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Remuneration: what can we learn from the private sector?

Incentive remuneration in the public sector shares many attributes with incentive remuneration in the private sector. Both are based on the principle that a significant part of executive reward should be related firstly to organisational performance, secondly to the performance of the business unit in which the executive works, and both last and least to the performance of the executive as an individual.

Both sectors also recognise that incentive remuneration is about rewarding results rather than effort. In the private sector it is even more pointed — such performance should be reflected in returns to shareholders. Shareholders are the owners of the company and therefore are the main stakeholders to whom the board and management are accountable.

There is one attribute of incentive remuneration, however, on which they can be very different: the role of incentives relative to base pay. For example, the Victorian public service executive employment handbook states that executives may receive performance bonuses where they are assessed as exceeding the requirements of their performance criteria. In the private sector, the point of incentive remuneration is to share the performance risk with shareholders with the result that pay is lower when performance is below target and higher when it exceeds target.

Private sector remuneration philosophy concerning incentive remuneration is that the total remuneration package that will be generated when target performance is achieved is the market-competitive target level of remuneration. Thus incentive elements of remuneration are not additional to competitive remuneration, but part of a competitive total remuneration package.

Though not explicit in any policy statement I know of, the public sector philosophy on this point appears to be that base pay assumes competent performance, therefore no additional payment is necessary as compensation.

The other attribute on which the public and private sectors diverge is well known. The following table expresses executive incentive policies in the private sector as a percentage of base (i.e. fixed) remuneration:

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Incentive opportunities in the public sector are obviously much smaller relative to base pay and in absolute terms than their private sector counterparts. They are therefore likely to be less consequential to public sector executives relative to private sector executives. (The absolute difference is large enough that this assertion is likely to hold true despite the marginal utility of an incentive dollar being higher for a relatively less well-paid public sector executive.) This is not to say that effective performance management practices don’t exist within the public sector — including the setting of clear, measurable goals — but simply that these practices are less likely to emerge where there is much less at stake financially.

Performance metrics and standards

Given the ownership of private sector organisations, it’s to be expected that the predominant performance metrics are those that drive shareholder wealth. Non-financial metrics are seen as useful if they are being used as a means of achieving an optimal financial outcome.

Care is applied when using non-financial metrics to ensure that the means are not confused with the ends being sought. For example, customer satisfaction or quality of a service or product may be important performance metrics if it has been established that by improving (or avoiding a decline) in these metrics there will be a meaningful improvement (or avoidance of a fall) in profitability and the rate of return it represents on shareholders’ funds. Such non-financial metrics can be critical success factors and, if so, they are used as executive performance metrics. However, they are not generally used as such unless their criticality has been properly assessed.

Perhaps the lesson here for the public sector is that not all performance metrics are the same. Whether through their corporate planning process or by some other means, it is helpful to establish a clear hierarchy of performance metrics to guide executive performance. If the context for establishing such a hierarchy is easier in the private sector, then all the more reason why it deserves a greater commitment of time and effort in the public sector.

It’s been my personal experience that performance standards, meanwhile, are generally specified more clearly in the private sector than they are in the public sector. Performance standards in the private sector are set by reference to business plans for the year. The key standard is the target outcome for the metric for the year. It represents a challenging but achievable outcome.

[pullquote] “… there may be stakeholder benefits to be reaped from ‘sharpening’ executive incentives in the public sector.” [/pullquote]

Typically, there may be two other standards: “threshold”, which represents a near miss of the target but sufficiently good to warrant a small incentive payment; and “stretch” or “maximum”, that represents an outstanding outcome that would be rarely expected to be achieved — it would warrant an incentive payment significantly higher than the target award opportunity amount.

Of course, even in the private sector some performance metrics are binary and therefore do not lend themselves to threshold and stretch/maximum standards of performance. But if threshold and stretch/maximum standards of performance are relevant for a performance metric then the elasticity of the potential outcome is given careful consideration when setting the outlying standards.

Elasticity of performance is linked to the nature of the business. For example, a business area with a high level of elasticity (extent to which the outcome could potentially deviate from the planned outcome) may have a -20% threshold and a +50% stretch performance requirement compared to target, whereas a business area with a lower level of elasticity may have a -5% threshold and a +10% stretch compared to target.

Weightings reflect the relative importance of each of the performance metrics. They reflect the proportion of the target award opportunity that may be earned by achieving target performance in relation to the performance metric. When selecting weightings in the private sector they are related to the company’s business plans and the nature of the role. Companies typically change such weightings from year to year to respond to changing circumstances and priorities. My experience is weightings are not common in the public sector.

Executive incentives in the public sector may be relatively less consequently than their private sector counterparts; and the strategic environment may make it harder to establish a robust hierarchy of performance metrics. Nevertheless, there may be stakeholder benefits to be reaped from “sharpening” executive incentives in the public sector. Multiple research studies have shown the dramatic impact of goal clarity on organisational performance.

The public sector could consider a bigger investment in that regard.

Author Bio

Nicholas Jackson

Nicholas Jackson is principal at Jackson Advisory. He has been a management consultant for 20 years, advising clients in Australia, South East Asia and China on strategy implementation.