Pay for performance—An instrument of strategy

Pay for performance—An instrument of strategy

40 Long Range Planning, Vol. 22, No. 4, pp. 40 to 45, 1989. Printed in Great Britain 0024-6301/89 S3.00 + .OO Pergamon Press plc Pay for Performanc...

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40

Long Range Planning, Vol. 22, No. 4, pp. 40 to 45, 1989. Printed in Great Britain

0024-6301/89 S3.00 + .OO Pergamon Press plc

Pay for Performance An Instrument of Strateg;V Terry

Murphy

Four years ago, Abbey NationalS Management and Board mappedout the future strategic direction of the organization. lt was clear that, with impending de-regulation and subsequent diversification opportunities, increasing competition from U.K. based and international companies in domestic markets and the changing nature of the market place itself, substantial changes were necessary in the management style and culture and in the way in which the human resource operated. This article sets out the historical background against which the existing culture developed, the changes that occurred in the market place and the regulatory environment, and the change of culture required as the framework within which performance based pay was introduced. It gives brief details of the methodology used to create the climate in which it could be brought to fruition and the system chosen for the Society.

It is important to realize that Abbey National was and is a successful organization by any standards that could be applied. The changes that have taken place in the corporate culture over the past few years were initiated as a result of a clear belief that, if we wished to fulfil our strategic aims of continuing as a successful provider of an ever-widening range of personal financial services, in this country and elsewhere, we had to make some radical changes in our culture and that our human resource strategy needed explicitly to reinforce those changes.

Building It is worth development understand formed.

Societies reminding ourselves of the origin and of building societies in order better to how Abbey National’s culture was

Building Societies were formed in the first half of the 19th century, generally in the first instance by small groups of people who had a desire to own their own house, particularly as property ownership was the key to enfranchisement. The chosen

mechanism was that each member of the group put a regular amount into a common fund until there was sufficient accumulated to purchase or build a house. A ballot was then held to determine which of the members had the house allocated to them. This process was repeated until all of the members owned their own house, at which point the building society was wound up. These were called ‘terminating societies’. It was a fairly logical progression from this to the formulation of building societies which provided a medium through which people could invest their savings, receiving a reasonable rate of interest, and for the building society to lend the money so raised to those who wished to build or purchase a house against the security of the property, at a rate of interest sufficiently higher than that paid on savings to cover costs and provide a reserve fund. These building societies, called ‘permanent societies’ were the foundation of what has become a major part of the U.K. Financial Services Industry. In this context, it is worth noting that if the top two societies were capitalized at seven times earnings, they would sit in the league table at numbers three and four behind National Westminster and Barclays Banks, but ahead of Lloyds and Midland Banks. Abbey National alone has assets greater than L26bn and reserves of over Llalbn. For the major part of their 150 year history, building societies operated in a single, captive market with very little competition, either external or internal to the industry. For most of this period they offered a simple product range consisting of a savings account and simple mortgage loan facilities. Also, during the latter part of the 19th century and the early 20th century, legislation which defined the role, purpose and powers of building societies, consolidated but little changed by the 1962 Building Societies Act, governed their operations until the 1986 Building Societies Act was passed by Parliament.

Performance

Historical

Market

Background

The building society industry operated then in a market place which was characterized by: lack of competition-the clearing banks were more interested in what were the more profitable sectors of corporate banking and corporate and sovereign debt. Other financial services organizations, foreign financial institutions and banks were not players in the U.K. mortgage lending market. dominance in retail savings-the building societies offered a safe haven for individual savings for the bulk of thrift money in the United Kingdom. The ordinary person had no real interest or even awareness of equity markets and the banks deposit rates were substantially below those offered by building societies. a mortgage lending market in which nearly always exceeded supply.

demand

an interest rates agreement among building societies which kept rates stable and which for borrowers were below prevailing commercial money market rates. This agreement also obviated the need for a concept of ‘profit’ inside societies as with fixed margins, all that needed to be controlled to keep reserves adequate were operating expenses. Societies grew rapidly in this environment in the post-war years in terms of assets and branch network size as a result of their virtual monopoly of the retail savings and mortgage lending markets. Most shopping areas of all major towns and cities in the country had one or more building society branch offices in prominent positions within it. However, the legislative framework within which they operated laid down very specifically the responsibilities of the Board and management for the control of interest rates, and for the type and size of loans in relation to the nature and value of the property taken as security for the loan. As a result of this, initially, all loans were scrutinized by the Board and subsequently as loan books grew, large centralized departments operated, under delegated authority, as scrutineers and controllers of lending. With very limited product ranges on offer and very little competition, the need for marketing of services and products was minimal. The management style that developed in Abbey National, in common with many U.K. financial institutions, was paternalistic. Also, promotion within the Society was largely based on patronage. Power was concentrated mainly in the hands of a few powerful managers and the ChiefExecutive ran the business on a day-to-day basis as an outsize single owner concern. The

culture

that emerged

as a result

of this was

Based Pay

41

typified as low risk, low profile and largely noncommercial in nature. Successful managers were those who took few real decisions, never exposed themselves to criticism and never took risks. Innovation was not prevalent, rather sound administration and tight controls were hallmarks of success. Although this is a slight caricature it is nonetheless broadly accurate.

More Recent

Developments

In the 1970s things started to happen which were the commencement of a period of rapidly accelerating change. There were the beginnings of a focus on results. However, during the operation of the ‘cartel’, profit remained a meaningless concept as margins determined by the interest rates agreement (and in the absence of any real external competition) were always adequate to finance growth. Also in a low risk environment, where variable rate mortgage loans were the norm, unlike the position of U.S. savings and loan institutions, who had fixed rate loans and variable rate funding, capital adequacy was an insignificant factor. Thus the league table of performance of building societies was based on ‘asset growth’. This focus on growth as a measure of success made it appropriate for managers to concentrate on driving up the volume of lending in a market place where demand still almost invariably exceeded supply. Lending had to be funded almost entirely from retarl savings sources and thus inter-building society competition began to become a significant factor. Retail savings products began to proliferate and a large number of accounts appeared offering, on various terms, interest rates significantly in excess of the normal share account. This process would have eroded margins but, because of the price insensitivity of the mortgage lending market, societies protected overall margins by charging higher rates of interest on larger loans or on endowment insurance linked mortgage loans. This put strains on the cartel or interest rate agreement operated by the Building Societies Association since, in their desire to attract retail savings, many of the smaller societies were paying premiums over the agreed interest rates structure, to the exasperation of the big operators. The early 1980s with interest rates at an all time high, corporate demand for finance low and international sovereign loans at risk, saw the entry into the U.K. mortgage lending markets of the U.K. clearing banks and foreign banks. The impact of the former had a significant effect in that within a few months of entry they had gained around 30% of mortgage lending market share. Fortunately for the building societies the clearers, with one or two notable exceptions, had entered the market with a fixed tranche of money to lend and when the)

42 exhausted withdrew

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this in a very short space of time they from the market place for a time.

The effect on building societies was, however, large as, in order to counter this new competition, they changed their approach to this market by deciding that, instead of rationing the lending they did and leaving the market place with a slug of unsatisfied demand, they would attempt always to be able to meet the demand. This had the effect of driving lending rates into much greater congruence with money market rates as, in order to meet demand, societies had to begin to raise significant funds on the wholesale money markets rather than relying totally on retail sources, which in turn made the market more attractive to other players as a source of low risk, profitable lending. The retail savings market, in the meantime, had also become very much more competitive. The Government, at this stage of its life, had decided to use the retail savings market as a source of finance. It did this through the medium of National Savings which, with no constraints on cost, could virtually raise any funds that were required in this market place as commercial institutions were unable to match the rates offered. At the same time, the 1980s have seen a spate of privatization issues, which had a marked effect on the market due to the ease with which ordinary savers could purchase the shares offered, the massive barrage of publicity surrounding each issue and the big premia shortly after issue which allowed profitable stagging operations. It is interesting to note the massive return of these savers to building societies in the wake of the October stock market crash which serves to underline the impact access to the stockmarket had. Unit Trusts emerged and enjoyed a great deal of success with more sophisticated investors, reducing the available funds for societies. Lastly, the clearing banks put a much greater emphasis on personal banking in their marketing. Thus the market places in which building societies operated had in a relatively short period of time become highly competitive, interest rates more volatile and their customer base more educated and willing to shop around for the best interest rate they could get, both for their borrowing requirements and for their investments. Under these pressures the cartel crumbled, broke and was finally abolished and made illegal. Finally, the legislative framework was changed with the passage through Parliament of the Building Societies Act in late 1986. This new Act provided limited ability for Building Societies to diversify their business thus providing a wider range of services to their customers and, at the same time, reducing their dependence on one market by

1989 allowing moves into other EEC countries and also into other related business areas such as Estate Agency and Life Assurance.

Culture

Change

The impact of market pressures and the explosive growth of the 1960s and 1970s made centralized control and decision making impractical. Also the use of new technology allowed the widespread dissemination of the ability easily to transact business securely and without loss of the prudential controls necessary under the statutes governing building society operations. As a result, in the late 1970s and early 1980s changes started which made possible the human resource strategies devised and adopted in 1984. Decentralization of control and decision making had begun and big central departments reduced in size and importance. Branch Managers were given authority to conduct the business of lending within defined guidelines and limits. The patronage system of promotion was eliminated by the adoption of a policy that all vacancies had to be internally advertised and filled by a method of selection based on assessment centres. Thus people were no longer ‘selected and moved’ by a patron more responsibility for and they were given developing their own careers. The breakdown of paternalistic management had begun. However, in 1984, when the executive sat down to map out a strategy for the future of the Society, it was evident that the process had not gone far enough and was not going fast enough for the Society to be truly effective in the market place. One of the key strategies that were decided on by the Executive and endorsed by the Board was ‘the Development of Human Resource Capability to enable us to carry out the business strategies’. Briefly the latter could be summarized as: *

the improvement of our financial strength by boosting our capital ratios through profit improvement.

*

the offering of a clear, simple product our core business.

*

the investigation and development tion opportunities.

*

the detailed

range for

of diversifica-

analysis of our corporate

structure.

We needed a set of human resource strategies which would change the culture of the Society into a more dynamic, commercially orientated, market and customer led and profit conscious organization. A sea change was required of which the keystone would be leadership and management style. Clearly,

there were a number

of strategies

involved

Performance but, for the purpose of this article, I am proposing to concentrate on those which created the climate in which performance-based pay could be installed. It was considered essential to have reward systems in place which reinforced the performance and results oriented culture we wished to evolve. In the negative sense, it was crucial that the behaviours necessary in the new culture were not punished by the operation of the reward system and, on the positive side, that high contributors received high rewards.

Changing

the Climate

In 1984, when the new Chief Executive, Peter Birch, arrived in the Society the climate was bad. Employee relations were at an all time low with the pay claim having been referred unilaterally to binding arbitration, talk of a strike-the first in building society history; a demoralized senior management who felt uninvolved in the decisionmaking process and whose pay scales were seriously overlapped by those of their subordinates. It was decided to address these issues immediately. Firstly the pay claim was settled very rapidly at an arbitration hearing to the satisfaction of both parties and work put in hand quickly to resolve outstanding grievances among the staff. Secondly, senior management were all re-graded in a participative system using the Hay evaluation system and pay scales moved significantly to reduce the overlap with the assurance that the situation would be progressively resolved. A number of other hygiene issues, such as car allocation were also dealt with quickly and decisively. It was decided to use training as a means radically to alter the culture and management style of the organization. These programmes, which have been dramatic and catalytic in their impact, owe much to the input of Dr Neil Miller of Miller/Ginsberg, a Philadelphia based consultancy. As a result of this training, a management style was evolved which involved the development of mechanisms for constant, high grade communications about the business and the changes which were taking place. It allowed the development of a top down/bottom up approach to planning and budgeting. Top management were given high visibility by the use of video communications for briefing and, in addition, high accessibility in the ‘management by walking around’ programme in which every branch and head office area is visited at least every 13 months or so by a director or general manager. These important and visible changes started to create a climate in which suspicion of motives had no part. Commitment

to profit and the raising of awareness

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of profit was also an important feature. The importance of profit was explained at every opportunity. The implementation of steps to improve our profit performance was widely communicated and the programme was implemented in such a way as to be felt sensible and fair, even when headcount reductions were involved. People affected were treated fairly and with dignity such that those who left the Society are still good customers, a fact that is vital, not only to them but to those who remain. Also when pressure points emerged, which were the result of cuts, prompt action was taken to relieve them. Lastly, WC developed a more business-like relationship with the staff union. Their representatives were given the same briefing on the annual plan and on the year-end results as the senior managers at about the same time. The briefings were followed by an open forum in which they could question the Chief Executive and General Managers on various related aspects and on employee relations issues generally, so that they had a clear understanding of what decisions had been taken and of the rationale behind them. All of these activities helped create the climate into which the introduction of performance-based pay was viable and would be acceptable. This was essential if it was genuinely to support the changes in style and culture.

Performance

Based Payment

Appraisal

In order to introduce a system where pay increases were totally linked to individual performance, a key pre-requirement was the total reform and overhaul of the appraisal system. For the majority of the staff, performance appraisal consisted of either a ‘tick in the box’ system based on subjective assessment of behaviour against oneword factors or, alternatively, an almost impossibly complex format of measurement of business results covering many pages of pre-printed forms and from which it was difficult to draw any sound conclusions. It was determined to replace these with a totally different method-that of performance against agreed objectives to agreed performance standards. The process is well established and simple in principle. Objectives are agreed which are measurable, preferably in quantified or in timescale terms, standards of performance for each objective (answering the question ‘How do I/you know that you have met that objective?‘) are also agreed. At the end of the review period a discussion takes place at which progress made towards meeting those objectives is reviewed, as a result of which an overall performance rating is decided upon. This rating

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determines below.

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the pay rise to be awarded

August

as discussed

It should at this point be noted that we did not ignore the body of opinion which has for many years argued the separation of the appraisal date from the salary review date. We thought about the issue and decided that we did not agree with such a separation. What we did do is to separate the appraisal discussion from the allocation of money and this separation also embraces the appeal process in which an appeal will be considered only about the appraisal rating and written comments on the form. Otherwise we believe that, as a fundamental principle, pay rises should be awarded and sized on the basis of appraised performance and coincident, as nearly as practicable, with the review. Two other features of the system are the interim reviews at the half year point, which were introduced to try to ensure more regular dialogue about performance other than at salary review time. Secondly, the commitment to meet identified development needs that emerge from the appraisal process has been specifically highlighted. Managers are required to discuss and identify development needs and career aspirations and to record them. These are then followed up as a matter of policy by the Manpower Development Department or the Regional Trainers.

The Payment

faster progress up the grade at the bottom top of the grade bands.

than at the

This matrix of salary increases is applied to each person using the computer and the manager receives a print-out of his or her staff with ‘recommended awards’ on it. Variation of individual increases by +20 per cent is allowed, but on the basis of fixed total budget equal to the sum of benchmark salary increases for his or her staff, so as to ensure that performance shadings within overall rating bands were genuine and had a real impact. The manager signs off his proposals and they go back to salaries to be implemented. Protective

Mecharzismr

In discussion with our staff union, who were consulted extensively over the strategy and the methodology, we decided to incorporate some protective mechanisms into the scheme to increase confidence in the fairness of the system. These are as follows : (i) Minimum rise for non-supervisory staJ The personnel in the bottom four grades other than those whose performance is rated ‘Unacceptable’, were guaranteed an increase of at least the January R.P.I. figure or half the budgeted percentage increase, whichever was the lowest. (ii) App ea I s y s t em against appraical rating. Used by a fraction of 1%) this allows appeals about performance ratings before money is attached.

Methodology

Overall performance ratings were collected over the computer links from Regional Offices and from Head Office Departments. Ratings were one of five ranging from ‘Unacceptable’ through ‘Less than Effective’, ‘Effective’, ‘Highly Effective’ to ‘Outstanding’. Distribution curves were produced for each Area and Department and for the total Society. Comparison of Area/Department rating curves with the overall curve were made and if significantly higher or lower in profile, the business performance was analysed to see if that position was justified. If it was not, then the allocated award structure was adjusted for that particular Area/ Department. The allocated award structure was based on a calculation of bench mark rises for each performance rating. The overall budget for pay increases is determined when the total annual revenue budget is set for the Year Plan. This budget is calculated in such a way that the various ratings attract awards in the following ratios: Unacceptable: Less than Effective Effective Highly Effective Outstanding

1989

0 0.5 1.0 1.5 2.0

The resulting percentages are applied to the midpoint salary in each salary grade thus providing for

The staff union is (iii) Staff union involvement. involved in negotiating the scale uplift, consultation about the ratios to be used between performance ratings year by year and finally considering analyses of the final output to satisfy themselves that the budget has been spent in line with the principles agreed and accepted during the development phase.

Profit Sharing The Performance-Based Pay system ensures that individual contribution is matched by reward. In order to make the picture complete, it was felt that the staff should have some participation in the results generated by their collective efforts. As Abbey National was a mutual organization, equity participation was not possible and so a cash scheme was adjudged best in the circumstances. The Profit Share Scheme is based on achieving the budgeted profit set in the Year Plan. No profit share is earned until the budget is reached. At the point when the budgeted profit is reached, 1 per cent of the total profit is put into the profit share pool. For all profits in excess of the budget, 10% of the excess is put into the pool. The resulting pool is paid out pro rata to salary.

Performance An important feature of this scheme is that it relates directly to profit, is easily understood and the reward follows fairly closely upon the publication of the results. It is also carefully communicated so that staff are regularly reminded ofwhat they can do to maximize their contribution to the overall profit.

Conclusion Abbey National needed to achieve a major shift in culture, in order best to meet the changing demands of its market place. The strategy involved significantly changing the behaviour of individuals with concentration on performance both as an individual and of the organization in terms of its profitability. The reward systems were changed to ensure that they supported and reinforced the strategy. However, before changing the systems the climate had to

be managed acceptable.

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to one in which such changes would be

If asked how successful it has been, I would just comment that we have had two cycles now and are in our third. The profits for 1985, 1986 and 1987, together with profit growth and Return on Capital figures (see Table 1) suggests that the bottom line is benefiting.

Table

1. Comparative

performance

Post tax Year

profit Pm)

Growth in profit (%I

Return on capital (%I

1985 1986 1987

140 171 223

22 30

20.3 20.3 21.6