Speaker 1:        Welcome to the Guerdon Associates podcast. We are really glad you are tuning in today.

Speaker 2:        Yeah, it’s great to be here.

Speaker 1:        This episode explores the behavioural science elements that inform executive incentive plans. It examines how time delays and risk profiles affect perceived reward values alongside the current operational limits of using artificial intelligence for remuneration queries. Finally, it outlines specific structural adjustments for incentive frameworks when companies operate in falling markets.

Speaker 2:        So to understand how boards might adjust executive pay, we first establish the baseline requirements of a functional incentive plan based on behavioural science.

Speaker 1:        Right. And I was reading through Guerdon Associates’ articles published in April 2024, and they outline the specific checklist for this.

Speaker 2:        They do, yes.

Speaker 1:        It starts with Vroom’s expectancy theory, which states that focus will result in a desired outcome.

Speaker 2:        And that distinction is necessary. The research uses the word focus instead of effort.

Speaker 1:        Oh, okay. So they are not the same thing in this context.

Speaker 2:        No, they are not. If an executive exerts effort but runs in the wrong strategic direction, the outcome is not met. An individual focuses on achieving goals when the goal is clearly described and understood.

Speaker 1:        I see. That clear expectation channels the effort into focus, which connects to the next concept in Guerdon Associates’ original research, which is McClellan’s findings on achievement motivation. Is this about making sure the goals are achievable?

Speaker 2:        Yes. McClellan found that individuals focus on goals they understand to be achievable.

Speaker 1:        Because they have self-knowledge of their own competence levels.

Speaker 2:        Exactly. And the operational limits of their organisation. So if a board sets unrealistic stretch goals expecting that high targets will automatically generate high motivation, it often backfires.

Speaker 1:        The executive’s brain calculates that the target cannot be reached.

Speaker 2:        And the goal may simply be ignored.

Speaker 1:        Right. So we cannot just set unrealistic targets.

Speaker 2:        Yeah.

Speaker 1:        Guerdon Associates’ original research outlines a checklist for a well-structured plan. First, understand the expectations.

Speaker 2:        Yes.

Speaker 1:        Second, ensuring goals are achievable and can be influenced. And third, trackable progress.

Speaker 2:        On that third point, trackable progress is required because the human brain relies on feedback loops. Frequent feedback may have more impact on behaviour than the reward value itself.

Speaker 1:        That part stood out to me in the reading. Creating those feedback loops may be difficult with certain measures like carbon emission targets where there’s often a long time delay before the outcome is measurable.

Speaker 2:        But the principle of trackability remains.

Speaker 1:        Yeah. And the fourth item on the checklist is meaningful rewards. At the executive level, at least 30% of base pay may be used as a reference to get sufficient focus.

Speaker 2:        Think of that 30% threshold as a mechanical requirement.

Speaker 1:        I picture it like this specific torque required to turn a heavy gear. If the force applied is below that threshold, the gear simply remains stationary. You need that leverage to initiate movement.

Speaker 2:        That is a good way to frame it. And the fifth item on the checklist is an awareness of negative outcomes.

Speaker 1:        Right. Because if someone is incentivised to reach a specific metric, they might cut corners elsewhere to achieve it.

Speaker 2:        Yes. And to address this, the research notes the use of deferred rewards, malus, or clawback provisions.

Speaker 1:        Wait, for those listening, what is the mechanical difference between a clawback and malus?

Speaker 2:        Clawback involves retrieving money that was already paid out. Malus is an arrangement where a pending payout is cancelled or reduced before it vests or pays out.

Speaker 1:        Got it. The article has also detailed the use of modifiers instead of flat measures. For example, using a modifier based on the degree of riskiness instead of a flat 10% measure of risk.

Speaker 2:        Yes.

Speaker 1:        How does a modifier function differently from a flat performance measure?

Speaker 2:        Well, a flat measure operates as an independent target. If risk is a 10% measure, the executive achieves it or does not, and it impacts that specific 10% of the financial outcome. A modifier applies to the entire reward outcome. If the degree of riskiness is outside the accepted parameters, the modifier changes the total payout regardless of how well the other independent measures were achieved.

Speaker 1:        Okay. So, the takeaway for a board director here from Guerdon Associates’ original research is to ensure performance goals are achievable, progress is trackable, and the structure incorporates appropriate reward references and modifiers.

Speaker 2:        Right. And since clear achievable rewards drive focus, we have to examine why executives often place a different perceived value on long-term incentives or LTI compared to short-term incentives or STI.

Speaker 1:        Because the delayed timeline alters behavioural responses.

Speaker 2:        It does.

Speaker 1:        According to Guerdon Associates articles published in September 2024, executives tend to value STI more highly due to greater immediacy and lower associated risks.

Speaker 2:        Let us look at the vesting scale of relative total shareholder return or rTSR. This is used by roughly 68% of the ASX 300.

Speaker 1:        Right. I want to break down that scale. There is zero vesting below the median.

Speaker 2:        Yes.

Speaker 1:        There is 50% vesting at median performance, 100% vesting at the 75th percentile, and straight-line vesting between median and upper quartile.

Speaker 2:        So, the expected rTSR vesting outcome is 43.75% of the maximum opportunity.

Speaker 1:        With a 50% chance of zero vesting.

Speaker 2:        Exactly. And that brings us to the behavioural economics concepts, specifically time discounting or hyperbolic discounting.

Speaker 1:        The time discount rate is estimated at 33% per annum.

Speaker 2:        Yes. So an award deferred for one year has about 75% of the perceived value of an immediate award.

Speaker 1:        Right.

Speaker 2:        After three years, this drops to around 50%.

Speaker 1:        So a grade of $2 million vesting in three years has a similar perceived value to an immediate $1 million grant.

Speaker 2:        It does. The research also discusses Richard Thaler’s endowment effect, which is divestiture aversion and loss aversion.

Speaker 1:        There is a difference between immediate vesting with trading restrictions versus a promise of future vesting, right?

Speaker 2:        Yes. The former may be more motivating.

Speaker 1:        And this ties into how companies handle departures. The articles discuss good lever treatments referencing Guerdon Associates’ original research on prorated versus no forfeiture approaches.

Speaker 2:        In a no forfeiture approach, unvested LTI remains on foot.

Speaker 1:        But looking at that 33% per annum discount rate, does this imply boards are overpaying on the face value of LTIs to achieve a specific perceived value for the executive?

Speaker 2:        It means that if perceived value drops to 50% over a three-year period, the face value granted at the beginning must be double the intended perceived value to elicit the desired focus.

Speaker 1:        Right. So, the takeaway for a board director from Guerdon Associates’ original research is that executives may discount the value of LTIs due to time delays and performance risks. Alternative vesting frameworks may alter this perception.

Speaker 2:        Yes. And with the complexities of perceived value and performance metrics, internal teams may turn to artificial intelligence to process these plan details.

Speaker 1:        But the technology currently interacts poorly with those behavioural nuances.

Speaker 2:        It does.

Speaker 1:        According to Guerdon Associates articles published in September 2025, AI extracts information in seconds compared to the 15 minutes it might take a human analyst to process one CEO remuneration package.

Speaker 2:        But the AI responses could be incomplete, outdated, or biased.

Speaker 1:        Right. The research provides a specific example. There is an about a 12% difference between an STI that is 100% of fixed remuneration and 100% of base salary due to superannuation contributions in Australia.

Speaker 2:        An AI may misinterpret those concepts like fixed pay versus base salary.

Speaker 1:        Or fabricate information.

Speaker 2:        Yes, hallucinating usual practise. Or overlooking nuance and struggling with logical connections.

Speaker 1:        Like overlooking David Smith when querying CEO pay.

Speaker 2:        Because it lacks judgement regarding a company’s strategy, culture, governance, principles, and shareholder sentiment. It may provide a different answer when asked the same question a second time or state the opposite when queried on its rationale.

Speaker 1:        I have to ask then, does the speed advantage of seconds versus 15 minutes justify its use if a human reviewer must spend time double checking for hallucinated facts or logic errors?

Speaker 2:        The human review remains necessary. AI may augment data collection processes, but it does not replace the judgement required.

Speaker 1:        So the takeaway for a board director here from Guerdon Associates’ original research is that AI may augment data collection processes, but human review and judgement remain necessary to ensure data accuracy and contextual alignment.

Speaker 2:        Yes. Because human judgement cannot yet be outsourced to AI, boards must rely on their own strategic review to adjust these baseline plans and LTIs when macroeconomic realities shift the landscape.

Speaker 1:        Like in falling markets. According to research published by Guerdon Associates in May 2026, there are several pressures on markets. Inflation, productivity constraints, higher interest rates, and geopolitical instability.

Speaker 2:        And those pressures create problems. TSR gateways may block vesting if absolute TSR is negative, even when relative performance is good.

Speaker 1:        Higher interest rates also increase the weighted average cost of capital or WACC requiring higher absolute return performance. Plus asset rationalisation losses may hit earnings.

Speaker 2:        So the research outlines a checklist for action. First, rely more on relative TSR to filter market noise provided the peer group is well-defined.

Speaker 1:        Second, reconsider positive TSR gateways.

Speaker 2:        Third, introduce another measure. It should be weighted at 20% or more to impact executive decision making.

Speaker 1:        Fourth, shift emphasis to capital efficiency measures such as ROIC or ROE.

Speaker 2:        Fifth, set wider ranges between threshold and stretch targets.

Speaker 1:        I think of that like driving a ship through a narrow canal during a storm. You widen the accepted navigation lanes and switch to different instruments to maintain course.

Speaker 2:        That aligns with it, yes. And sixth, consider changes to the reward vehicle such as share rights and RSUs instead of options or share appreciation rights.

Speaker 1:        So, the takeaway for a board director from Guerdon Associates’ original research is that market pressures may require boards to reconsider gateways, widen performance ranges, and shift focus to capital efficiency supported by a clear strategic rationale.

Speaker 2:        When you look at all of this together, behavioural science, market pressures, and the necessity of human judgement and remuneration are all connected.

Speaker 1:        Which leaves me with a final thought for you to mull over. If time discounting reduces the perceived value of a traditional three-year LTI by 50% and falling markets further obscure long-term target forecasting, could the three-year performance structure eventually be phased out entirely in favour of immediate restricted stock allocations?