The failure of GE’s incentive plan

Posted by Marc Hodak on February 19, 2009 under Executive compensation | Be the First to Comment

Whenever a CEO declines a significant chunk of change, as GE CEO Immelt did this past year with regards to his $11.7 million bonus, the reaction is predictable:  some react positively, feeling that Immelt is in touch with us regular folks, that feels our pain; others are decidedly more cynical about Immelt’s motives, or about the capitalist system that made such an ‘obscene’ payment possible.  The more sophisticated board observer would recognize that Immelt and the board finely executed their respective prerogatives, with the board proposing and the CEO disposing in one of the few areas of goverance where that is the way it’s supposed to be.

My perspective is a little different.  I’m left wondering, why did the bonus plan fail so badly?

It failed for two common reasons that bonus plans fail:  it was based on the wrong metrics, and the pay-for-performance leverage across those metrics was miscalibrated.  Immelt’s $11.7 million came from GE’s long-term incentive plan.  This plan was based on performance against four metrics:  earnings per share growth; revenue growth; cumulative return on capital; and cumulative cash flow from operating activities.

Taken together, these four metrics are a pretty good basket of indicators.  But GE’s plan, as is common, does not take these metrics together–it calculates distinct pay-for-performance schedules for each of them individually, and individually half of these metrics would not be expected to closely relate to shareholder value.

For example, revenues can be bought with extra costs.  If a company did this, you would expect to see it in a decline in earnings.  In fact, GE just met its maximum revenue growth target, but fell well below it’s minimum earnings target.  What do shareholders care about more?   If one item on the menu is delicious, but the other is poison, is it an OK meal on average?  For bonus plans, the answer is often “yes,” as it was in GE’s case.

So, GE’s long-term plan, suffering from some rather common afflictions, mistakenly created large awards for their managers.  Immelt was a mensch for forsaking his portion of the award.  The real question is, will he and his board realize what a crappy plan it was that created such an award, and will they bother trying to design something better next time?