Behavioural economics and executive pay effectiveness

There is a general consensus among boards and institutional investors that companies should be managed for long-term value. While this does not seem to stop these institutional investors from parking our superannuation savings with short-sellers, it does nevertheless seem that the sentiment is definitely for the long-term.

This sentiment has been a primary factor in the gradual increase in long-term incentives. Investors prefer this focus on the long term. Executives do not. And a big reason is that a chunk of LTI is usually contingent on relative Total Shareholder Return (TSR) performance.

If you are unsure of the issues behind executive sentiment, have a look at some of our previous articles (just to show we have been consistent over the past decade) HERE, HERE , HERE and HERE.

It is also difficult to fathom why investors support LTIs with a relative TSR hurdle given (ok, perhaps counter-intuitively) that it does not relate to superior performance, see HERE  and HERE.

Perhaps it is because fund managers’ bonuses are based on TSR performance?

In any case, the preference of some proxy advisers and investors, and the say-on-pay vote with the “two strikes” law, mean that companies are unlikely to adopt an alternative approach, at least for now. This is, in part, because the transparency resulting from the say-on-pay vote and related remuneration disclosures has had the effect of homogenizing remuneration. It is enough to make remuneration consulting boring.

Understanding the issues has only become more complex since the global economic crisis of 2008 that led many to question whether the types of compensation on offer motivated overly-risky behaviour that may have triggered the crisis.

The conventional wisdom in recent years has been to increase the proportion of executive pay that is specifically tied to long-term performance, typically through performance-based equity compensation. As a result, fifty per cent or more of a CEO’s pay is performance-based.

Some academics have argued the best performance metric is economic profit, i.e., net operating profit minus a capital charge for invested capital.

Others have taken an altogether different view, contending that no type of performance-based pay for CEOs makes sense because the work performed by CEOs requires deep analysis and creative problem-solving, tasks that are typically not susceptible to performance incentives. Rather, these proponents have suggested top executives should be paid with a fixed salary only.

Recently, we summarised the proposals of the UK Investment Association’s Executive Remuneration Working Group. The Group suggested that no-one model is best (hooray!) but, rather, perhaps four models could be considered (…well, that is better than one model). See HERE.

One would hope that most informed people would accept many current compensation plans are just a hodgepodge of reactions to accounting rules, tax laws, shareholder requirements, proxy adviser views and legal considerations.

The outcomes from all these forces are remuneration structures that have no empirically demonstrated validity.

Based on behavioural economics, people are irrational when interpreting and acting on financial data. What is missing from most standard analyses is any assessment of how incentive rewards impact behaviour.

Consider a CEO whose board promises her a big pot of money if the company’s TSR beats other companies’ TSR after 3 years. Behavioural economists argue that the CEO will not have regard for the true value of the award because of a psychological quirk called ‘hyperbolic discounting’ or, our tendency—demonstrated in dozens of academic studies— to prefer a dollar today over two dollars some time from now (non-economists can see a summary HERE ). In theory, this means the board could extract the same effort from the CEO with, say, $3m doled out at closer intervals than $3m paid at the end of 3 years.

That’s right – pay the total LTI amount as smaller and more regular amounts over a shorter term and you get 3 times the effectiveness by having the CEO focus on what the board considers most important.

Alternatively, increase LTI opportunity to be at least 3 times the STI opportunity to get CEOs to pay attention. But somehow we cannot see proxy advisers applauding this sort of increase in pay.

Behavioural economics suggests that executives are more likely to put priority on their annual STI opportunity, which arrive sooner and are more often tied to measures over which they have some control, such as profit and efficient use of capital.

Over time, improvement in metrics like profit and efficient use of capital should be reflected in a higher TSR.

The challenge is to design short-term structures in a way that will improve long-term performance.

Ah, remuneration consulting is getting more interesting…

© Guerdon Associates 2024
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