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May 26, 2017

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 at the (Compensation) 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.