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ROYAL INSTITUTE
OF TECHNOLOGY
Incentive Plans
Within Real Estate Firms – A Partial Review of Existing
Literature
SAMUEL AZASU
Stockholm 2004
Working Paper No. 51
Real Estate Economics
KTH: Infrastructure
Royal Institute of Technology
Incentive Plans
Within Real Estate Firms – A Partial Review of Existing
Literature
SAMUEL AZASU
Stockholm 2004
Working Paper No. 51
Real Estate Economics
KTH: Infrastructure
Royal Institute of Technology
ISSN 1401-9175
TRITA –BFE-WP51
Sammanfattning
Frågor om forvaltning av änstallda ökar i betydelse då medvetenheten inom fastghetsektorn
växer angående till vilken grad foretangandett är beroende av manniskor och hur olik
arbetstyrkan faktiskt är. Detta kommer att kräva mer uppfinningsrika steg för att hantera en
ökat utmannade uppgift att förvalta de manskliga resursena. Denna uppsats identifiera de
vanligaste osakerna för att använda incitamentsystem och undersöker olika typer av
incitamentsystem som använd. Givet att incitamentsystem inkludera någon grad av
resultatmätning, har olika typer av möjlig påverka på motivationen av resultatmätning har
diskuterats. I synnerhet har den potentiella rollen av icke-finansiell resultatmätning
identifierats. Ett antal alternativ och komplementara bakomliggande teoretiska ramverk för
användningen av incitamentsystem har också diskuterat.
I uppsatsen identifieras också debatten omkring använding av incitamentsystem; den omfattar
debatter aktuella typer av incitament till nyckeltal för resultat. Antangander i Agency Theory,
den huvudsakliga paradigm bakom utförmning och införande av incitamentsystem har också
ifrågasatts – dessa frågor fäster uppmärksamheten på behovet av att se bortom finansiella
incitament som motiverade. Det finns ett behov av detaljerad förskning om nuvarande
incitamentsystem för att bestämma vad some fungerar och varför, så väl som att undersöka
vad some kan göras annorlunda.
Azasu: Incentive Plans within Real Estate Firms
5
Incentive Plans
Within Real Estate Firms – A Partial Review of Existing Literature
SAMUEL AZASU
Royal Institute of Technology, Stockholm, Sweden. E-mail: [email protected]
Abstract
Issues of talent management are becoming increasingly important as research points to a
growing awareness within the real estate sector about how much the business is people-driven
and how diverse the workforce actually is. Both the academic and practitioner literature point
to the need for more innovative steps to tackle an increasingly challenging task of managing
human resources in business organizations, including real estate firms. This paper has
outlined the usual reasons given for using incentive plans as well as exploring the various
types of incentives in use. Given that incentive plans involve some degree of performance
measurement, the various types and potential impacts of performance measures have been
discussed. In particular, the potential role of non-financial performance measures has been
identified. A number of alternative and complementary theoretical frameworks underlying the
use of incentive plans were also discussed.
The paper also reviews the controversies surrounding the use of incentive plans; these have
ranged from the actual incentive items to performance measures. The assumptions underlying
agency theory, the principal paradigm underlying the design and implementation of incentive
plans has also been questioned by socio economists– these questions draw attention to the
need to look beyond financial incentives as motivators. There will be the need for detailed
research into current incentive plans in order to determine what works and why, as well as
explore what can be done differently.
Key words: incentive plans, performance measurement, performance management
Acknowledgements
The author would like to thank the following people who provided material support and very
helpful comments: Prof. Stellan Lundstrom, Assoc. Prof. Hans Lind, Assoc. Prof. Mats
Wilhelmsson and Dr Svante Mandell. Financial support for the project came from the Real
Estate Academy at KTH.
6Azasu: Incentive Plans within Real Estate Firms
1. Introduction
According to the Equinox Report 2003,
“ The real estate sector is beginning to acknowledge that good human capital is hard to come by,
harder to keep, expensive to lose and overwhelmingly the greatest determinant of success”1
The Towers-Perrin Talent Management Report 2001 identifies a number of issues that underscore the
importance of people management for any firm that desires long-term success in today’s marketplace.
Firms need people to turn new ideas into products as well as transform technology into usable tools.
The complexity of customer needs, coupled with the speed that accompanies the emergence of new
customer needs calls for customized, speedy responses that are primarily people driven. Firms may also
try to diversify their workforce to more closely reflect an increasingly diverse customer base.
The report also identifies an increasingly sophisticated workforce that is very well informed about their
career options and whose sense of loyalty is weakening when it comes to how long they want to stay
with an organization. In any given work environment, three groups of workers can be identified:
•
Workers who aspire to develop a broad skill set from carrying out different assignments
•
Those who aspire for a balance between work and private life, and
•
Fast trackers who desire challenging work, high rewards and quick career progression.
In addition to the above, workers differ in terms of age, marital status, and cultural background and, of
course skill and talent. The growing importance of people in the corporate success equation, coupled
with the worker whose characteristics are as described above makes talent management2 an enormous
challenge.
The challenges firms, including real estate firms, face are three-fold: recruiting new workers, retaining
them and those already there who are worth retaining; and not only that - motivating them in the sense
of getting them to work in ways that promote the interests of the organization, nowadays to the extent
of putting forth what is described as ‘discretionary effort’, that is, doing more than is expected of them.
One of the principal tools for managing the firm’s workforce is the incentive plan.
This paper will be a partial overview of the literature on incentives plans in business organizations. It
will review what has been done on the usefulness and the limitations of incentive plans as a human
resource management tool. The review is important in the sense of summarizing what is known about
the subject and the ways it can inform research into how these plans fit into the general human resource
management strategy of real estate firms in Sweden. In addition, the issue of talent management will
1
Equinox Partners. Real Estate – The Human Capital Factor. The Equinox Report 2003.
Defined as “the collective actions an organization takes to attract, engage and retain employees”.
Towers Perrin (2001).
2
Azasu: Incentive Plans within Real Estate Firms
7
remain a challenge for many years to come as demographic changes in Western Europe and North
America reduce the pool of the labor force from which companies can recruit (Towers and Perrin,
2001).
For the purposes of this review, incentives will be defined as awards given out when pre-determined
objectives have been attained within an organization. It is also important to note that incentives, by
definition, may not be guaranteed but mostly contingent on performance. As noted by Appelbaum and
Mackenzie (1996), when an employee’s performance exceeds a pre-determined target3, they tend to be
granted a form of incentive payout4. This incentive payout can be a one-off payment, a bonus, or take
the form of an addition to base pay which then remains until the next decision period5. Bonuses in the
future then become contingent on future performance whereas additions to base pay become part of the
compensation landscape once it is granted, being independent of future performance. Sometimes,
opportunities for career progression are seen as an incentive device; this is because they ultimately
entail financial rewards and in a lot of cases involve opportunities for growth and development.
The rest of the paper is organized as follows: types of incentives will be outlined followed by a review
of largely economic theories of worker motivation. Issues relating to performance measurement and the
related concept of performance management will follow this. Problems and controversies connected to
the implementation of incentive plans will then be discussed, including comparisons between Europe
and the US. The paper will conclude by raising a number of issues to be explored by further research.
2. Types of incentives
There are many ways of classifying the incentives awarded to employees of business organizations.
The following sections discuss some of the commonest classifications.
2.1 Individual v. group incentives
Milgrom and Roberts (1992) have identified incentives awarded to individuals as well as group
incentives. Relevant examples of the former include stock options for executives and commissions for
real estate agents6. Incentive pay directed at individuals has the advantage of inducing hard work and
discouraging mediocre employees from joining the organization. Kanungo and Mendonca (1992)
identify the following as requirements for the successful implementation of individual incentives:
3
•
The employee must be capable of attaining the desired level of performance
•
The employee must consider the reward valuable and highly dependent on performance.
Of course in some organizations, meeting the target is enough to qualify for incentives.
Which they label as ‘merit pay’
5
This could be accompanied by a promotion
6
This is usually a fraction of the sales price of the property.
4
8Azasu: Incentive Plans within Real Estate Firms
The fulfilment of this latter condition is said to lead to the existence of a clear ‘line of sight’ between
performance and reward. ‘Line of sight’ describes the employee’s ability to see how effort translates to
higher performance and ultimately greater rewards (Zobal, 1999). Milgrom and Roberts (1992) also
point out that individual incentive systems require work situations where an employee can work at
different paces for extended periods of time and also for the firm to be capable of limiting production
in times of limited demand. Individual incentives may, however, undermine productivity in a team
environment where cooperation is key to improved performance.
Examples of team/group incentives include Profit Sharing Plans, Employee Stock Ownership Plans and
Gain Sharing Plans. Team/group incentives are a way of introducing a sense of collective responsibility
within the firm with the aim of achieving superior performance through team effort. This is because
organizational change that emphasizes teamwork among people who previously worked largely as
individuals does not necessarily lead to higher performance (Zobal, 1998 pp.238). To alter performance
it is necessary to make cooperation among workers attractive. This calls for rewarding team effort; but
it is also worth noting that team rewards are necessary but may not be sufficient for team success
(Zobal, 1998 pp.239). One reason could be the possibility of free riding, which weakens incentives for
individuals to do their best. To avert this situation, a system of peer monitoring must be put in place, in
addition to pre-employment screening of potential employees who are not team players. This cannot
obviously eliminate free riders completely.
2.2 Short-term v. long-term incentives
Incentives can be short-term or long term. Short-term incentives include annual bonuses and
commissions based on performance in the period immediately preceding its award. Incentives can also
be deferred or long-term in the sense that the benefits are not realized until after some time period has
elapsed. Contributions to pension funds for company executives are an example; non-vested options
awarded to employees are another example. In the case of the latter, the employee must stay with the
company for a specified period in order to vest the options; the employee loses the options if they quit
the company earlier (Lazear, 1999). The usual argument is that such non-vested options encourage
employee retention. The issue of using incentives especially options to retain workers will be explored
later in the paper.
2.3 Financial v. non-financial incentives
The examples given above are examples of financial incentives. However, there are whole classes of
incentives that are non-monetary in nature in the sense that they do not involve actual cash awards
whether immediate or in the future. Examples of non-monetary incentives include company cars,
recognition and opportunities for training and development as well as promotions. The latter example,
of course, is usually associated with a higher monetary reward usually in the form of a salary increase.
The next section explores mainly economic theories of worker motivation.
Azasu: Incentive Plans within Real Estate Firms
9
3. Theories of worker motivation and incentive contracts
Issues related to organizational incentives are not new. As noted by Laffont and Martimot (2002),
Adam Smith (1776) recognized the role of incentive contracts in agriculture. However, they ascribed
the first attempt at developing a theory of incentives in management to Barnard (1938). Khanna (1999)
examined the case of the English East India Company. Carlos (1992 and 1994), Carlos and Nicholas
(1990 and 1993)7, as well as Milgrom and Roberts (1992) have examined the agency problems of two
trading companies, namely the Hudson Bay Company and the Royal African Company and the use of
incentive contracting to tackle the problem of aligning traders’ interests with those of owners in their
home country.
One of the principal theoretical models of incentive contracting is agency theory. In a review of agency
theory, Eisenhardt (1989) identifies an abstract and mathematical version of agency theory as the
principal-agent model that is widely applicable to a variety of situations. One application is the
problems that arise from the separation of ownership of a publicly held company and its managers.
The principal agent problem arises out of two issues: lack of goal congruence and differences in risk
preferences (Wright and Mukherji, 1999). The goal conflict arises because whereas the principal’s
costs and benefits are primarily financial, the agent’s costs and benefits are both financial and nonfinancial (Wright et al, 1996, cited in ibid). Thus, while the principal tries to maximize his wealth, the
agent tries to maximize not only his financial but also non-financial benefits. The differences in risk
preferences arise because the principal can be risk neutral or at least risk averse because he can
diversify his investment in many firms. The agent, however, is more risk averse since they are unable
to diversify their employment opportunities.
A primary contention of the agency model is that differences in risk preferences and lack of goal
congruence and the inability of the principal to perfectly observe the agent could lead to the agent
engaging in opportunistic behavior, at the expense of the principal. The contract is the unit of analysis
in the model. The focus is on finding the optimal contract for the principal and an agent whose
characteristics are as stated above. Laffont and Martimot (2002) have made an outstanding exposition
of this model.
The two central problems of the agency relationship are information failures resulting from precontractual withholding of private information by the agent (adverse selection) and the post-contractual
opportunistic behavior by the agent (moral hazard). Holmstrom (1982) defines adverse selection as the
situation “where actions can be observed, but it cannot be verified whether the action was the correct
one, given the agent’s contingency, which he privately observes.” He also defines moral hazard as the
7
Cited in Khanna (1999)
Azasu: Incentive Plans within Real Estate Firms
10
“problem of inducing agents to supply proper amounts of productive inputs when their actions cannot
be observed and contracted for directly”. The introduction of the concept of moral hazard is credited to
Arrow (1963), with the latter’s work further extended and relabeled as the ‘agency problem’ by Wilson
(1968) and Ross (1973)8.
The principal-agent model suggests that either investing in information systems through performance
monitoring, or contracting on the outcomes of the cooperation process (with more risk being passed on
to the agent) can mitigate these problems. The model points to trade-offs between the costs of
monitoring and the cost of measuring outcomes on the one hand, and transferring risk to the agent.
Thus incentive contracts, with the associated monetary reward are an attempt to provide incentives,
which align employee interests with those of the owners of the firm. Some of the application of agency
theory to organizations in recent times is credited to the work of Jensen and Meckling (1976), Fama
(1980), Fama and Jensen (1983)9.
The principal agent model and its use to justify the provision of incentives for managers has been
criticized at both a theoretical and empirical level. The usual framework of analysis is a singleprincipal and a single agent. The model can run into difficulties when applied to business
organizations, which are characterized by:
•
Multiple principals (shareholders) and multiple agents (employees including the executives)
•
Multiple principals and a single agent; for example a real estate broker dealing with different
clients
Lazear (1999) points out that free-rider effects in a multi-agent setting dilutes the incentives to each
agent to the point of trivializing it. Holmstrom (1982) also notes that for teams, moral hazard is
possible even if there is no uncertainty in output because free riders are difficult to identify if joint
output is the only observable indicator of agents’ performance.
Socio-economic theorists have also challenged the assumptions of agency theory about principals and
agents. Their main argument is that agency theory’s assumptions about principals and agents do not
lead to the attainment of competitive advantage (Wright, Mukherji and Kroll, 2001). In particular,
Wright et al (2001) contend that agency theory is too narrow given that its assumptions exclude the
possibility that different individuals behave differently. Socio-economic theorists have pointed out that
agents are not always selfish, neither are they all similar in trying to maximize only economic benefits
from their contractual relationship with the principal. The implication would then be that economic
rewards are not necessarily motivating for every agent in the contract situation.
8
9
Laffont and Martimot (2002)
Eisenhardt (1989)
Azasu: Incentive Plans within Real Estate Firms
11
Lazear also suggests, that empirical data supports the sorting role of the use of incentive contracts more
than motivation. Furthermore, tying a company executive’s reward to the firm performance does very
little to align his/her incentives with the owners of the firm. This is because the proportion of the
company that is usually owned by say, the CEO of a firm is too small to have any real motivating
effects on them. Even if one considers the extreme situation of making the CEO the full residual
claimant of the firm’s earnings, bankruptcy possibilities protect him from fully bearing the brunt of a
downturn in the firm’s fortunes. Thus, the lack of a downside to this situation can actually turn an
otherwise risk-neutral CEO into a risk lover, creating incentives for the CEO to make decisions that put
the company at risk. In addition, given that all10 workers need to be motivated, one sees the
impracticability of making all the workers residual claimants of the firm.
An alternative school of thought is that a worker’s motivation can be generated by career concerns. The
model, which explained this link, has been attributed to the work of Holmstrom (1982)11. The essence
of this model is that the worker is motivated to work hard in order to influence the labour market’s
beliefs regarding his capabilities. The model establishes a link between wages and expected
productivity, which in turn, depends on observed output in previous periods. An implied link is thus
created between current output and future wages.
Burgess and Metcalfe (1999) note the following as some of the central conclusions of the career
concerns model:
•
Career concerns are more effective motivators if output observations are more accurate or if there
is more uncertainty about the worker’s abilities
•
Given that the market’s information is believed to be more diffuse for younger workers, they tend
to work harder in order to establish a credible track record
A number of extensions to the Holmstrom (1982) model have been made. Drawing on some these
extensions especially that of Wilson (1989), Burgess and Metcalfe (1999) have suggested that career
concerns may be more important for public officials than financial incentives. They infer from Dixit’s
(1997) extension to the Holmstrom and Milgrom (1991) model that firms in the public sector are less
likely to offer performance-related pay.
The idea that motivation can come from pay differences within the organizational hierarchy has been
attributed to the work of Lazear and Rosen (1981). They formulated tournament/relative compensation
model with the following features:
10
11
•
Wage slots are fixed in advance and independent of absolute performance
•
A worker’s promotion depends on how he compares with everyone else in his cohort
Emphasis supplied
See Burgess and Metcalfe (1999) for a review of this model.
Azasu: Incentive Plans within Real Estate Firms
12
•
The higher the salary increase associated with the promotion, the higher the effort a worker
expends on trying to qualify for a promotion
This latter feature suggests that incentives are created for the worker to exert effort as long as there are
wage disparities along the hierarchy of the organization. Motivation is therefore strengthened by wider
disparities along the organizational hierarchy. It must be noted, however, that promotions cease to
motivate as one reaches the top of the organization; under such circumstances something close to piece
rates must be used. Lazear recommends stock price as an appropriate proxy. Stock prices have been
criticized in many ways. This will be covered later in this paper.
The potentially negative impact of workers competing for promotions is that there will be diminished
cooperation between workers. In a team setting reduced cooperation would then imply that even if
individual effort increases, overall organizational output might suffer. The likely explanation of this is
that competition reduces the amount of ‘connective capital’ available to each worker. Connective
capital is defined as ‘a worker’s access to the knowledge and skills of co-workers’ (Ichniowsky and
Shaw, 2003). This has been identified as a key ingredient in effective problem solving in a team
environment, and a source of increases in productivity. The absence of connective capital when
cooperation fails could explain the adverse effects on an organization that uses an incentive plan that
undermines team effort. The next section explores issues around performance measurement.
4. Performance Measurement
If the award of incentives to the employees of an organization is not to be arbitrary, performance has to
be determined. Thus, a performance measurement system is an integral part of an incentive plan.
4.1 Definitions
Jensen and Meckling (1986) describe performance measurement/evaluation as a process in which
value weights are assigned to various measures of performance to represent the importance of
achievement on each dimension. Amaratunga and Baldry (2003) also define it as “a process of
assessing progress towards achieving pre-determined goals, including information on the efficiency by
which resources are transformed into goods and services, the quality of those outputs and outcomes,
and the effectiveness of organizational operations in terms of their specific contributions to
organizational objectives”. Neely, Gregory and Platts (1995) define a performance measure as a metric
used to quantify the efficiency and/or effectiveness of an action. Typically, within an organization, a
collection of metrics are used, forming a performance measurement system. The performance
measurement system is not only the basis for determining who qualifies for incentive rewards but even
Azasu: Incentive Plans within Real Estate Firms
13
more importantly a reflection of the goals and strategies of the organization as a whole (Woodford and
Maes, 2002).
Peck (2000) has identified a number of performance measures attached to executive compensation
packages. These measures he has divided into market based performance measures and accounting
based performance measures. McKenzie and Shilling (1998) identified three classes of measures:
traditional accounting measures, the commonest example being accounting profits; value-based
measures with Economic Value Added (EVA) as the easiest example. Hybrid measures combine
financial and non-financial measures with the balanced scorecard as a typical example.
Within the real estate sector, a number of performance measures exist (Baum, 2000). This depends on
whether one wants to evaluate direct or indirect investment in real estate. In the US, where there are
sophisticated vehicles for indirect investment, there are a number of performance measures such as the
NAREIT Equity REIT Share Price Index for Equity REITs, with a corresponding index for mortgage
REITs as well as a hybrid index for REITs that own properties and make loans. The NCREIF Index
measures performance on direct investment.
In Europe, there are a number of national indexes; however, they mainly cover direct investment and
are under the control of Investment Property Databank (IPD), a UK-based firm. It provides benchmark
measurement services in 12 European countries including Sweden as well as Canada. They are
compiled from valuation and management records for individual properties in complete portfolios,
collected directly from investors by IPD. Examples of typical performance measures include income
return, capital return and their sum referred to as the total return. Baum (2000) notes that performance
measurement organizations in the UK and the US typically use total return measures for one-period
performance assessment for all assets. There is also the time-weighted rate of return, which is deemed
appropriate for quoted unitised and other co-mingled funds, in a situation where the manager has
discretion over cash flows and investments.
Performance measures can also be classified as financial, non-financial, subjective and objective. The
following sections explore the distinctions in detail.
4.2 Financial performance measures
As already mentioned, financial measures are a class of measures that are derived from the statements
issued by the firm on its financial performance. This includes accounting profits and earning per share.
These are examples of traditional accounting measures. There are also value-based measures, the
commonest example of which is Economic Value Added (Mackenzie and Shilling, 1998). This
performance measure is used to evaluate a manager on the relation between profits and the assets used
Azasu: Incentive Plans within Real Estate Firms
14
to generate them. It is appropriate when a manager is allowed to determine the amount of assets used in
a line of activity where asset utilization costs are important (Jensen and Meckling, 1986).
Financial performance measures have been criticized as a basis for determining company performance.
Kaplan and Norton point out that:
“…financial measures tell the story of past events, an adequate story for industrial age
companies for which investments in long-term capabilities and customer relationships
were not critical for success. These financial measures are inadequate, however, for
guiding and evaluating the journey that information age companies must make to create
future value through investment in customers, suppliers, employees, processes,
technology, and innovation.”
4.3 Non-financial performance measures
These are measures that are not derived strictly from financial records. Examples include product
quality, customer satisfaction, market share or even employee turnover. They are normally used jointly
with financial performance measures.
Banker et al (1998) have given a number of reasons for their use: they are considered better than shortterm profits with respect to measuring the firm’s progress towards attaining its long-term goals.
Whereas financial measures are evaluations of past achievement, some non-financial measures could
be shown to be drivers of future performance. They also enjoy the advantage of being less susceptible
to manipulation in addition to being easy to understand, providing feedback for timely corrective
action. From an agency perspective, Feltham and Xie (1994)12 note how noisy and imperfect financial
measures are as indicators of agents’ efforts; one use of non-financial measures is to reduce the noise in
making inferences about agents’ efforts.
Perhaps the most important reason cited by Banker at al (1998) for using a non-financial performance
measure is that they are lead indicators of financial performance. Among the non-financial
performance measures identified above, customer satisfaction has been identified as a key long-term
measure that is an important predictor of long term performance in business areas where repeat
business is important (Phillips et al 1990; Griffin and Hauser, 1993; Hauser, Simester and Wernefelt,
1994)13. Using the case of a chain of establishments in the hospitality industry, Banker et al (1998)
demonstrated that both financial and non-financial performance improved after implementing an
incentive plan designed to include non-financial performance measures.
Within the real estate sector, a number of transactions qualify as repeat business: renewal of lease and
asset management contracts. Thus the case can be made for considering the use of customer
12
13
Cited in Banker et al (1998)
Cited in ibid.
Azasu: Incentive Plans within Real Estate Firms
15
satisfaction as a performance measure in an incentive plan that is geared towards driving long-term
financial success. This will be further discussed in the concluding sections of this paper.
4.4 Objective v. Subjective Performance Measures
Performance measurement can be more or less subjective or objective depending on whether or not it is
easy to measure a worker’s output. Where this is easy, the appropriate incentive scheme is usually
called Performance-related pay (PRP). PRP would then involve paying the worker an amount that
depends on some objective measure of his output.
There are situations where performance-related pay can be inappropriate in spite of the existence of
accurate performance measures. This is because the worker may be interested in only those activities
that are measurable and rewarded, at the expense of not so easy to measure but equally important tasks.
Holmstrom and Milgrom (1991) show the difficulties of implementing incentive pay in multi-tasking
situations. Burgess and Metcalfe (1999) infer from Holmstrom’s model that performance-related pay
would be inappropriate in public sector firms, given that such jobs involve many difficult to measure
tasks.
In service firms, output/performance measurement may be problematic; this is where subjective
measures come into play. This leads to incentive payments classified as merit pay. The problem with
subjective assessments, according to Burgess and Metcalfe (1999), is that they are not verifiable by a
third party; thus the evaluator has an incentive to distort the evaluation ex-post for private gain,
weakening the incentives for employees to work hard.
It can argued that individual output will not be easy to measure in service organizations. One may thus
infer that incentive plans should be less easy to implement in service organizations than in
manufacturing firms. Thus one should be more likely to see the use of merit pay plans, team rewards
and bonuses in service organizations, (including the real estate sector) instead of explicit PRP schemes.
Agell (2003) in a study in Sweden found that only 37% of managers in public administration who
report or indicate they were able to evaluate performance compared to 55%, 56.7% and 57.1% in
manufacturing, skilled and unskilled services respectively.
The exact nature of a performance measurement system depends on whether a sub-unit of the firm is
organized as a cost, revenue, profit, and expense or investment center. A cost center aims at
minimizing costs for a given output, or minimizing average costs (with no quantity constraint).
Revenue centers aim at maximizing total revenue for a given price or maximize total revenues with no
quality constraint. A profit center’s performance is assessed on the basis of the difference between its
revenues and costs. A variant of a profit center, an investment center focuses on the relationship
Azasu: Incentive Plans within Real Estate Firms
16
between profits and the assets used to generate them. A sub-unit of a firm can also be organized as an
expense center typically providing services for the rest of the firm without levying any charges on the
consuming sub-units of the firm.
Thus, the performance measure used for an incentive plan within an organization may vary across subunits of the firm. Peck (2000) notes the widespread use of Accounting Profits as the basis of
determining executive bonuses. Jensen and Meckling (1986) and Delves (1999) suggest, for example
the use of Economic Value Added14 (EVA) for firms that use a lot of physical capital such as real estate
companies. Delves (1999) points out the merits of EVA over accounting profits as a performance
measure. Accounting profits do not take into account the use of the firm’s equity. Thus, what EVA
does is to subtract from the firm’s after tax net operating profits some form of rent for using its own
assets. Thus, a firm may be profitable from an accounting point of view and yet show negative
performance once this profit is compared with the owners’ asset charges.
Neely, Gregory and Platts (1995) suggest a 3-level analysis of any performance measurement system:
•
Individual performance measures
•
The collection of performance measures, i.e., the performance measurement system, and
•
The performance measurement system and the environment within which it operates.
Figure 1. Three-level analytic framework for design of performance measurement systems.
Source: Neely, Gregory and Platts (1995)
14
Defined as the difference between after tax net operating profits and an ‘asset charge’.
Azasu: Incentive Plans within Real Estate Firms
17
At the level of individual measures, they suggest a determination of the actual measures used, the
purposes for which they are used, their costs as well as benefits. Analyzing the system as a whole
involves, among other things, consideration of what they regard as all the appropriate elements of a
performance system: internal, external, financial and non-financial; the relationship between the
measures and the long and short-term objectives of the firm; the presence or absence of any conflict
between the measures. At the firm level, the system can be analyzed in terms of the extent to which it
conforms to the firm’s strategies as well as the organizational culture; whether the measurement system
is consistent with the existing recognition and reward structure; whether some measures deal with
customer satisfaction as well as how the firm compares with its competitors.
4.5 Performance Management
The traditional approach to performance measurement entails a manager or supervisor annually writing
his/her judgment regarding the performance of a subordinate employee on a document provided by the
Human Resources Department. The advantage of this approach is that “ the immediate superior usually
has the best knowledge of the individual job content, objective and overall performance” (Hume,
1995). However, in most cases the appraisal captures only what the immediate supervisor/manager can
remember and these are understandably the most recent events. Heathfield (2002) also notes the
following as criticisms of this approach to performance appraisal:
•
It is reminiscent of the “ old fashioned, paternalistic, top-down autocratic mode of
management that treats employees as possessions of the company”
•
It is not in consonance “with the values-driven, mission oriented, participative work
environments favoured by forward thinking organizations today”
•
“It is harmful to performance development; damages work place trust, undermines harmony
and fails to encourage personal best performance”.
The alternative to performance measurement is performance management. Macaulay and Cook (1994)
define performance management as an approach to management aimed at harnessing and focusing
employee performance. According to Armstrong (2000), performance management
“ …is about the agreement of objectives, knowledge, skill and competence requirement,
and work and personal development plans. It involves the joint and continuing review of
performances against these objectives, requirements and plans, and the agreement and
implementation of improvement and further development plans. The focus is on
improvement, learning, development and motivation.”
Essentially therefore, performance management appears to be forward looking. Unless measures that
determine future long-term business performance are used, performance measurement may end up
being only backward looking. One can argue that the way in which the worker’s output is assessed
could actually serve to de-motivate the worker; proper handling of the assessment/evaluation process
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18
would communicate the values of the organization and motivate workers towards attaining them. At
this juncture, one may want to examine issues surrounding the implementation of incentive plans.
5. Incentive plans in practice
From an international perspective, there have been differences in the extent to which business firms
have adopted incentive schemes. The United States leads the world in the size and extent of adoption
of incentive plans as part of the corporate compensation schemes. (Peck 2000), notes that “in broadly
comparable organisations, a US CEO earns more than 125% more than their UK counterpart”. What
is even more interesting is the comparative proportion of salaries, bonuses, and long-term incentives in
the direct compensation package of either CEO. While a UK CEO’s salary formed about a third of total
direct compensation, with the remainder almost evenly shared between bonuses and long term
incentives, salaries for a US CEO accounted for only 2% of direct compensation, bonuses 10% and
long-term incentives rising to as much as 88% (ibid).
5.1 Controversies surrounding compensation Schemes
The introduction and implementation of incentive schemes have not been without controversy. While
there appears to be consensus over the use of incentive packages to align employees and managers’
interest with owners, there is disagreement on:
•
The size of the compensation packages,
•
Particular elements of the packages,
•
The performance standards on which they are based, and
•
The process of determining reward especially for the topmost executives of firms.
Conventional wisdom on the subject is that there is a positive association between compensation and
company performance. In Europe, the evidence is mixed, as research points to a strong, significant
positive link between executive (cash) pay and company size overshadowing the smaller but significant
positive link between pay and performance. The implication is therefore that management may be more
interested in growing the company for its own sake rather than improving performance (Peck 2000).
5.1.1 The Size of the packages
The executive compensation component of incentive plans has also come in for sharp criticism on
grounds of fairness. The criticism is strongest in the United States, and quite naturally because,
according to Business Week’s annual survey the average annual CEO pay for a major corporation was
$12.4 million in 1999. This was an increase of 17% from the previous year, and 475 times more than
the average blue-collar worker, and 6 times the average CEO pay check of 1990. For companies that
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19
have global operations, the situation is worsened when compared with the compensation paid to their
employees around the world. Proponents of this argument cite the impact this perceived inequity can
have on employee morale and productivity. They advocate a compensation system that is characterized
by proportionality between CEO pay and that of the average worker. This is expected to reflect the
recognition that all employees contribute to the firm's success. It is important to point out, that
criticisms are not just about the size of CEO pay checks; they are about the pay setting process and the
role of board members and Executive search firms as well (Cox and Power, 1991).
Others have countered this argument by pointing out the absence of a ‘social contract’ in business.
Thus, ethical issues do not come into place when compensation, especially executive compensation is
set by the market place (ibid).
In addition, the almost exclusive focus on senior management compensation may be ignoring the
motivational effects of earning differentials across the organizational hierarchy according to the
tournament model. Lazear (1998) notes:
American CEOs have recently come under attack for their high salaries, particularly in
comparison to their European counterparts. While their salaries may be too high,
focusing on salaries alone misses the entire point of the compensation structure. The
CEO’s salary is there not so much to motivate the CEO, as it is to motivate everyone
under him to attain that job. It is impossible to determine whether the CEO is overpaid
simply by looking at the relation of the CEO compensation to output. …the structure of
compensation is key…. It makes no sense to evaluate a job independent of the rest of the
firm’s hierarchical structure.
5.1.2 Elements of the package
A related issue is on particular elements of the compensation package. Stock options have been singled
out as the most important part of the increase in executive compensation. Graef Crystal has cited 3
reasons for this:
•
The strong performance of the stock market in 1990s,
•
The fact that options needed not be charged against earnings, making it ‘cost-free compensation’,
•
The belief that it provides an incentive to improve corporate performance.
On the contrary, Crystal is reported to have found that the exercise of stock options by executives is not
correlated with stock appreciation. In a study of the relationship between CEO option gains and stock
price appreciation over 10 years, he found stock appreciation accounted for only 15% of the variation.
This he attributed to the lack of a ‘down-side’ to option grants, due to the possibility for executives to
Azasu: Incentive Plans within Real Estate Firms
20
often swap lower priced options for underwater ones. The latter possibility has been made difficult, at
least in the US, by the Financial Accounting Standards Board, which has formalized its ruling requiring
companies that cancel underwater options15 in order to reissue lower priced ones to take a substantial
charge against earnings (Reingold and Jespersen, 2000). Nevertheless, it is a well-known fact that a lot
of average managers reap millions of dollars in a bull market, while hardworking executives sometimes
fail to translate their corporate profits into stronger P-E numbers.
In this regard, Employee Stock Ownership Plans have been touted as a better alternative in two
respects: it turns employees into owners, resulting in goal congruence. It is also expected to foster long
term thinking on the part of employees. The problem with ESOPs is that employee beneficiaries may
leave just to realize the benefits due to concerns about the lack of diversification. In response to this,
firms sometimes have clauses in the plans that defer distribution to the legal limit16. Firms may also
not want former employees to continue to participate in the growth of their stocks.
Lazear (1999) also criticizes the use of non-vested stock options as a retention tool. This is because
equity-based rewards shift risk from capital to labor even though employees are poorer bearers of risk
than outside investors, given the diversification opportunities available to outside investors. He points
out, for example, that bonds that are put in an escrow account for a defined time period will provide the
same retention effects without having any risk passed onto the worker.
The controversy surrounding stock-based compensation has only deepened especially since the recent
corporate scandals in the US and Europe. According to Martin (2003), when firms award stock-based
compensation they create incentives for executives to exaggerate expectations about company earnings,
given that this is what drives stock prices. These executives can use their knowledge of the company to
cash in on their rewards before earning expectations and hence stock prices fall. The suggestion is that
executive reward be instead based on real earnings growth.
15
Options that become worthless as a result of a fall in their current price
‘Converting ESOP Stock into Other Investments for Former Employees’, excerpts from the
Employee Ownership Report, http://www.nceo.org/columns/news20.html, 2nd March 2001.
16
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21
5.2 The impact of firm size
Performance-related pay (PRP), as the name implies, involves paying the worker an amount that
depends on some objective measure of his output. As has already been mentioned, performance
measurement is not costless. If these measurement costs are fixed, Lazear (1986) points out that these
fixed costs could be spread over more workers, making it cheaper for large firms to adopt this method
of incentive contracting. This would then imply that larger firms should be more likely to adopt
incentive plans than smaller firms. Yet again, studies in Swedish industry may be interpreted to be
supportive of the implication of Lazear’s (1986) work: “managers in large establishments are more
prone to exploit incentives based on performance pay and relative rewards, and that managers in
smaller establishments tend to believe that incentives based on relative pay and competition among
employees have counter productive effects on employee motivation” (Agell 2003). However, a survey
of the real estate industry in the United States indicates the reverse, with larger companies laying
greater emphasis on fixed pay (The Equinox Report, 2003).
5.3 Public-private sector differences
One of the obvious differences between firms funded by private capital and government or quasigovernment organizations is that the former focus on profitability and maximization of shareholder
value. Government organizations, or public sector firms as they are called, tend to have multiple
objectives, which in some cases exclude profits. As pointed out above, Holmstrom and Milgrom’s
(1991) work imply that public sector firms with multiple objectives, some of which are difficult to
measure, should be less likely to use incentive contracts (Burgess and Metcalfe1999).
Burgess and Metcalfe (1999) also refer to the work of Dixit (1997) in describing public agencies as
agents with multiple principals, each with different objectives. Given that these principals are not
colluding, using incentive contracts will be extremely costly, relative to the case where they actually
collude.
5.4 Limitations of incentive plans as employee motivator
Conventional wisdom cites the use of incentive plans as a recruitment, retention as well as motivation
tool. This arguably is in line with recommendations of agency theorists who believe that this is one of
the best ways of curbing the excesses of opportunistic managers as well as motivating employees. As
already pointed out, these recommendations rest on two crucial assumptions about agents –
opportunistic behavior and economic rationality. Socio-economists have challenged both assumptions.
In particular if all agents are not out to maximize their economic benefits, then the universal reliance on
financial incentives as motivators for all employees becomes questionable.
Azasu: Incentive Plans within Real Estate Firms
22
One of the major conclusions of the Towers Perrin Talent Report (2001) is that even though incentive
plans using mainly financial rewards may serve to attract people to a company, other factors are needed
to keep and motivate them. Specifically, attractive pay and benefit packages may serve as effective
recruitment tools, but retention may require factors such as leadership development and the extent to
which employee skills are tapped. In addition, employee commitment and motivation depends on
factors such as recognition and promotion of talented workers, and a culture that promotes teamwork
and innovation. Employee motivators also differ across age groups; thus while leadership development
and challenging work would motivate workers between the ages of 30 and 44, work/life balance and
recognition/reward for talent and leadership issues appear to be important to older workers17.
These findings have also been confirmed by a survey of the real estate sector (The Equinox Report
2003). Effectively, what these studies show is that pay and benefit plans may serve to attract workers
into a firm. However, given that every other firm can replicate this, retention and motivation of workers
require firms to differentiate themselves in terms of non-financial rewards. All this is in agreement with
socio-economic views that agent heterogeneity imply different things motivate different people.
Lazear (1999) has questioned the wisdom of staff retention, especially when the value of a worker’s
outside opportunities exceed his value within the firm; in that case everyone will be better off
negotiating an exit for the worker. He recommends using incentives for retention only when the firm
has made unique investments in the worker or that the worker has talents that are of unique value to the
firm. All the theoretical models of incentive contracting, as well as empirical research into the
implementation of incentive plans show that they are limited as a people management tool. Free riding
bedevils group incentives, while individual rewards tend to undermine cooperation within the
organization. Burgess and Metcalfe (1999) also find too few incentive schemes in the public sector.
Recent research on the limitations of incentive plans would suggest that both sectors can limit the
adverse effects of the presence or absence of incentive contracts if they implement what is called
‘complementary human resource practices’: employee training, hiring criteria that screens out free
riders or people without good team skills18, establishment of a team culture, job design and employee
hierarchies. These not only limit the negative impacts of using incentive pay but also strengthen their
productivity impacts (Ichniowsky and Shaw, 2003).
17
It is important to remember this study was conducted in North America.
This calls for extremely strong interviewing skills on the part of the human resource departments as
well as other concerned senior managers in the respective firms.
18
Azasu: Incentive Plans within Real Estate Firms
23
6. Questions for further research
When it comes to the real estate sector in Sweden, it is obvious that people management issues would
be of concern to the sector. This will be independent of prevailing economic conditions because even in
a downturn, people are needed to solve problems, develop new products and translate new technologies
into usable tools. It is also reasonable to suppose that incentive plans are being used to an extent as a
people management strategy. The question therefore that arises, is that given that the sector may
already be implementing incentive plans, what types of incentive items should they use? Specifically,
what types of incentives should be implemented – individual or group incentives? Should they be
annual bonuses or should they be explicitly linked to performance?
One of the major conclusions of the Towers and Perrin study is that incentives may serve to recruit and
retain workers but what is uncertain is their effectiveness as motivators. The study points to the role of
non-financial factors as more important as motivators. It would be pertinent to test the extent to which
these conclusions apply to the real estate sector in Sweden, the level of awareness of these issues
among human resource professionals in the sector and the implications this would have for their
incentive plan design and implementation.
It can also be argued that no comprehensive assessment of the use of incentive plans in the sector will
be complete without determining employee perceptions about incentives plans. It will therefore be
important to explore the factors, which drive employee decisions to:
•
Join
•
Stay with and
•
Do their best for a particular company.
This will provide hard facts that would enable individual firms within the sector to determine what
elements of the job situation they should alter to differentiate themselves from their competitors in
order to optimize their use of their human resources. In addition to this, it will be important to
determine the extent to which employers survey their employees in order to identify and understand
employee profiles; this will provide indications about their ability to adjust their people management
policies and practices towards the fulfillment of corporate goals.
The existing literature also shows that performance management as a process can influence employee
behavior towards the fulfillment of the long-term goals of the firm. One may therefore need to know
which performance measures would be appropriate for the real estate sector, and what would be the
appropriate mix between individual and group performance measures for the sector.
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24
As has already been pointed out, Accounting profits may not provide an accurate picture of the
profitability of the firm, especially in the real estate sector where the use of physical assets is primary.
The question is whether EVA may be a better performance measure. In addition, there are a number of
performance measures specific to the real estate sector. As has already been mentioned, the Swedish
real estate sector has an index, the SFI / IPD Swedish Property Index, which measures returns to direct
investment in property. This measure could provide a useful benchmark for evaluating how a company
performs, relative to the real estate market, given that contributors to the index use common valuation
guidelines.
As has been pointed out earlier, stock-based performance measures can lead to workers enjoying
rewards arising from general increases in stock prices. This creates resentment among shareholders of
the companies, while a general downturn in general stock market conditions would imply that
otherwise hardworking employees would fail to qualify for any bonuses. This can demoralize
hardworking employees and lead to increased employee turnover. This provides an additional
motivation for the use of a benchmark that is real estate specific and cancels out the influence of
general stock market movements, and rewards performance only in comparison to other companies or a
collection of companies.
In order to create a line of sight between performance and reward, it will be important to assess
workers on the basis of measures they can actually control. It will be important therefore to test if there
are any differences between performance measures across the firm hierarchies.
There are also a number of other performance measures, particularly relevant for fund and asset
management situations. What is unclear is whether such funds should be evaluated on the basis of total
return or internal rate of return (IRR). There is also the question of whether there should be a single
performance measure or whether a set of multiple measures should be used. Having decided on the
measures, there is an equally relevant question of what will be an appropriate time frame over which
performance can be measured. One year measures may not accurately reflect a fund manager’s abilities
if general market conditions undermine his investment decisions, or if he rides on the back of favorable
market movements to qualify for bonuses; longer time frames may provide a better idea of their
abilities and provide an indication of how consistently they can outperform a benchmark.
Another issue worth considering is whether real estate companies listed on the Stockholm Stock
Exchange use stock-based compensation measures. This issue is particularly interesting for two
reasons: the huge controversy surrounding such measures merits an investigation of the extent to which
the Swedish practice of awarding incentives conforms to international standards. This may influence
international investor decisions as to which companies to invest into. The second reason is the rather
negligible role of real estate companies in the total market capitalization of the Stockholm Stock
Azasu: Incentive Plans within Real Estate Firms
25
Exchange. This may place into doubt the attractiveness of indirect real estate investments and hence the
trading frequency of these stocks. Thin trading of these stocks may render them unsuitable as a basis
for determining rewards.
Given that financial performance measures largely measure historic performance, a lot of attention is
being paid to non-financial measures, particularly those that are linked to future performance. The
commonest examples of these are customer service, market share and service quality. It can be inferred
from the academic and practitioner literature that financial performance measures (especially those
reported on an annual basis) are essentially short-term in nature and using them as the basis for
measuring performance cannot but encourage short-term thinking on the part of employees. There is a
growing call for a consideration of the use of non-financial performance measures. The question is,
which ones should be used? Ultimately the measure is expected to help predict long-term financial
performance. In that case this must be the primary criterion.
It has also been demonstrated that non-financial measures, especially customer service are better
predictors of future long-term financial performance especially in repeat sales situations. What is more,
using the case of one establishment in the hospitality industry, Banker et al (1998) have found that both
financial and non-financial performance improved after implementing an incentive plan designed to
include non-financial performance measures. The extent of use of non-financial measures may
therefore give an idea about how effective current incentive plans are in driving long-term financial
performance.
It is also important to identify what type of relationship that needs to exist between the performance
measurement systems and the companies’ business strategies. Given theoretical predictions backed by
empirical evidence from elsewhere it will also be important to determine and explain possible
differences between the public and private sub-sectors in their use of incentive plans. In addition one
may want to know what implications this will have for their talent management strategies. Specifically,
will the private sector have the upper hand in recruiting, retaining and motivating talent? What role will
differences in worker risk aversion play in which sub-sectors they choose to work for? Further research
should also answer the question as to whether large firms will be more likely to use incentive plan than
small firms.
To conclude, issues of talent management will increasingly become important as the real estate sector
becomes more and more aware of how much the business is people-driven and how diverse the
workforce actually is. This will call for more innovative steps to tackle an increasingly challenging task
of managing its human resources. This paper has outlined the usual reasons for using incentive plans as
well as exploring the various types of incentives in use. Given that incentive plans involve some degree
of performance measurement, issues around performance measurement have been discussed. The
Azasu: Incentive Plans within Real Estate Firms
26
potential role of non-financial performance measures has been identified. A number of alternative and
complementary theoretical frameworks underlying the use of incentive plans were also discussed.
The paper also identifies the controversies surrounding the use of incentive plans; these have ranged
from the actual incentive items to performance measures. The assumptions underlying agency theory,
the principal paradigm underlying the design and implementation of incentive plans has also been
questioned – these questions would imply the need to look beyond financial incentives as motivators.
There will be the need for detailed research into current incentive plans in order to determine what
works and why, as well as explore what can be done differently.
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