Getting CEO Appraisal Right
Say-on-pay and a growing demand for transparency have helped usher in an era that finds boards in search of a more robust approach to CEO evaluations, with CHROs ideally playing a bigger role in the process.
By Mark McGraw
The CEO performance-evaluation process is a different ballgame for CHROs and boards of directors.
While assessing employee performance is part and parcel of any HR leader's job, appraising the company's top executive presents challenges unlike those encountered in evaluating employees and managers at lower levels of the organization.
"Doing [CEO evaluations] well is more difficult than it appears," says Rick Ketterer, a partner of the Delta CEO and Board Effectiveness unit at New York-based Mercer.
"We all know mid-level managers get evaluated to death," says Ketterer. "But, as you get higher in the ranks, the feedback gets less rigorous and less direct."
Why? Part of the problem is what Ketterer calls "the appraisal paradox," which maintains that "the higher you go [in the organization], the less likely you are to get rigorous and constructive feedback."
For starters, HR leaders and boards are often dealing with "large personalities operating at the highest levels," says Ketterer. "That can make it tough to be candid. You'd think the board could sit down and have a frank conversation with the CEO, but we've found that's often not the case."
Historically, some boards have displayed a tendency to defer to CEOs on performance evaluations, continues Ketterer. He recalls one client company, for example, where the CEO's performance review process consisted solely of the chief executive doing his own annual self-evaluation.
"Until recently, many public company boards operated under the strong influence of the CEO, with limited board independence and oversight of key functions, including CEO succession, financial audits, risk, etc.," says Ketterer.
The last decade, however, has ushered in a new era in which legislative and regulatory demands, escalating shareholder activism and harsh economic realities have led boards to become "more independent and accountable," he says, "with stronger lead director and non-executive chair roles; meaningful, independent directors meetings; and more rigorous risk, management, compensation and governance practices."
Nevertheless, the dynamic between public company boards and CEOs continue to evolve, he says, "as each party learns to partner and share accountability with the other in today's ever-changing governance environment."
Indeed, the CEO evaluation process is still very much a work in progress -- and a bit of a mystery -- at many organizations, says Ketterer.
"Due to the lack of standards regarding the CEO evaluation process, the sensitive nature of the work and the paucity of data on the topic, little is known about how public companies actually assess CEOs," he says. "What information we do have is largely anecdotal, and suggests wide variance in the quality and rigor of the evaluation process."
Still, faced with growing demands for transparency and recent rules giving shareholders say-on-pay votes, organizations would be well-served to make their CEO evaluations more robust, ongoing processes supported by human capital metrics that look beyond the financials to provide clear pictures of chief executive performance.
A recent study of 160 chief executives and directors of North American companies, titled 2013 Survey on CEO Performance Evaluations, found organizations placing little weight on many non-financial performance measures for the top executives.
The poll, conducted by the Center for Leadership Development and Research at Stanford Graduate School of Business, Stanford University's Rock Center for Corporate Governance and the Miles Group, revealed only a 5 percent weighting given to CEOs' performance in the areas of talent development and succession planning, and a 2.5 percent weighting given to employee satisfaction/turnover.
The CHRO should be playing a significant role in the effort to make these factors an integral part of CEO evaluations, experts say, collaborating with the top executive and the board in defining fundamental CEO effectiveness attributes, providing input and expertise on performance metrics, and designing and executing CEO evaluations.
Given the reporting structure at most companies, CEO performance evaluations are an inherently risky proposition for HR leaders, says Kim Shanahan, managing director of Los Angeles-based Korn/Ferry International's Human Resources Center of Expertise.
"The role of the CHRO is tricky, as he or she reports directly to the CEO," says Shanahan.
Indeed, several chief HR officers contacted by HRE declined to comment for this story, on the basis of their reluctance to discuss the machinations behind the CEO evaluation process.
CHROs may be hesitant to talk about the process, but can still be a critical part of it, says Shanahan.
"CHROs play an important role in coaching CEOs through key development areas and are responsible for ensuring CEOs are evaluated in a fair and consistent manner," she says. "Ultimately, the board is responsible for this process and outcome, but HR can be a strong partner."
One of the CHRO's primary responsibilities is to aid the board in establishing criteria by which the chief executive will be judged, she says.
Financial measures -- while not the only gauge of CEO performance -- are vital, of course, and should be determined at the beginning of each fiscal year, says Ketterer.
Indeed, factors such as revenue growth, operating margins, net sales, earnings per share and shareholder returns have a prominent place on CEO scorecards, he says.
Yet, while these financial metrics are key, "there are many variables affecting CEO performance," says Shanahan. "Other measures -- human capital, customer and operational metrics, turnover, employee engagement levels, talent management and succession planning -- are also used," she says. "The key is to measure both short-term and long-term performance."
"The CHRO would normally be the primary person responsible for these human capital metrics -- determining what they are and why they should be included, and validating the data when [they come] in," adds Ketterer.
"The CHRO should also have a say and help influence the shaping of the company's leadership effectiveness model," he says. "In a sense, [HR] owns the CEO scorecard around human capital and talent metrics, and should play a major role in developing this model, with the CEO's input."
In addition to broadening evaluation criteria beyond established financial metrics, HR must "clarify the leadership behaviors expected of the CEO" and put the necessary methods -- structured interviews and 360-degree surveys, for example -- in place to assess CEO performance, continues Ketterer.
The HR leader should also seek performance feedback from the CEO as well as other stakeholders -- including but not limited to independent directors and the CEO's direct reports -- and share evaluation results with independent directors, he says.
HR should also give careful consideration to the CEO's primary objectives when determining how he or she will be measured, and how much weight to place on these factors, says Jeff Pon, chief human resources and strategy officer with the Alexandria, Va.-based Society for Human Resource Management.
For example, he asks, "what role is the CEO being asked to play? Was he or she brought in to oversee a complete company turnaround? Is the CEO's primary role a financial one? What does the market you're operating in look like? These variables are going to affect the CEO's role, and how your top executive will be evaluated compared to their peers."
Room to Improve
Despite the weight that non-financial metrics and the organization's unique circumstances should be given, there's little to suggest that companies have incorporated many of these factors into their evaluation approaches, as evidenced by the aforementioned Stanford study.
Yet, it seems most CEOs and directors don't presently see a need to significantly shake up the process, according to the same research.
In the study, 83 percent of directors said they believe their organization's approach to CEO appraisal achieves the right balance between financial performance and non-financial metrics such as strategy development and employee and customer satisfaction, with 64 percent of chief executives indicating the same.
Part of the reason why non-financial metrics don't carry more weight is the difficulty HR leaders frequently face in tying these measures to financial performance, and moreover, how to demonstrate that connection to the board, says David Larcker, professor of accounting, co-director of the Center for Leadership Development and Research at the Stanford Graduate School of Business and co-author of the study.
"It can be hard to measure these things," he says. "There aren't a lot of rules. For example, how do you measure innovation? So, if the board is pretty sure about financial measures that are in place, and unsure about these other metrics, the board's tendency is to go with the measures they know and understand. I think that's what's happening."
To make these and other human capital metrics a more integral part of the evaluation process, HR has to first show their economic impact to the board, he says.
Say, for example, that employee engagement is a metric by which the CEO is measured, and recent employee satisfaction survey scores have gone down, says Larcker.
Viewed independently, such a drop "may not mean anything significant," he says. But a subsequent spike in turnover rates -- which management understands is costly to the organization -- may be an outgrowth of simmering discontent in the workforce, and possibly an indication of an area in which the CEO's performance could improve.
Indeed, the Stanford study found directors giving high marks to chief executives with respect to decision making, but low scores in people-management areas (see sidebar). In addition to "mentoring" and "developing talent," "listening" and "conflict management" were the skills least mentioned by directors as strengths of the CEO.
Naturally, these should be strengths for the HR leader, who could take the lead in establishing meaningful measures around talent management and other areas, and helping the chief executive improve at them. Oftentimes, however, the board -- again, as seen in Stanford's research -- doesn't focus so much on these facets of the top executive's job.
And therein lies the ultimate challenge for HR, says Larcker.
"There has to be a high-level discussion involving the CHRO and the board," he says. "[HR has to say] 'we're serious about this. We don't think financial metrics capture everything.'
"There's a gap between what HR is doing and the measures they look at, and the kinds of things the CFO and the board want to see," continues Larcker. "Upper management- and CEO-speak doesn't necessarily translate that neatly to the language that HR speaks. There's a communication gap that needs to be bridged."