A New Approach to Executive Pay

Prof Alexander Pepper

Prof Alexander Pepper

The beginning of 2016 brought with it further controversy about executive pay.  A hard-hitting report from the High Pay Centre claimed that, by the end of the first Tuesday of the New Year –dubbed “Fat Cat Tuesday” – the UK’s top executives would have earned more than the average worker would make in an entire year.  The think tank’s reported aim was to draw attention to the “unfair pay gap” that exists between society’s highest and lowest earners, and it raised doubts about the government’s ability to curb executive pay inflation.

While news items like this catch the headlines, the reasons why executive pay has risen so fast are complex.

In trying to attract top talent at executive level organisations often face a ‘prisoner’s dilemma’ – attempting to second-guess their competitors offers and proposing larger remuneration packages to ensure success. The problem is exacerbated when other companies follow suit, resulting in spiralling offers which, in time, become viewed as normal, but which do not necessarily reflect the skills and abilities of individual executives.

The fundamental issue lies in the reliance on outdated financial theories. The principal agent model assumes that executives are self-interested, fully rational and solely financially motivated, reasoning that organisations must provide high-powered, performance-based incentive packages to encourage performance.

What agency theory fails to account for is the real psychology of incentives. Research conducted over the past 35 years has found little evidence of a significant link between executive pay and performance. Many executives I encountered during my years with PwC raised similar concerns; they found incentive packages too complex, too long drawn-out, and they didn’t properly appreciate the value of the rewards on offer.

My own research has attempted to better understand the relationship between executive pay and motivation by surveying more than 750 senior global executives on their preferences, using questions shaped by behavioural economics and economic psychology.

Four key points have emerged. Firstly, executives are more risk averse than financial theory suggests, preferring smaller certain outcomes than uncertain, yet potentially more rewarding, alternatives. They also attach heavy discounts to ambiguous and complex incentives. Secondly, intrinsic motivation is highly important. Many executives would sacrifice more than 20% of their income to work in more personally satisfying roles. Thirdly, executives typically discount the value of long-term awards at a rate in excess of 30%, significantly reducing their perceived value of the awards on offer at the offset, requiring organisations to provide larger pay-offs over the long term. Finally, fairness matters.  Executives pay attention to their level of reward in relation to their peers, rather than in absolute amounts.

These factors suggest that conventional methods of financial reward – especially long-term equity plans – contribute to the inflation in – not the regulation of – executive pay.

My research also sets out six principles which could provide organisations with a more effective means of regulating top pay;

1. Performance-related pay is expensive and should be used wisely. Performance-related pay is not a universal solution as executives expect higher awards due to their risk discount factors (up to 50% higher than predicted by financial theory)
2. Deferral is costly; instead use annual bonuses to encourage performance. Subjective time-value discount factors make short-term incentives far more efficient than long-term incentives
3. Equity plans are inefficient. The economic and accounting costs typically exceed the perceived value which awards hold for the recipients. Where possible pay in cash or in other financial instruments whose value is readily appreciated
4. Complexity destroys value. Simple but challenging performance metrics are far more effective than complex conditions as executives are not motivated by things they do not understand
5. Fairness matters. Ensure that pay differentials in the top management team are commensurate with relative contributions and are therefore perceived to be equitable
6. Money isn’t everything. 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

However, it would be almost impossible for one company alone to enact such changes successfully. Collective action is required.

Revolutionising executive pay will require institutional change on a large scale.  This will involve social pressure, investor action, and government intervention with new laws and tighter regulation, in order to encourage corporate buy-in.  On top of this, academics need to develop new theories of executive agency to support the case for change.

Alexander 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. Prof Pepper has recently written a book, The Economic Psychology of Incentives, published by Palgrave Macmillan, describing the research which forms the basis of this article.