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Executive incentives are “deeply flawed”

A new authoritative study questions whether incentives are achieving what they set out to do.

Swellendam: – It is one thing to pay too much for something. It is another if what you have paid for does not work. It is becoming increasingly clear that both of these conditions may be applicable to executive incentives, still one of the most contentious socio-economic issues of our time.

The global corporate consultancy, PWC in collaboration with the London school of economics has just released the findings of a study examining the issue against the background of what it describes as “an emerging consensus, at least in Western economies, that there is something deeply flawed about the current model of executive pay”.

It argues: “Executive pay has risen dramatically over a period when, in hindsight, the Western economic model has not been at its most successful.”  This may be too broad an assumption to conclude what PWC has concluded, but it backs up many similar research findings, one by author and Columnist Roger Martin who has determined that: “Total returns on the S&P 500 for the period from the end of the Great Depression (1933) to the end of 1976, the beginning of the shareholder-value era, were 7.5% (compound annual). From 1977 to the end of 2010, they were 6.5% — suggesting that shareholders have little to celebrate, despite having been made the clear priority.”

Business Report’s Ann Crotty has written consistently and critically about the subject over many years and has earned an authority equal to that of a practitioner in the field. In a recent column she highlighted an interesting point extracted from the PWC study regarding demands for disclosure “in the innocent belief that these executives would be shamed into being reasonable in their demands.” The effect has been the opposite!

“Despite a huge amount of guff, passing itself off as insightful and expensive analysis, the key factor influencing pay was that playground whine: ‘He’s got more than me, that’s not fair.’ In the corporate world this puerile attitude is dressed up and presented in a sophisticated form, as ‘market forces’, which apparently cannot be challenged.”

The “market forces” theory can also be effectively debunked from other perspectives. I have questioned the benchmarking of executive pay in several previous articles which in summary have argued:

  • The term “executive” is far too broad, and includes entrepreneurs (builders and creators) who are distinctly different from the risk-averse professional managers demanding similar rewards. The agency theory (getting executives to think like owners) does not work.
  • The supply pool of executives is artificially constrained by an insistence on “track record” which often takes decades to build up and very often means very little in a different industrial context.
  • Supply is further constrained by poor leadership, mentorship, succession-planning and management development.
  • Global “peer-group benchmarking” has no tangible scientific validity that warrants general automatic remuneration levels on a global standard. It is indeed contested in the PWC findings which highlight stark differences in executive expectations and behaviour in different countries.
  • Executive pay is based on the wrong measurement criteria and performance outcomes.

 

Regular readers of the Human Touch can be forgiven for starting to believe that I am a bit obsessed with this subject. But even old stories can have fresh angles and when it deals with an issue that extends beyond business to social discontent, then each new development deserves attention. What makes this latest study very different is that it not only examines the efficacy of executive incentives from a shareholder perspective, but, as far as I know for the first time, from the perspectives of the executives themselves — about 1100 from 43 countries.

The key findings are:

  • Executives are risk averse: Most people chose fixed pay over a bonus of a higher value. Only 28% chose the higher risk option.
  • Complexity and ambiguity destroy value. The majority of the respondents prefer a clearer pay package over a more ambiguous one of the same or potentially higher value.
  • The longer you have to wait the less it is worth.  Deferred pay is valued at significantly below its economic or accounting value and is typically discounted by up to 50%. This puts a high cost on long term incentives (LTI’s) which typically have a three year horizon.
  • It’s all relative – fairness is fundamental. Most executives would choose to be paid less in absolute terms, but more than their peers.
  • People don’t just work for money. Participants would accept nearly a third less pay in exchange for their ideal job.
  • The key motivation of a long-term incentive plan is recognition. Fewer than half of executives think that their LTI is an effective incentive. But most still value an opportunity to take part in something similar.

 

The report emphasises that one simply cannot apply a one-size-fits-all approach to executive incentives. They have to take cultural and geographic features into account, but in particular be based more on understanding individual behaviour than classic economic cause and effect theory.  

Executive pay levels have been subjected to many critical analyses, media attacks, shareholder disquiet and socio-political agitation. Few can contest the premise that it is an intolerable assault on the concept of socio-economic fair play. Those directly involved appear to be doing little more than burying their heads in the sand in the hope that it will go away.

It won’t.

All this attitude is doing is to provide a very effective arrow in the quiver of those agitating for misguided and enforced egalitarianism. 

Jerry Schuitema is an award winning journalist, author, retired management consultant and former economics broadcaster who focuses on behaviour in business & economics.

Get in touch with him: Website | E-mail

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