Chances are your board’s remuneration committee is pragmatic and realistic. This is because most ASX 300 executive remuneration frameworks comply with the various governance standards. As most governance standards promote remuneration frameworks that are sub-optimal, it would therefore follow that board remuneration committees approve remuneration that is suboptimal.

Stewards of investor funds, proxy advisors and the remuneration committees engaging with them make decisions based on a key assumption: that executives are economically rational beings.

At Guerdon Associates we thought that an article highlighting this unfortunate fact is timely, given the passing on the 27^th of March of Daniel Kahneman at age 90. In 1979, Daniel Kahneman and Amos Tversky, published a paper in Econometrica titled “Prospect Theory: An Analysis of Decision under Risk.” The paper presented a new model of risk and reward  called “prospect theory,” which elegantly captured the experimental evidence on risk taking and reward, with reliable and valid evidence that people do not optimise risk and reward rationally. More than 30 years later, prospect theory is still widely viewed as the best available description of how people evaluate and act on risk and reward variations.

Another name for Prospect Theory that most believe is more apt is “loss aversion”. This proposes that the pain of losing $100,000 is greater than the pleasure of winning $100,000. Practically, an incentive plan that provides a payment upfront of $100,000 and requires repayment if a target is not met will be more effective than a promise to pay $100,000 if a target is met. How effective? All else being equal, it would be about twice as effective. That is, a $100k incentive configured for loss aversion would be the same as an incentive with an upside opportunity of $200k.

Offshore there are examples.

Configuring incentive plans to take advantage of this behavioural bias should be a no brainer. But it is not market practice, while proxy advisor and investor guidelines are not configured to applaud an incentive payment in advance of results being delivered.

So, how many ASX 300 boards have overseen an incentive plan like this? None. Pity, although understandable. Company directors have backgrounds and training that reinforce and support the belief that executives, people like themselves, are economically rational (aka, confirmation bias). Even in the consumer discretionary industry, social media companies, gaming and wagering companies and increasingly news media, whereby success is contingent on leveraging human behavioural biases, it has not been either fully realised or acted upon that behavioural biases extend to the executive team as well.

Vale Daniel Kahneman. We celebrate his work and that of a long line of behavioural science forbears stretching back to Adam Smith who understood that humans are not always economically rational and have behavioural biases. This understanding can be readily applied in executive incentive frameworks. For some of our other articles with examples, see HERE, for some others and for application in incentives HERE, HERE and HERE.

In the year of Professor Kahneman’s passing, will your Remco be pragmatic and realistic or effective and different?

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