Making executive pay work: The psychology of incentives - Video Summary


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Psychology of incentives

Executive pay is in the spotlight like never before, under scrutiny from shareholders, regulators, politicians. But what do executives think?

Our study into the views of over a thousand executives globally sought to find out the answers and we found that actually many aspects of the executive pay model that we have today, are designed to fail.

So what did we find.

First of all executives are risk adverse. Throughout the study, only around a quarter of executives would swap fixed pay for a less-certain bonus, even if that bonus could be substantially higher.

Secondly, we found that complexity and ambiguity destroy value, executives would consistently choose the simpler, more predictable scheme over the one they found harder to understand. Part of that complexity and ambiguity in executive’s minds, relates to deferral. The longer you have to wait, the less it is worth and to quite a dramatic extent.

Across the study executives would typically discount one dollar of deferral all the way down to 50 cents and in some territories it was even more extreme. Many emerging markets, for example, would value a deferred dollar at just 30-35 cents.

But perhaps the biggest driver of how executives view pay schemes, is fairness. Fairness is fundamental. In the study two executives would rather be paid more than their peers, but less in absolute terms, for every one executive, who would rather have the higher absolute amount but find out that they are paid less than their peers. Getting the answers right in the eyes of executives is absolutely critical.

But people don’t just work for money. We asked executives what discount they should take for an ideal job. They were first asked this about someone other than themselves, a hypothetical example. On average they said that person, from taking their ideal job, should take a 60% pay cut. Realism bites when they are put in the first person and asked the question about themselves - there, typically, executives would take a pay cut of a little under 30% for their ideal job.

What does this tell us – it tells us that actually people will work for more motivational factors than just the money they earn, but it also shows that pay expectations get anchored quite quickly at an individual’s current level of earnings.

Why do we offer long term incentives plans? Our study finds that only 50%, a little under actually, of executives, feel that long term incentive plans are an effective incentive. But fully two thirds value the opportunity to participate in them. So long term incentive plans are as much about recognition as incentives.

So if we look at this overall, we find that complex pay schemes that we operate today, can easily be discounted by half in executive’s minds. Surely there must be a better way.

So what are the design recommendations?

First of all, performance pay has a cost. This needs to be recognised and so the business case for introducing performance pay needs to be clear and we need to be more discriminating about how it is used. When we do use it, we need to keep it short, sweet and simple, avoid complexity wherever possible and whenever given a choice, let’s take the simpler path.

One size does not fit all. There were significant variations in the sample by gender, by geography, the region someone was from, by demographic. Organisations have a great benefit that they can gain if they recognise this and offer packages that are more tailored to their own individual employees and the type of organisation that they have.

Money, of course, is only part of the deal – so organisations need to focus on the non-financial motivators that executives will work for. There is a premium to be had there. But actually also to recognise that individuals get anchored at a certain level of pay expectation, so we must be realistic about how variable pay can be. If performance pay is forming three quarters of the package, it's probably unrealistic that it's going to be fully variable. There is a much better way to be had for designing performance pay. If we focus on what really motivates the key constituency - executives themselves.

Executive pay is featuring in the media like never before. Our Psychology of incentives study highlights the views of those in the spotlight. The results illustrate much of what's wrong with executive pay, but also what works.

Tom Gosling, Head of Reward, explains the findings in our short video and makes some recommendations for business leaders to consider when structuring pay packages to incentivise their executives.

To explore the report in more detail click here.