June 19, 2025
Escaping the Target Trap: The Power of Relative Performance
The article was generated from the video transcript and edited by Dr. Hermann J. Stern.
In our ongoing exploration of the pitfalls and complexities of "pay for performance," we've highlighted the challenges of defining good performance and the inherent difficulties in setting effective growth targets (see: The Target-Setting Trap: Why Growth Goals Are Often Set Too High (and Why It Matters)). Now, we turn to a powerful solution for navigating these traps: relative performance measurement. As discussed in a recent lecture at the University of St. Gallen, by benchmarking company performance against that of its industry peers, we can create a more robust, fair, and motivating incentive system that overcomes the limitations of absolute targets.
The key insight lies in combining company-specific growth data with industry-wide trends. This allows us to create an Operating Index, providing a clearer picture of whether a company is truly outperforming or lagging its market. By visualizing this combined data, and importantly, by adding the first and third quartiles of industry performance, we establish a reliable framework for setting growth targets. The blue shaded area in the accompanying graphic represents the range within which 50% of all companies in the industry fall, offering a clear benchmark for performance.
The core principle here is simple yet profound: pay for being better than the market. This aligns perfectly with the Nobel Prize-winning work of Professor Bengt Holmström, who mathematically proved the necessity of using relative performance evaluation in executive compensation due to the inherent information deficit faced by outsiders, including boards. This "informativeness principle" underscores the value of market-based comparisons over negotiated absolute targets.
Obermatt was founded on the principles of relative performance measurement, and our very first client, Sika, a highly successful construction supplier, recognized its inherent fairness in 2009. Facing ambitious absolute growth targets, they understood the logic of linking pay to outperforming their market. Read the case story here: Dynamisierte Unternehmenssteuerung – Teil IV: Erfahrungen zur Einführung (Article in German).
The beauty of relative performance extends beyond fair target setting. It maintains incentive even in a down market. Consider a scenario where the overall industry experiences negative growth, say -3.0%. With absolute targets, there's no incentive to perform. However, with relative measurement, a company that achieves -1.0% growth is still outperforming the median and thus deserves to be rewarded. Conversely, even in a booming market, simply reaching the rising tide doesn't guarantee a bonus; outperformance is required.
Furthermore, relative performance allows for the elegant use of percentile ranks. A company performing at the 25th percentile of its peer group receives a certain payout, the 50th percentile triggers target pay, and the 75th percentile and beyond yield higher rewards. This creates a clear and continuous performance curve, eliminating the "no incentive" zones often associated with absolute hurdles and caps. There's always a reason to strive for improvement.
Interestingly, proxy advisors often advocate for starting bonus payouts at the median (50th percentile). While seemingly aligned with "being better than the market," this approach has several drawbacks. It can incentivize executives to manipulate figures to just reach that 50% threshold and demotivates those performing below, as reaching the median might seem unattainable. Moreover, it effectively means that in 50% of the cases, there's no bonus. It also introduces more risk into the pay structure, as payouts become highly binary around the median, which is generally undesirable as it can encourage short-termism or even unethical behavior.
At Obermatt, for long-term incentive plans based on relative performance, we often utilize a curve that starts paying at the 25th percentile and caps at the 75th percentile across multiple metrics measured over time. This approach increases the likelihood of executives falling within a well-compensated performance range.
This short video vividly illustrates the power of relative performance measurement in overcoming the pitfalls of absolute growth targets. Witness the explanation of how combining company and industry data creates a fairer and more motivating system that rewards true outperformance in any market condition. Click play in the video above to see the explanation and perhaps reconsider the limitations of absolute targets in your executive compensation plans.