Q&A: Incentives for Executives

Research finds flaws in common compensation approaches

By Adam Van Brimmer Aug 1, 2013
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Compensating corporate leaders appropriately is a high-stakes proposition. Top executives command a financial premium. Putting together compensation packages that attract, keep and motivate executives to perform their best with an eye toward long-term profitability and business growth remains a challenge.

A study published in January by the Human Resource Management Journal explores the connection between pay, performance and the alignment of executives’ and shareholders’ interests. Based on surveys and interviews with 90 senior executives at FTSE 350 companies, researchers found that companies often place too high a value on long-term incentives, such as stock options, in putting together executive compensation packages.

London School of Economics professor Alexander Pepper, a study co-author, suggests that a more balanced compensation approach would better motivate executives—and better serve organizations. Pepper is an expert on employment relations and organizational behavior and a senior fellow at the university.

What do employers aim to achieve through executive stock options and other long-term incentives?

There is a strong body of theoretical literature, developed in the 1970s and known as agency theory. Proponents argue that since owners and managers of companies have different interests, it is important to give incentives that encourage managers to act in ways beneficial to shareholders. The objective is absolutely right. That’s what boards of directors want from their executives.

So what are the flaws in a long-term-incentive approach?

Start with the argument that if something is good for you, more of it is better for you. Stock options might be good, but large amounts of stock options are not necessarily proportionally better. An aspirin is good for you if you have a headache, but 100 aspirins are not 100 times better. In fact, 100 aspirins will probably kill you.

Human psychology suggests the idea of a direct relationship between pay and performance is flawed. Start with the notion of risk. Executives generally do not evaluate risk the way accountants and financial advisors do. Executives are much more risk-averse and loss-averse than financial theory would suggest.

The second flaw is that we don’t deal with uncertainty in a rational way. The most significant flaw in agency theory is the belief that we discount the future at the rate of inflation. In reality, we discount the future at much higher rates. Executives discount the future at around 30 percent. So when you incentivize people with rewards such as stock options that will not pay out for three years or more, the executive values that much less than the theory would have you believe.

What adjustments should HR professionals make in formulating their executive compensation packages?

I am not arguing that long-term incentives are bad. Nor am I arguing that companies should pay top executives bigger salaries and do away with long-term incentives altogether. A better strategy would be to offer smaller—but much more balanced—packages: bigger salaries, bigger short-term bonuses and smaller long-term incentives. Evidence suggests executives value short-term incentives such as annual bonuses more than long-term incentives because there is a better line of sight between what they do and how they are rewarded. Simpler, more balanced reward packages would be much more effective.

Stock options currently make up 58 percent of the typical executive compensation package. How do you change the mindset?

Government officials, regulators and institutions are already putting pressure on corporate leaders to find different ways to compensate executives. That could gradually force companies to change their approaches, and executives would then see the value of balanced packages and begin to change their behavior, too.

If executives place less value on long-term incentives than believed, why do stock options continue to figure in recruitment?

It comes down to the executive’s concept of fairness. We all look at what we are paid not in absolutes but in relative terms—how we are paid in comparison to our peers of similar grades and at similar organizations. Offering more stock options makes that reference point harder to find.

There is a threshold level of earnings where monetary compensation loses its effectiveness. Once we hit that threshold, we focus on other rewards. We become motivated by whether we are doing what we want to do. Managers would do well to design jobs that maximize the sense of achievement people get from doing them.

History suggests that striving for a sense of achievement tends to result in innovation and other positives for companies. Why?

What makes an entrepreneur motivated to work in his garage on something? Is it really the thought of a big payday? Or is he just fascinated by what he is doing? When [Steve] Wozniak and [Steve] Jobs invented the Apple computer, did they envision being wealthy, or did they just love doing it? I think it’s the latter. The focus on extrinsic motivation is a detriment. In many corporate settings, behavior is about making sure you don’t do something wrong and miss out on incentivized pay. Big companies are good at incremental innovation as a result, while small companies are better at radical innovation.

Adam Van Brimmer is a business reporter for the Savannah Morning News and a freelance writer based in Georgia.

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