Making executive pay work: The psychology of incentives

There is an emerging consensus, at least in Western economies, that there is something deeply flawed about the current model of executive pay. Executive pay has risen dramatically over a period when, in hindsight, the Western economic model has not been at its most successful. Surely something must be wrong?

The debate about executive pay has focussed on whether shareholders are getting what they want, whether current levels of executive pay are acceptable to society, whether remuneration committees are doing their job properly.

But surprisingly little attention has been paid to perhaps the most important constituency: executives themselves.

If executive pay were genuinely motivating executives towards higher levels of performance, with benefits for all, there would surely be less controversy about the subject. But is it? Does the current model really work for the individuals it is meant to be motivating?

Key findings

Executives are risk-averse

  • Most people chose fixed pay over bonus of a higher value – only 28% chose the higher risk bonus.
  • Executives in Australia and the UK are most risk-averse, those in Brazil and China most willing to take on risk in their pay.

Complexity and ambiguity destroy value

  • Fifty percent more executives choose a clearer pay package than a more ambiguous one of the same or potentially higher value.
  • Two-thirds more executives prefer an internal measure they can control (such as profit) as opposed to an external relative measure (such as total shareholder return).

The longer you have to wait the less it’s worth

  • Executives value deferred pay significantly below its economic or accounting value – a deferred bonus is typically discounted by around 50% over three years.
  • Discounts are particularly high in Asia and Latin America, with deferred payments being discounted by up to two-thirds in the eyes of executives.

It’s all relative – fairness is fundamental

  • Most executives would choose to be paid less in absolute terms but more than their peers – only a quarter choose a higher absolute amount, but which is less than their peers.
  • Fairness is much less important in Brazil and China than in other territories, but you can’t generalise about BRICs, as it is most important in India.

People don’t just work for money

  • Participants would take a 28% pay cut for their ideal job.
  • The result is very consistent, globally, with the lowest cut being 24% (India) and the highest 35% (USA).

The key motivation of a long-term incentive plan is recognition

  • Fewer than half of executives think that their long-term incentive plan is an effective incentive.
  • But two-thirds of participants value the opportunity to participate in their firm’s long-term incentive plan.