“You get what you pay for.” When it comes to executive pay, the old adage holds true.
Companies’ compensation committees typically evaluate their CEOs, like any employee, based on performance benchmarks, and like every employee CEOs will work to hit the benchmarks they are measured against. Because incentives drive behavior, poorly designed incentives can precipitate poor choices. Recent studies have shown that such benchmarks, and corresponding compensation packages, are incentivizing short-term decision-making at many of today’s public companies.
To dig deeper into the issue and workshop possible solutions, two MBA student groups from Boston University’s Questrom School of Business have produced new work that examines how executive compensation can influence long-term decision making at public organizations. In collaboration with FCLTGlobal, BU’s team researched behavioral insights that can explain short-term decision making by organizations’ chief executives, connections between this behavior and compensation plans, and proposed changes to such compensation plans that could encourage longer-term decision-making.
Many companies, according to BU’s team, “intend for variable performance compensation to reward executives proportional to the degree they generate long-term value for the firm”. However, many modern pay structures create incentives for executives to increase value in the short-term at the expensive of longer horizon goals.
Looking primarily at variable pay (as opposed to base salary), the BU team cites stock ownership as an example of a commonly used method of executive pay that can create more issues than it solves, but could also align internal goals and objective-setting. The papers cite certain studies showing that when compensated with stock, executives often forgo decisions that could affect near-term prices so as not to decrease the value of their own holdings. Oppositely, the report also references work that claims that CEOs are “subject to the same upside and downside risk associated with the stock price and therefore are more likely to make decisions that align with the goals of the board of directors.”
Bonuses are another element of compensation that is often most influenced by time related pressures, the reports find, but if paid at recurring intervals over a number of years (yearly, biannually) they can influence behavior over the long term.
The BU team draws a number of correlations between executive compensation and common behavioral tendencies that occur as a result. If structured poorly, the papers claim, an executive’s compensation prompts behavior that yields short-term strategies and capital allocation decisions. Most theories on compensation tend to view executive pay as a means of addressing the principal-agent issue between corporate managers and owners, says BU, but also contend that compensation solely based on economic incentives wrongly implies that executives lack intrinsic motivation. The team’s studies agree that the compensation-driven behaviors that most weigh on executive decision-making are:
- Loss aversion: Occurring when “investors take a short-term view of their investment, encouraging them to react negatively to recent losses, potentially at the expense of long-term gains.
- Social Comparison/Fairness: When an executive’s satisfaction in compensation is tied to benchmarking against that of their peers’.
Chief executives are prone to the same cognitive biases as anyone else. Without stopgap measures or appropriate evaluations, these behaviors and the structure and cadence of an executive’s compensation could lead executives to pursue plans that they may otherwise avoid in hopes of maximizing their firm’s short-term return. Because no two organizations are exactly alike, the BU team proposes several approaches in light of their findings that can streamline the process of executive compensation and optimize it for long-term value creation.
Compensation is just one of the many things that can compel someone to do their job well, but it is the one that is simplest to improve upon. While the findings are preliminary and the solutions are theoretical, this study provides insight on how to shift executive behavior in a highly practical way. There are many key drivers to long-term value creation, and a motivated executive is a critical part to achieving any of them.
To read the full reports from the MBA student teams at BU’s Questrom School of Business, follow the links below: