by Cydney Posner
How to structure executive pay to drive performance over the long term—while avoiding pay levels that would be considered excessive—is a conundrum for compensation committees, consultants, proxy advisory firms and others involved in setting or analyzing executive compensation. And the analysis has only become more complex since the global economic crisis of 2008, which led many to question whether the types of compensation being offered motivated the overly risky behavior that may have triggered that crisis. With that in mind, the challenge has been to structure compensation to motivate the right behaviors without inadvertently inducing overly risky activity or conduct that has the effect of boosting executive compensation irrespective of the operational success of the company. Could it be that short-term incentives are once again the answer? That’s the view of one compensation consultant.
There have been a variety of—often conflicting—prescriptions for solving the compensation puzzle. For the last several years, the conventional wisdom has been to increase the proportion of executive pay that is specifically tied to long-term performance, typically though performance-based equity compensation. As a result, often 60% to 80% of CEO pay is performance-based. And these days, tying pay to total shareholder return is the most common performance metric in long-term incentive plans. It makes sense intuitively, especially to investors, who view it as a way to align their goals with those of the executive. However, the use of TSR as a metric has come under criticism, with some studies showing no real correlation to improvements in company performance. (See this PubCo post.) Some academics have argued that the best performance metric is economic profit, i.e., net operating profit minus a capital charge for invested capital. (See this PubCo post.) Others have taken the opposite approach altogether, contending that no type of performance-based pay for CEOs makes sense because the types of work performed by CEOs require deep analysis or creative problem-solving, tasks that are typically not susceptible to performance incentives. Instead, some have proposed paying top executives with a fixed salary only. (See this PubCo post. and this PubCo post.)
In this Bloomberg article, behavioral economics again frames the picture, but with quite a different result. In this instance, a compensation consultant argues that most current compensation plans are just “a hodgepodge of reactions to ‘accounting rules, tax law, shareholder requirements, and legal considerations.’” These plans, he believes, have “no empirically demonstrated validity.” Instead, based on behavioral economics, this compensation consultant contends that CEOs should be paid with more near-term incentives.
The consultant argues that people are irrational when interpreting and acting on financial data. What’s missing from most standard analyses, he contends, is “any assessment of how millions in cash and stock motivate the executive brain—or don’t…. Consider a CEO whose board promises her a $5 million pot if company shares rise a certain amount over three years. Behavioral economists argue that the executive won’t weigh 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 to two dollars some time from now. In theory, this means the board could extract the same effort from the CEO with, say, $3 million doled out at closer intervals.”
The theory may seem counterintuitive, especially in light of the often-voiced concern that executive compensation programs must avoid driving short-term thinking. Nevertheless, a number of commentators quoted in the article seemed to agree with the consultant’s view. One commentator observed that “‘[h]uge grants of stock are likely inefficient….We still haven’t addressed this fundamental issue of how do we measure whether these plans, which cost shareholders a fair bit, are actually driving and rewarding the behaviors that we think they do?’” Another similarly voiced the view that “‘[y]ou’re not getting the bang for the buck you think you are, because the executive will mentally discount that future value…Our research shows long-term plans are nowhere near as effective as people think.’”
According to the consultant, the trick is to design short-term incentives in a way to improve long-term performance. Behavioral economics suggests that “executives are more likely to put priority on their annual bonuses, which arrive sooner and are more often tied to measures over which they have some control, such as profit and efficient use of capital, he says. Over time, improvement in those metrics should mean a higher stock price.”
However, the article argues that companies are unlikely to adopt this approach, at least for now, in part because the transparency resulting from the say-on-pay vote and related proxy disclosures “has had a homogenizing effect,” leading companies to avoid innovation that might make them conspicuous or fail to satisfy “best practices” as contemplated by ISS and other proxy advisory firms, which “take little account of any business’s specific circumstances.” The article observes that over half of the CEOs in the S&P 500 “received compensation last year that was at least in part linked to stock returns, a metric preferred by ISS.” But one commentator predicts a reversal of the current trend: “‘I think the pendulum is going to swing back toward driving behaviors….But it’s going to be the brave companies that do it first.’”