June 16, 2022 Executive Compensation ESG & Human Capital Management Articles

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How Boards Can Avoid the Pitfalls of DE&I in Incentives

Nearly 30 percent of companies in the S&P 500 used a diversity, equity, and inclusion (DE&I) metric in executive incentive design last year, and a quarter of these businesses did so for the first time. However, companies looking for a quick fix to DE&I should move cautiously.

Compensation is a sensitive topic, and what gets measured gets done. Without careful consideration, DE&I metrics in incentive plans can produce unintended or counterproductive outcomes.

Effective DE&I metrics in incentives require groundwork

Boards should work with management to determine the most material aspects of DE&I that support the business strategy, clarify objectives for those areas, confirm that incentives are the right tool to achieve those objectives, and encourage efforts to shift corporate culture to better support DE&I. Below are common pitfalls associated with DE&I incentive metrics and ways to increase success.

Metrics focus on representation only

Boards may be tempted to focus on the diversity aspect of DE&I, which is the easiest to measure. However, the “E” and “I” are just as critical. Representation of women and minorities may increase, but without a culture of inclusion, companies risk tokenizing groups or gamifying quotas. A corollary situation is found in financial incentive design, where multiple metrics balance each other out, e.g., if incentives measure sales growth only, employees may pursue sales at the expense of profits.

Boards can measure “E” and “I” by including a metric on improving engagement scores focused on belonging, measuring individual leader performance partly on building inclusive environments and offering equitable career development opportunities across different groups, and developing metrics on recruiting and development strategies focused on marginalized groups.

Easily achieved goals disconnect from long-term aspirations

Boards typically set incentive targets with reasonable stretch where there is a clear path toward achievement, but they may be lenient with new metrics. The temptation is exacerbated for new DE&I metrics because companies worry about the optics of publicly missing targets. Boards should be wary of layups. They can also map metrics to longer commitments and consider goal gradations to motivate executives toward additional achievement (set an accessible threshold, a reasonable stretch target, and an aspirational maximum).

Metrics displace strategic priorities

Incentives have limited real estate. Beyond DE&I, other strategic priorities can get crowded out of incentive design if not considered holistically. Rank ordering priorities can help. Some companies may find that other tools effectively reinforce DE&I, such as performance management systems, promotions, and terminations. Alternatively, boards can use a performance scorecard, measuring DE&I alongside other priorities; the scorecard sends a clear message that each goal matters.

Metric definitions are not stress-tested. For example, companies may get granular with representation definitions to promote progress for specific underrepresented groups, leaving out other groups. Along these lines, a company might exclude a group from organization-wide representation targets because that group has strong representation across the whole organization. However, if that group isn’t well-represented in leadership, it can be indicative of an inclusion problem.

In addition, boards sometimes fail to consider how mergers or acquisitions will impact goals. Acquiring an organization with a less diverse population could harm progress toward DE&I goals, yet the deal might still be in the company’s strategic interest. Boards should include allowable adjustments in incentives to anticipate these challenges or design their plans to maintain the legacy business goals separately until the next performance cycle begins.

Meanwhile, every country has a different mix of ethnicities and legacies. International boards may decide to measure gender globally but race and ethnicity only in the United States. Alternatively, the board could allow each region to set its own goals.

DE&I goals that are included in executive incentives should emerge from a holistic strategy and scenario planning rather than a quick response to outside pressure. Boards should work with management on a comprehensive plan for areas in which DE&I can truly make progress: in recruitment, promotion, retention, career development, employee affinity groups, and overall communication. Only then can these metrics be noteworthy.

View the full article as it was originally published.

Blair Jones

Margaret Hylas

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