money rain

According to the popular French economist Thomas Piketty, one of the main factors contributing to the growing inequality in the western world is inflated rates of executive pay.

Whilst executive pay is frequently the subject of furious political and ethical debate, it too remains a difficult topic for the organisations employing top managers. Despite the fact that it would certainly be in the interests of most companies to moderate executive pay, it has proved to be impossible to control pay inflation in recent years. In trying to attract top talent at executive level organisations are often caught in a prisoner’s dilemma, attempting to second-guess the offers their competitors might put on the table, and offering larger remuneration packages than necessary as a result. The problem is exacerbated when other companies follow suit, resulting in spiralling offers that, in time, become viewed as the ‘norm’, but do not necessarily reflect the skills and abilities of the executives in question.

The fundamental issue lies in the widespread reliance on out-of-date financial theories firmly grounded in the principal-agent model, which assumes executives are self-interested, fully rational and solely financially motivated, and postulates that to encourage executives to perform within the best interests of shareholders, organisations must provide high-powered, performance-based incentive packages.

Despite providing economists with an elegant model to work with, agency theory fails to consider any other factors beyond financial reward that may engage those at the top levels of organisations. The argument for continuing with this model falls down further when we acknowledge that the conventional wisdom behind it is no longer born out either in research or in practice. Studies conducted by Jensen and Murphy in 1990, Tosi and others in 2000, and Frydman and Saks in 2010 have demonstrated there is little evidence of a significant link between executive pay and performance. Indeed, far from underpinning their motivation, the majority of executives I encountered during my years with PwC raised the same critical concerns; they found long-term incentive packages too complex in structure, too drawn-out, and didn’t understand the value of the rewards on offer.

By surveying 756 senior global executives on their financial reward preferences, asking questions drawn from the behavioural economics and economic psychology literatures, my research attempts to gain a better understanding of the relationship between an executive’s pay and their motivations.

Four key points emerged from the research. Firstly, executives are much more risk averse than commonly accepted financial theory suggests, preferring more certain outcomes than risky, yet potentially more rewarding, options. They also attach a heavy discount to ambiguous and complex incentives. Secondly, intrinsic motivation is much more important than traditional economic theory might allow, to the point where many executives would give up almost 30 percent of their income to work in more personally satisfying roles. Thirdly, executives are very high time discounters. They typically discount the value of complex long-term awards at a rate in excess of 30 percent, reducing the face value they attach to the incentive on offer at the beginning. Finally, fairness matters. Executives are more concerned about their level of reward relative to their peers than in absolute amounts.

These factors suggest that conventional compensation methods are contributing to the rapid inflation of executive pay, rather than helping to contain pay inflation, as companies are required to provide larger and larger pay-offs to counter the reduced subjective values that executives attach to their offerings.

Through analysing the core issues surrounding the pay-for-performance model of executive remuneration, my research sets out six principles that could provide organisations with a more effective means of moderation:

  1. Performance-related pay can be expensive and should be used wisely. Performance-related pay is not a universal solution to the pay design question. Executives will expect to be compensated with higher awards because their risk discount factors are up to 50 percent higher than predicted by financial theory.
  2. Deferral comes at a cost, so better to use annual bonuses to signal desired behaviours. Short-term incentives are much more efficient than long-term incentives. Subjective time-value discount factors are much higher than objective financial discount factors.
  3. Equity plans are inefficient and should be used sparingly. The economic and accounting cost to the company typically exceeds the perceived value such schemes hold for the recipient. Where possible pay in cash or in other financial instruments whose value is readily appreciated. Executives should be required to invest their own money in buying company shares to align their interests with those of shareholders.
  4. Complexity destroys value. Executives are not motivated by things they do not understand. Simple but challenging performance metrics are far more effective means.
  5. Fairness matters. Executives assess the value of their incentives and rewards relative to the awards made to their peers. Ensure that pay differentials in the top management team are commensurate with relative contributions and are therefore perceived to be equitable.
  6. Money is not everything. Intrinsic and extrinsic motivation are independent constructs. Extrinsic rewards may crowd out intrinsic motivation. Companies should pay attention to the qualities of the person and to the design of their jobs, not just executive remuneration arrangements.

I’m sure if you asked most people whether executives should be paid in a different way the majority would agree wholeheartedly. But it would be nigh on impossible for one company alone to enact the changes described in this article successfully without risking significant loss. Revolutionising executive pay will require institutional change on a considerable scale; enlisting governments to introduce new laws, tighter regulation to ensure adherence to an industry-accepted set of terms and conditions, and corporate buy-in. Aside from this, academics and economists will need to develop new theories of executive agency to support the case for change.

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Alexander PepperAlexander Pepper is Professor of Management Practice in the Department of Management at the London School of Economics and Political Science. He is a leading researcher in HR management and labour markets issues, especially the impact of incentives and rewards on the behaviour of senior executives. Before joining LSE, he had a long career at PricewaterhouseCoopers (PwC) where he held various senior management roles, including Global Leader of the HR Service business. Professor Pepper has recently authored The Economic Psychology of Incentives published by Palgrave Macmillan.