The Case Against Long-term Incentive Plans

Research shows four reasons why managers undervalue a key component of pay packages.

AALEXANDER PEPPER SPENT 27 years at a large accounting firm helping client companies devise ways to compensate CEOs and other senior executives. Starting in the early 1990s, pay packages have typically included longterm equity incentive plans aimed at aligning managers’ and shareholders’ interests. But over time Pepper grew disillusioned. “I began to realise that the people we were putting the packages in place for didn’t necessarily like them very much, and the plans didn’t do what they were intended to,” he says. In the early 2000s, Pepper went back to school, eventually earning a DBA; he teaches at the London School of Economics. Today he researches why pay-for-performance plans don’t work. “I was part of the system that I’ve subsequently come to say is not very effective,” he says.

Since 2013 Pepper has published four academic studies based on indepth surveys with 756 senior executives across 40 countries. He sought to measure how well the executives understand and value the components of their pay plans and how their pay affects their behaviour. Although compensation practices differ dramatically from country to country – CEOs in the US earn far more than their counterparts elsewhere, for instance – Pepper finds that regardless of region, executives have the same general misperceptions about pay. He identifies four reasons why pay-for-performance incentives don’t work as well as proponents expected.

Executives are more risk-averse than financial theory suggests. Would you rather have a 50 per cent chance of getting a $90,000 bonus, or a guaranteed payout of $41,250? In theory, the rational choice is the risky payout, since its “expected value” is $45,000, but 63 per cent of executives chose the sure thing – and when asked similar questions involving stock option payouts, they consistently showed a preference for less risky choices. Someone who’s risk-averse assigns less value to dicey propositions, which suggests that executives see the at-risk portions of pay packages as less valuable than economic theory would predict. In interviews they attribute this attitude partly to how “extraordinarily complex” and even “arbitrary” equity plans are. Pepper says that if people view something as not worth very much, more of that thing is needed to make it meaningful – and this dynamic inflates the value of pay plans.

Executives discount heavily for time. Would you rather get a $1 payout today or a $2 payout in a year? The rational choice is to wait, because you’ll earn a 100 per cent return during the interval, but behavioural economists have found that many people choose the early payout – a phenomenon called “hyperbolic discounting”. Pepper’s studies show that it applies to executives’ thinking about pay: A long-term incentive package that may be worth a lot in three or four years is valued very little today. (His data suggests that executives discount distant payouts at the remarkable rate of 30 per cent a year – about five times the discount economic theory suggests.) One executive in the study summed up the situation this way: “Companies are paying people in a currency they don’t value.”

Executives care more about relative pay. Consider a simple question: Would you rather earn $50,000 or $1,00,000? Now consider the same question with some added context: Would you rather earn $50,000 in a society where the median income is $30,000, or $1,00,000 in a society where the median income is $1,25,000? Assuming that prices are the same in both settings, you should choose $1,00,000 – it lets you buy more, regardless of whether it’s more or less than what other people make. But economists have long known that people are highly sensitive to relative earnings and prefer to outearn others even if it means a lower absolute income. Pepper’s research shows that this holds for executive compensation. The executives surveyed were less concerned with absolute earnings and more focussed on (and motivated by) how they were paid in relation to their peers, both inside the company and at rival firms. Fully 46 per cent indicated that they would prefer a lower pay package if it was higher than those of counterparts. One said: “The only way I really think about compensation is, ‘Do I feel fairly compensated relative to my peers?’” If everyone asks that question, the resulting arms-race mentality drives pay packages higher.

Pay packages undervalue intrinsic motivation. People work for all sorts of reasons, but executive pay packages tend to discount non-monetary motivations. Pepper’s research shows that achievement, status, power, and teamwork are all important incentives; in answering survey questions, executives made it clear that extra-large pay packages don’t necessarily create

stronger incentives. “I do not believe, nor have I ever observed, that $100 million motivates people more than $10 million or $1 million,” said one company chairman. Executives said they would willingly reduce their pay packages by an average of 28 per cent in exchange for a job that was better in other respects.

How should companies use these findings? Given that executives dramatically undervalue long-term incentive pay, Pepper believes that companies should eliminate that component and increase others. “My research suggests, somewhat perversely, that companies would be better off paying larger salaries and using annual cash bonuses to incentivise desired actions and behaviours,” he says. Additionally, they should require leaders to invest those bonuses in company stock (or should pay the bonuses in the form of restricted stock) until a certain share of leaders’ net worth, or some multiple of their annual salary, is invested. As long as executives hold substantial equity, Pepper says, their interests will be aligned with those of shareholders – and this arrangement would achieve that aim without the confusion and inefficiencies of longterm incentive plans. Some companies, including Berkshire Hathaway, already have plans structured along these lines.

Pepper and other observers recognise that companies looking to implement such changes will face headwinds. In the United States, for instance, salaries above $1 million are not tax deductible, and in most countries the notion of pay for performance is so ingrained that big salary increases could draw criticism. However, Pepper says that like fashion, executive pay tends to go through cycles, and he believes that the long-term incentives in vogue for the past quarter century may soon fall out of favour. “My argument is that pay for performance makes the problem worse, not better,” he says. “You can pay executives considerably less in total – but do it in a different way.”