Should You Scrap Your Long-Term Incentive Plans?

If you're like most companies, you provide stock options, restricted stock grants, and other long-term-incentives to your senior executives. But do you know why you provide those incentive packages? Are those packages working?

Conventional thinking (and economic theory) tells us that long-term incentive packages solve the agency problem: they align the incentives of the decision-makers (senior executives) with those of ownership (shareholders) by transforming decision-makers into owners. So, to get senior executives to behave in ways that create shareholder value, we give them long-term incentives that make them shareholders.

But are those incentive packages working? According to Alexander Pepper, a 27-year veteran of CEO and senior executive compensation package design, the answer is no:

"I began to realize 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 do."

Pepper's current research focuses on how well executives understand and value the components of their pay plans and how their pay affects behavior. He has identified four reasons why long-term incentive packages don't work as well as we would expect them to work.

1. Executives adjust for the time value of money with a very heavy discount rate. Time is critical to the value of money; we would rather have $1 today than $1 tomorrow, but would likely be willing to forgo $1 today for $2 tomorrow. This same principle applies to how executives think about the value of long-term incentives. A long-term incentive pay package that may be worth a lot in four or five years may have very little value today. Pepper's data suggests that executives discount long-term payouts at a rate of 30% per year, which is about 5 times greater than the discount rate suggested by economic theory! 

2. Executives are more risk-averse than typically thought. Which do you prefer: (A) a 50% chance of winning $100,000 or (B) a guaranteed payment of $45,000? Economic theory tells us that you should prefer choice A, since the expected value of a 50% chance of winning $100,000 (which is $50,000) is greater than the guaranteed payment of $45,000. However, when Pepper posed similar questions to executives, about 63% of them chose less risky options. This implies that executives may see the at-risk portions of compensation packages as less valuable than what economic theory would predict. Based on his interviews with research subjects, Pepper attributes part of this phenomenon to how "extraordinarily complex" and "arbitrary" equity plans can be. Again, these equity plans may be paying in a currency executives don't value, or don't value as much.

3. Executives care more about relative pay. We all intuitively understand that people are highly sensitive to relative earnings. Pepper's research subjects indicated that they were less concerned with absolute earnings and more focused on - and motivated by - how they are paid relative to their peers. The central question appears to be "do I feel fairly compensated relative to my peers?" Pepper notes, however, that "if everyone asks that question, the resulting arms-race mentality drives pay packages higher." 

4. Pay packages undervalue intrinsic motivation. We've talked about extrinsic and intrinsic motivation here at the Café quite a bit. We know that people work for a variety of monetary and non-monetary reasons. Executive pay packages tend to discount those non-monetary reasons. Pepper's research indicates that larger pay packages create stronger incentives for executives. Pepper's research subjects indicated that they "would willingly reduce their pay packages by an average of 28% in exchange for a job that was better in other respects."

How should we think about these findings? The bottom line can be summed up by one of Pepper's research subjects: "companies are paying people in a currency [people] don't value."  

Does this mean you should scrap your long-term incentive plan? Perhaps - it may be more effective and more efficient to eliminate these components and increase salaries and annual cash bonuses. Even without options and stock grants, we can still solve the agency problem by requiring executives to invest those cash bonuses in the organization's restricted stock until a certain share of those executives' net worth is invested in the organization. Berkshire Hathaway has taken this approach; approximately 98% of Warren Buffet's net worth is in Berkshire Hathaway. This seems to have solved their agency problem quite effectively. 

Stephanie Thomas, Ph.D., is a Lecturer in the Department of Economics at Cornell University. She teaches undergraduate and graduate courses on economic theory and labor economics in the College of Arts and Sciences and in Cornell’s School of Industrial and Labor Relations. Throughout her career, Stephanie has completed research on a variety of topics including wage determination, pay gaps and inequality, and performance-based compensation systems. She frequently provides expert commentary in media outlets such as The New York Times, CBC, and NPR, and has published papers in a variety of journals.

Comments

[Dan Walter]

As you may guess, I love this topic.

LTI programs, especially those denominated in company stock, ae used improperly far more than they are used properly. Like so many things, the key is in education and understanding. The key to that is frequent and consistent communications through the lifecycle of these programs.

Executives need to understand:
1) Why they get equity (and not something else).
2) Why they get a specific type of equity
3) Why the features of the grant are crafted as they are
4) Why this form of compensation is good for them, the company and its shareholders
5) How and when to best take advantage of the real and potential value of equity. Tax planning, income planning, etc...
6) What the realistic expectations of potential value should be
7) What is happening with the company stock price, and why (and where they do, or do not, fit into that equation at any given moment.

Most companies very little of the above (many companies do NONE of the above.) Even those who put some effort into it, seldom put the effort into the entire life of the award. It's kind of like cheering someone on for the first two miles of a marathon then disappearing until the last 100 yards of the race.

And, part of the purpose of equity and similar LTI programs is to combat the real-time, human nature-oriented, selfishness that is found in most people. Equity is NOT just for the benefit of the executive and should not be expected to be loved as much as cash in all circumstances. It should make people think, and act, differently. Many company simply check the box and move on. Many companies look at survey or proxy data for values and simply grant something similar, without understanding the "why" of the other companies programs.

Equity ain't easy. Equity compensation is complex, volatile, exciting and confusing. It is like the difference between a weekly sitcom and a great oscar award-winning movie. The latter usually requires more commitment, time and thought, but the impact is generally far greater and deeper.

[Tricia]

This is an interesting study, but LTI programs are used to mitigate risk. A company would not want their executives solely focused on short-term incentives.