On September 8, 2016, the New York Times reported this about Wells Fargo:
For years, Wells Fargo employees secretly issued credit cards without a customer’s consent. They created fake email accounts to sign up customers for online banking services. They set up sham accounts that customers learned about only after they started accumulating fees.
...Regulators said the bank’s employees had been motivated to open the unauthorized accounts by compensation policies that rewarded them for opening new accounts; many current and former Wells employees told regulators they had felt extreme pressure to open as many accounts as possible.
The headline of the article read: Wells Fargo Fined $185 Million for Fraudulently Opening Accounts. I suppose the message here is obvious, but please indulge me anyway. How did this happen?
Pay and Profits
One of the lessons this case teaches is that the pay philosophy and strategy of an organization has significant reach. In addition, it illustrates that how an organization pays its people is more important than how much it pays its people (not that the level of compensation is irrelevant). Here’s what I mean.
Businesses run into trouble when their compensation gets out of balance and unaccountable. For example, when variable pay is set up as an “incentive” instead of value-sharing, you run the risk of employees gaming the system to maximize short-term payouts. A balanced approach means you first set and communicate clear short and long-term performance expectations and then effectively link financial rewards to those expectations. When you employ a value-sharing philosophy and strategy (as opposed to paying “incentives”), those benefits are paid strictly out of productivity profit. This means value is paid out only after a pre-defined value creation threshold has been met.
In striving for the appropriate balance in their rewards approach, most organizations don’t pay enough attention to the long-term component. This is problematic both in its strategic implications and in identifying performance priorities. In an article for Strategy+Business, Ken Favaro offered the following perspective about the importance of a balanced focus between short and sustained results:
Peter Drucker once wrote that the manager’s job is to keep his nose to the grindstone while lifting his eyes to the hills. He meant that every business has to operate in two modes at the same time: producing results today and preparing for tomorrow.
But “preparing for tomorrow” really means investing in the future, an expensive and uncertain proposition. It demands taking an incremental hit to today’s performance in exchange for an unguaranteed payoff. Meanwhile, you have to meet your previous promises of big gains to have the wherewithal to continue investing. But that wherewithal will soon be lost if meeting those promises means forgoing new investments that are essential to future results. Drucker’s dictum is not only an acrobatic feat, but a managerial one as well. (Don’t Let the Short-Term–Long-Term Tension Drag Your Strategy Down, Strategy+Business, June 24, 2014, Ken Favaro)
Forward thinking CEOs recognize that the "acrobatic feat” Drucker references has implications for pay. Compensation is a strategic tool that’s employed to communicate “what’s important” to your people—and to what extent. If you’re a business leader, this can create a dilemma,. How do you use pay to reinforce the importance of maintaining the revenue engine of the company while simultaneously getting your people to focus on growth? If your compensation strategy rewards only one or the other, employees will likely have only half the focus you want them to have. The pay approach you take needs to emphasize both priorities and help the company sustain a kind of performance equilibrium. (Among other things, that equilibrium appears to be something Wells Fargo failed to achieve.)
Therefore, to address the issue of whether to reward short or long-term performance, CEOs and other business leaders need a different way of looking at pay planning, particularly when it comes to incentives. That starts with the establishment of an overall performance framework that defines the relationship between the organization's business, compensation and talent goals and targets. Compensation is as strategic as any other decision an organization makes. And the way you approach value-sharing will have a significant impact on your ability to successfully address the Drucker dictum. As a result, you can't divorce pay planning from other strategic pursuits your company has defined.
And as it relates to long-term value-sharing, the Wells Fargo debacle illustrates why this part of your pay strategy is so critical. Long-term value-sharing protects against bad profits and promotes good profits. In his book The Ultimate Question, Fred Reichheld, a Bain Fellow and founder of Bain & Company's Loyalty Practice, explained the difference between the two:
Too many companies these days can’t tell the difference between good profits and bad. As a result, they are getting hooked on bad profits.
The consequences are disastrous. Bad profits choke off a company’s best opportunities for true growth, the kind of growth that is both profitable and sustainable. They blacken its reputation. The pursuit of bad profits alienates customers and demoralizes employees.
While bad profits don’t show up on the books [at least they aren’t identified there as such], they are easy to recognize. They’re profits earned at the expense of customer relationships.
Whenever a customer feels misled, mistreated, ignored, or coerced, then profits from that customer are bad. Bad profits come from unfair or misleading pricing. Bad profits arise when companies save money by delivering a lousy customer experience. Bad profits are about extracting value from customers, not creating value. (The Ultimate Question, Fred Reichheld, Harvard Business School Publishing Corporation, 2006, 3-4.)
If Reichheld’s book were being released today, I suppose he could use the New York Time’s headline to put an exclamation point the effect of bad profits.
Long-term value-sharing arrangements, if designed properly, become a self-enforcing means of perpetuating good profits. Everyone will assume a greater level of stewardship for good profits if their wealth multiplier rises or falls on the ability of the company to sustain the right kind of profitability.
Conversely, companies that focus solely on short-term results (in terms of “at risk” pay) set themselves up for bad profits. Leaders of such companies can (and do) talk all they want about building value for the customer and improving return on equity for shareholders; but if they pay people in a way that communicates the opposite, how can they expect employees not to pull them into the bad profit trap? In this sense, long-term value-sharing protects the company’s interest in developing good profits, acting as a kind of insurance policy against a strictly short-term focus.
So…here’s to learning the “bad profits” lesson the easy way rather than the hard way.