Why thinking in averages is below average thinking – Strong analytics II

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Introduction

As a reward specialist I am asked questions like, what is our pay inflation going to be next year?  I used to go away, do research and say 2.4% – having used the historic average.  Of course it was never exactly 2.4% so my boss would turn round and say – “but Ian, you said it was going to be 2.4%, you’re fired”.  If asked the same question now, I respond with an answer; “there is a 50% probability that it will be 2.4%; but there is as 10% probability it could be 4%, so we should factor that in to our budget.”

The problem is that point data estimates, like, pay inflation is going to be 2.4%, have a high possibility of being wrong.  Using a probability approach gives more information about outcomes and new ways of thinking about those low probability, high impact events in our lives – our “Black Swans”.    Dr Sam Savage, a pioneer in work on probability, tells the story of the mathematician who drowned in a river that had an average depth of three inches – that average hid a deep trench right across the centre.

Average forecasts are wrong on average

Taking point averages and using them to forecast is a common fallacy.  House prices have gone up, on average, $20,000 per year, the forecast is that they will go up $20,000 next year – oops, they fell $50,000.  Using a probability approach tells us that there was a less than 40% chance of a $20,000 increase and, a 10% chance of a $50,000 fall.  

Playing with Monte Carlo

So how do we get to the “50% probability that inflation will be 2.4%”?  My favourite method (but not the only one) is to use a Monte Carlo Simulation.   This is a statistical technique that allows me to account for volatility in numeric analysis.  It does this by producing a probability distribution for any factor that has variable outcomes and by producing a large number of random samples.  What does this mean?  Well, I took some UK National Health Service (NHS) quarterly sickness data over five years.  The average percentage absence was 4.2%.  I ran one million random trials (it took about twelve minutes) against the data distribution.  It showed that while there was a 50% chance of absence being 4.2% there was a 10% chance of it being 5%.  That may not seem like a big difference but when you are dealing with the biggest workforce in the UK, 0.8% is a large number of doctors and healthcare workers off ill.    I used a different set of NHS data on the number of sick days lost per employee.  The 50% probability of days lost was 6.1 – but there was a 10% chance of 9 days, a large difference. 

As an HR professional it is better to say that we have a 50% probability of wage inflation at 4.2%, which clearly gives a large range of other probabilities than saying it will be 4.2% with a very high probability of being wrong.

Probable advantages

There are a lot of advantages to using the probability approach.  We can show what might happen and also the probability of each outcome.  One example of this that I have used is to look at the probability of different performance measure outcomes in an organisation if they were normally distributed.  I then compared this with actual outputs and was able to show the CEO which departments were “outliers”; had produced markings that were higher or lower than forecast.  That allowed us to talk to the line mangers to find out why the department was marking higher or lower than was predicted if the performance was normally distributed – which is what you would expect.

Using probability analysis is invaluable for “what if” exercises.  How many times have we been asked to model what would happen if you cut the budget by 3%? Using one number you get one output.  Using the probability approach you can give a range of possibilities.  I have looked at death rates in an organisation against the probability forecast.  On one occasion, using a probability approach, I suggested increasing insurance cover just in time for a sad increase in the number of employees dying. (The increase was, of course, entirely random, but I had forecast that probability). 

Another important use of probability is that of project planning. One statistical quirk in project planning is that if all the tasks are completed, on average, on time, then the project will be delivered late!  (Think about that for a minute….) 

Fooled by Black swans while thinking fast and slow

You may have read “Fooled by randomness” by Taleb or “Thinking fast and slow” by Khaneman.  Both make the same point. As humans we are programed to apply heuristics and biases to problem solving: dismissing or ignoring the unlikely in favour of what we think we know or what happened recently.  Yet unlikely outcomes are more common than most people would guess; also the outlier outcomes tend to be extreme by definition.  Of course, in HR we work with people, who act in quite random ways sometimes……

Bombs and gas masks

When in investment banking I worked with an outstandingly good business continuity manager called Stuart Dunsmore.  He talked about the possibility of a bomb in central London being extremely small; but the effects would be highly disruptive. Sadly, he was proved right, but the upside was we came through the London bombings with our UK business unharmed due to his preparations.

When in the City of London I carry an emergency gas mask.  Why, well, the chances of needing to use one are small, but I only need to use it once to save my life!  The probability of a biological or chemical attack in London is tiny; but the chance of death is high.  Low probability events with high impact; do not let them take you by surprise. 

The dark side

Now for a public health warning.  First, those of you who have a statistical background (unlike me) will spot holes in my argument.  There are issues with Monte Carlo simulations or even using probability approaches.  But, they are better than point averages for forecasts.  It is a continuum, yes, there is better mathematical or statistical approaches available but even starting to think on the basis of probability is a game changer.  Second, probability often depends on the future being similar to the past – but it will not be!  However, using the probability approach makes us more aware of both that factor and that highly unlikely events do occur with surprising frequency.

Conclusion

Most of us in HR are not statisticians  Using the probability approach does involve some understanding of statistics and how to use the programs that are available, be they Microsoft Excel add-ins or programs designed specifically for this work. However, taking the time to understand probability both as a mind-set and as a set of techniques is a major game changer for HR. 

I would urge you to give it a try; you have little to lose.  The gains are large; greater chance of producing “better” forecasts, certainty of being wrong, on average, less often.  Increased credibility and perhaps a more open mind set to when those outlier events do occur.  Enjoy!

 

 

 

 

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Balance of power – Executive pay and shareholders

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Introduction

There is considerable controversy over levels of executive pay.  There are a multitude of stakeholders or would be stakeholders pugnaciously striving for influence.  Remuneration committees are supposed to control executive remuneration.  However, as the MM&K recent survey shows, FTSE CEO Remuneration increased, on average, by 10% in 2012.  Why are shareholders allowing this to happen?

Balance of power argument

I had a fascinating discussion with the executive pay guru Cliff Weight on the subject of the balance of power argument (although the discussion below is entirely mine) when looking at executive pay. 

The Executive’s power

Most of the time the executives hold the balance of power because:

  • Changes in executive board members, unless well managed, tends to lead to a fall in share price
  • Changes in senior management generally signals a failure of strategy or strategic uncertainties – which lead to a fall in share price
  • A lack of good succession planning by the Board so there is no immediate, obvious internal or external replacement.
  • A shortage of good candidates with the relevant experience and willingness to take high profile roles.  This tends to mean organisations can be without a CEO or Finance Director for six to nine months; which leads to a fall in share price.

No Board or Remuneration Committee wants to be seen to be acting in a way that damages shareholder returns. 

The Stephen Hester debacle

A good example of how NOT to carry out changes in senior management is shown by the apparent decision of the UK Treasury to replace Stephen Hester, the CEO of RBS.  The announcement seemed to take the markets by surprise – leading at one point to a 7% drop in RBS share price.  Further, the lack of any successor or allegedly any succession planning by HM Treasury means there is something of a leadership vacuum in RBS (even with their excellent senior management team) that causes great uncertainty to both investors and employees.  This, just at the point when RBS had turned around and had a clear and compelling vision of its mission and future.

The Shareholder’s power

Shareholders have limited power over executives; they have the upper hand mainly when:

  • There are downside earnings surprises
  • Takeover or mergers are under discussion
  • There is a strategy dislocation – a disruptive technology or social trend; look at Smartphones impact on the traditional phone manufactures
  • The market loses confidence in the management of an organisation

These tend to be seminal points in an organisation’s existence that hopefully do not occur too often.

Important issues for Remuneration Committees and Executive management

Both parties to pay discussions need to think about the balance of power issues and how they influence the reward dynamic.  Strategy needs to be owned and driven by the entire executive team; hopefully mitigating the effect of the departure of any executive.

Good management of shareholder relations and open communication will help reduce any share price “shocks” when changes do take place.  Good financial PR will again mitigate both the shock and share price impact.

The paradox of succession planning

One of the potential failings of Boards when considering the balance of power argument is succession planning.  In an ideal world a replacement for the CEO would have been identified and prepared for the new role well in advance of the change.  Unfortunately there is a paradox here.  A CEO could perceive that work by the Board to identify her successor was a signal of their imminent departure.  As invariably such issues leak, so the market would view it in much the same way.  Dammed if you do and dammed if you don’t.  There is also the issue that the heir apparent may become impatient with the wait and either go elsewhere or worse actively seek to undermine the existing CEO with the Board.

There is no easy or obvious answer to the succession paradox; but clearly it is an issue that must be taken on board in the balance of power debates.

Conclusion

The balance of power approach is a useful framework to view trends in executive pay.  I can see no immediate answer to how or even if, the balance of power should be more equally distributed.  Like any good explanatory framework, the balance of power debate asks more questions than it answers.

 

 

 

What are Pension Funds’ Greatest Challenges in 2013?

Excellent blog on Pension Fund challenges in 2013

Robert Gardner

Pensions has always been a tricky business. But perhaps never more so than in 2013. The regulation changes of the early 2000’s rewrote the rulebook for those running pension funds, and a survey of the key challenges of that time would have produced, it seems logical to assume, a set of concerns about changing regulations, accounting issues that accompany them, and governance. Today, the landscape has changed. Pension funds, on the whole, got to grips with those systemic changes in pension infrastructure only to be faced, in 2008 onwards, with the greatest seismic economic shift of our lifetimes. It wasn’t just that markets plummeted and equities didn’t turn out to be the knight in shining armour pension funds had hoped and planned they would be; it was that the very foundations of modern economic markets changed. Everything we thought we knew about risk, return and the relationship between the two…

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Rebuilding trust in the City of London

 

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Introduction

I was at a recent meeting in the City of London to launch the document “Focus on rebuilding trust in the City” a Chartered Institute of Personnel and Development (CIPD) survey of staff in financial services in the City of London on trust and their employment relationship.  (I tweeted from the meeting #rebuildtrust )  The keynote speakers to an invited audience of senior City HR people and journalists were:

 

It was an informative meeting presenting both the survey results and material on initiatives taking place to build trust after the calamities, errors, poor judgement and near criminal activity in the City over the last few years, which has badly eroded trust in what was once a gold standard for honesty and integrity.

Both Peter Cheese and Andrea Eccles gave particularly good presentations from different ends of the initiative spectrum.  Peter spoke on the big picture and in particular the role that HR has to play in leading the changes.  Andrea spoke of the very important key initiatives at grass roots level that City HR are taking, working with the Lord Mayor’s City Values forum.

The key themes during the meeting were:

Each of these themes is explored below.

Culture

Culture has been identified by the CIPD in earlier work as being fundamental to the required changes in the City.  The survey indicated clearly that the existing culture is a long way from being what is needed.  45% of the participants said their employer put profit before values.  Only 47% of staff saw customers as their key stakeholder.  As one of the speakers said, “What is required is a return to the core values of caring for customers and caring for employees”. 

One interesting take on the subject was the suggestion that financial services organisations need to focus more on recruiting “ethical” people.  My own experience, backed up by the survey results, is that a lot of people join financial services to make money.  In order to be seen as successful and to make the big bucks you need to be aggressive and egotistical; otherwise how would you make deals worth millions of pounds?  Unfortunately, aggression and egotism are not good indicators of ethical behaviour.  This goes to the heart of the matter; it is very difficult to make lots of money in an ethical and customer focused way.  The demands on one hand, by shareholders and analyst to make shed loads of money on one hand, and on the other, regulators, politicians (especially the European Union) and media on the other trying to stop profitable activity.

The role of HR in leading the changes was highlighted several times.  Again the paradox between this approach and the role of HR in supporting the business to carry out its activities was evident.  A good example was a comment about the morality of HR being involved in compromise agreements in financial services.  It was alleged that these compromise agreements can (as in the case of the NHS) be used to gag whistle blowers.  The reality is that compromise agreements are an essential part of the HR toolkit.  It allows for the amicable separation between employer and employee, normally on a “no fault” basis.  In the fast paced and rapidly changing environment like financial services, there will be differences of opinion, strategy and personality clashes.  Compromise agreements lead to a civilised and low cost way of managing these situations.  The suggestion that HR should stop using them is really throwing the baby out with the bathwater.  HR has far more important tasks in providing the frameworks for culture change than worrying about compromise agreements.  It is getting tied up in the detail rather than working on the big strategic picture that often leads to HR being perceived as a barrier rather than an enabler.

There was some good news.  RBS, the largely state owned bank in the UK, was singled out for praise for its work in introducing a much more ethical and customer centred approach – something of which I have some personal experience. (And would like to have more if Rory Tapner is reading this).  Sadly examples of good practice are few and far between. 

Values

Part of the discussion on culture must include values.  City HR is leading a lot of work on the development of toolkits to help.  The presentation by Simon Thompson went in to detail on the work of the Institute of Bankers on professional standards and many big employers in the City have signed up to these standards and the educational and training frameworks that support these approaches. 

Professionalism

This was a key theme in the presentations.  Raising the level of professionalism is very important in defeating the current broken culture.  What do I mean by broken culture?  It is the behaviours that allowed the manipulation of LIBOR rates for profit; that mis-sold products including PPI and, perhaps, some derivative products for gain rather than the good of the customer.

The survey showed that only 30% of staff are in professional bodies with standards.

To work in HR in the City you need to be CIPD qualified, yet to work as a banker you need no qualifications at all

That quote summed up for me the entire issue around professionalism.  One can argue about professionalism and its meaning.  It does normally provide a framework of acceptable (and unacceptable) behaviour that can form the basis of reward on one hand and disciplinary action on the other.

There was a comment that there are a vast number of codes of practice, regulations, laws, (domestic and foreign) and guidance – some of which is in direct contradiction.  True, but no one said it was going to be easy.

I must again praise the work of City HR in providing structure and good practice for professionals in the City.  This slow drip drip drip of information, tools and frameworks are, over the long term, likely to prove to be a bigger boost to professionalism than grand culture change initiatives by those embedded in the current City ideology. 

Leadership

One of the more disappointing results from the survey was that 41% of the participants said that there was one rule for senior management and another of other staff.   Given that nearly all the speakers emphasized the key role of senior management and CEO’s in leading the culture change; there is still a big mountain to be climbed.  The fact that only 36% of “other ranks” are aware of their organisations values indicate that organisational leadership has a large communications issue on their hands; and what is leadership if it is not communication of the vision.

Risk Management

A key theme during the presentation and during the Q&A session that followed was risk management.  It is clear that the framework to support culture changes needs good human capital measures and strong analytics.  Why?  Two major reasons were discussed.  First, it is difficult to discuss change if it cannot be properly measured.  Second, in the world of financial services number crunching and risk analysis are part of the bread and butter of daily activity.  To have credibility, the change activity, particularly if led by HR, needs to adopt this approach.  When I worked in investment banking I sat on the Operational Risk committee and that experience led directly to my design and implementation of a reward risk framework.     Exactly the same type of approach can be used when thinking about risk and culture in the financial services environment.  It is this sort of fundamental change in thinking that is going to provide the scaffold for the success of the work in culture change.  HR does, on occasion, shy away from people metrics; yet they are an essential framework for designing interventions and supporting our businesses. 

Role of HR

There was a lot of discussion on the role of HR.  Here I must depart from the gospel according to the panel speakers.  There are two places the pressure for change will come; the first is from senior management.  There is a bit of an issue with this one.  Senior management got where they are by supporting and encouraging the status quo.  Much of this has been made in management literature; the ideology of management has support for the status quo deeply imbedded within it.  Asking senior management to support massive cultural change may be like expecting turkeys to vote for Christmas….  The second place is from the employees within the organisation.    It is possible, as history has shown, for small but articulate groups of people to push for change from within the organisation.  Given the above mentioned ideology that is a possibility but not a strong probability. 

If culture change becomes another HR intervention it has the possibility to be marginalised and not become part of mainstream business thinking.  The survey showed that a number of culture change initiatives have not worked so far.  Only 17% of participants saw the culture change in their organisation as being very effective.

Clearly HR does have a role in providing the toolkits, interventions, training and development necessary to carry out the culture change; but leading it is not, in my view, going to happen and if it does it is more likely to lead to a marginalisation of the change on the business agenda as so often happens with HR led initiatives.

HR does have a key role in modelling and supporting behavioural change as well as ensuring that the new generation of bankers coming through at least start with an ethical mind-set. 

Reward issues

Reward is at the heart both of what is “bad” in the City and what will help drive change.  But,

  • 73% of staff think that some people in financial services are overpaid
  • 67% say there is secrecy around pay for senior mangers
  • Only 36% see reward as being “fair”.

As reward professionals we have to stand up and be counted.  Discussion needs to take place on what is “fair” pay.  Pay systems have to be somewhat more open so there is a greater understanding of what people are being paid for,

Key tasks include:

  • Better advocacy of pay levels and differentials in organisations
  • Development of incentives to encourage professionalism
  • Development of reward and performance management that encourage thinking about how an objective is reached as well as the measure of the objective.
  • Being as open as is appropriate to stakeholders on our reward approaches and outcomes
  • Being an advocate both internally and externally for the reward systems and outcomes.
  • To bring measured, data led, rational debate to politicians, the media and other commentators to prevent or at least moderate the near hysteria around financial services and senior executive pay

Conclusion

The CIPD report is a timely looking glass in to the views of those who work in financial services as to issues of trust and reward.  It is well written and influential; I would recommend it to you. (Disclosure note; I undertook some analysis of the raw data in the report for the CIPD).  Both the CIPD and CityHR are clearly thought leaders in this field and their activities are to be applauded.  The report is an important part and input to the on-going discussion on this subject.

The report is also timely.  The results from the Banking Standards Inquiry by the UK’s House of Commons are due to be produced very soon.  Unfortunately it may be argued by some that it has been badly tainted even before release because:

  • The standards of politicians in the UK are at an all-time low and lecturing other people on ethics and standards is at best the pot calling the kettle black and at worst rank hypocrisy.
  • A lack of understanding of the world and work of financial services by MP’s who have seldom operated in the real world and those who have did so via the playing fields of Eaton (an elite fee paying school in England  attended by many of the UK cabinet and their advisors).
  • A large part of the problems with the collapse of trust in financial services is due to inaction by politicians and regulators who believed that light touch and not actually understanding what was going on was a good way to regulate a very complex, risky, global business.
  • A potential perception that there is a lot of band-standing and jealousy going on at Westminster village that does not aid credibility

I hope I am wrong and wait to read the report with interest.  However, the weight of history is against them; since when have politicians made anything better?

Failure is not an option unless we do want the politicians to bring their incredibly costly sledge hammers to smash some nuts that, it turns out on closer inspection, actually have nothing to do with the problem.

It is only by hard work based on sound data such as the CIPD report; and not taking some moral high ground and seeking to apportion blame; that will make the very necessary changes.  HR and reward in particular do have key roles to play.  At the end of the day there must be the drive and will in the Board room to make the required culture change a reality. 

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