critical for success.

5. Establish a clear and independent governance process. Plan governance defines the roles of all stakeholders (i.e., executives, human resources, and the board of directors/compensation committee) and the process for administering the plan. Specifically, it outlines the process for evaluating performance, determining payout, and documenting the decision making as well as a timeline for decisions. Specific governance provisions are also important because they are required to create a “rebuttable presumption of reasonableness of compensation.” In order to obtain the benefit of the rebuttable presumption, the following governance conditions must be satisfied:

Independent board or committee approval. An independent group of trustees (three or more) or a compensation committee that is responsible for the approval and oversight of executive compensation must approve the design in advance.

Documentation. The board of directors/trustees or committee must adequately document the basis for its approval and be consistent with their formally stated policy of compensation pay-level targets and position comparison methodologies. (i.e., a description of what happened, when, who was involved, and follow-up actions, if any, in a formal and approved document).

Use of comparable data. As described above, when approving the transaction, the board of directors/trustees or committee must obtain and rely on appropriate comparable data. The information must be sufficient to allow the board of directors/trustees or committee to determine whether the transaction is reasonable. Relevant information may include for-profit or not-for-profit compensation surveys or data compiled by independent firms reflecting the size, complexity, and location of the institution. All elements of compensation must be considered as they relate to functionally comparable positions.

6. Manage plan optics. It is critical that all incentive-plan designs and payouts pass the optics test—that is, participants and the board of directors should be completely at ease if the plan and payouts were published on the front page of the local or university newspaper. If there is any hesitation about potential payout levels, metrics, or design features, it is the obligation of the board of directors to address this before the plan begins. Follow the adage: “If you can’t explain it, get rid of it.”

Despite the ongoing debate, we expect the prevalence of incentives within higher education will continue to grow over time as more institutions become comfortable with the process outlined in this article. The next article in this series will address broad-based pay for performance and incentives within higher education.

Richard V. Smith is a senior vice president and principal at Sibson Consulting and the firm’s executive compensation and governance practice leader. He works with college and university boards and leadership to optimize executive compensation programs and the performance of the institution. E-mail: rsmith@sibson.com.

Jason Adwin is a vice president at Sibson Consulting and a lead consultant in Sibson’s executive compensation and governance practice. He consults in the areas of pay strategy, incentive design, performance management, and governance. E-mail: jadwin@sibson.com.