Psychology of Incentives Part 1

Behavioral Psychology

In the past, we have often said that HR personnel are now required to be a strategy swami, a finance guru, an operations rock star and now unfortunately, we add another discipline to the requirements – you will need to be a behavioral psychologist Jedi.

Why? Because recent findings are concluding that behavioral psychology drives the success of any incentive, reward, or recognition scheme

… it determines the way that stakeholders view and measure incentives and increasingly, examines the question of whether incentives conclusively provide the company with a return on investment.

Unfortunately, this is a long article with constant reference to academic research and experiments. We would urge you to wade through and persevere because if you do not understand the behavioral psychology of incentives, it pains us to say – you can never become an incentive ninja.

Yes, you may understand the mechanics of a phantom share scheme, the vesting periods, and the valuation methodology but unless you understand what will motivate, and what will demotivate employees about the scheme, you do not fully understand the phantom share scheme. Further, you will not be able to evaluate the true success of the scheme and whether it is in fact, achieving the outcome envisaged at the design stage.

Obviously, this cannot be an exhaustive treaty on all aspects of behavioral psychology that influence incentive scheme design. Rather, the following is our choice of factors that we feel should be considered when designing incentive schemes, determining which scheme is applicable for your company, and perhaps most importantly, deciding whether the current methodology of short-term incentives (“STI”) and long- term incentives (“LTI”) is still relevant.

Why is this important? Your STI, LTI, and other schemes are vital components of your Employee Value Proposition and influence the company’s ability to attract and retain talented individuals, introduce a high-performance culture that ensures attainment of the company’s strategy, and concomitantly, higher profitability.

Rather than formulate a solution to the problem in the conclusion of this article, we would rather state it here upfront. This will enable you to constantly interrogate and challenge our conclusion. As we raise various behavioral factors, you can ascertain their importance or relevance to the following radical and bold hypothesis:

Do executives welcome incentives?

At the outset, given that incentive remuneration represent variable pay which is “at-risk”, one must examine whether executives welcome risk if they are risk adverse. Are all executives gamblers like Koos Bekker? When he became CEO of Naspers, a top 5 Johannesburg Stock Exchange company, he elected to be paid in shares rather than earn a salary – to his huge advantage.

There are several studies and experiments which have been conducted which illustrate that executives are in fact risk adverse. Consider the following findings from some studies:

The majority will choose fixed payments over a possible bonus of higher value. Only 33% are willing to gamble a certain sum for a potentially higher bonus.

Further, almost 50% would choose a smaller certain amount over a higher bonus.

Geographic regions exert an influence on the risk adversity of executives. For example: Bonus schemes in South Africa are popular and have become entrenched in the remuneration policy of most companies. However, in general, Africans are the most risk adverse – almost 66% would choose to receive a fixed amount rather than the possibility of a slightly higher potential bonus. The dearth of incentives schemes in Africa is therefore not surprising; the salient reason for their unpopularity can be attributed to the risk adverse mindset of the executives. How many times in Africa have you heard “You keep the possible bonus and just pay me a little bit extra every month”.

Asian executives on the other hand welcome higher risk in the form of higher potential variable pay.

The lesson to be learned here is that it is extremely difficult to introduce a generic global incentive plan – different regions will attribute different values and utility to the global plan. One plan does not fit all, and often regional tweaks must be incorporated to recognise and mitigate the concerns and risk profile of different regional executives. “Think globally but act locally” is also applicable to incentive plans.

The research would appear to offer empirical evidence that executives do not like incentives and would rather settle for a higher salary.

Given this evidence, perhaps shareholders and owners should re-evaluate their perception of executives as risk-loving, big bet taking, prima donna’s who love, treasure, and are preoccupied with their incentives?

Do executives value incentives correctly?

The answer to this question is emphatic and resounding:

Of significant concern, is the fact that executives should be financially astute and have the fiscal acumen to evaluate the inherent value of their incentives – or at least one would think so.

Executives are prone to hyperbolic discounting. Assume I was to receive $100 in 3 years. The present value (the value today) should simply be the future value discounted by the risk-free rate applicable in that country – on average this would probably be around 5% per annum. $100 would then be worth $86.38 today – a discount of 14%. Executives however discount the $100 by almost 50%.

Executives, therefore, apply discount rates to deferred payments that are massively more than the correct economic discount rates. Hyperbolic discounting is not time-consistent; it is neither linear nor occurs at a constant rate. Values placed on rewards decrease very rapidly for small delay periods and then fall more slowly for longer delays.
Once again, the various surveys and experiments illustrate that the region exerts an influence on discounting. For example:

African and the Middle East executives will discount the future incentive by double the amount of a Western European executive. That is, they will only assign half the value that a Western European executive would, to a specific future amount.

Younger executives will discount the incentive by almost double the percentage to that of an older executive.

In both cases (young executives and African and Middle East executives) would not have significant experience with such schemes which probably contributes to their incorrect calculations.

Hyperbolic discounting is behavioral economics and not financial theory. It is difficult to convince the executive that his/ her thinking is flawed as the calculation is based on behavior rather than an equation.

Lesson Learned

This is an important lesson or observation. The immediate response is often – “that’s stupid”. It’s not, as our brains are hard-wired to think like this and the miscalculation is not an indication of lower intelligence of the lack of financial nous. It is simply behavioral psychology which must be understood and factored in when designing incentive schemes.

What is also imperative is that change management and an adroit communication strategy must be formulated when introducing such schemes, or else executives will place a lower (and incorrect) value on incentives which in turn erodes the company’s Employee Value Proposition.

Do executives value equality?

The strongest message emanating from the myriad research is that executives are concerned that their pay and incentives are comparable to their peers; this peer group includes other executives in the company and similar positions in competitor companies.

Numerous experiments have been conducted where executives were asked which of the following options they would elect:

OPTION A

Earn $50 when the median market pay is $30

OPTION B

Earn $100 when the median market pay is $125

Obviously, B is the correct answer given that the earnings are higher however, most executives elect option A.

The quantum or amount of the incentive is not important to the executive, provided it is comparable to their peers. The remedy to allay this concern, is to ensure that the incentive scheme is transparent, clearly defined and where the same parameters/ measurements are consistent and generic to all within the company.

For example, all Grade E1’s has an on-target of x% of Base Salary and that the decision to pay out an objective, is a binary decision – it can only be “Achieved” or “Not Achieved” with no partial discretionary awards.

The factors discussed above are general behavioral psychological factors which influence the perceived value of incentives. Are they important – yes, they are? If your LTI scheme only vests in 5 years’ time whereas your competitors, or the market norm, is a 3-year vesting period, your scheme will be viewed as inferior because of hyperbolic discounting.

In Part 2 we will concentrate on the impact of behavioral psychology on LTI.

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Psychology of Incentives Part 1

Behavioral Psychology

Why? Because recent findings are concluding that behavioral psychology drives the success of any incentive, reward, or recognition scheme

Do executives welcome incentives?

Do executives value incentives correctly?

Lesson Learned

Do executives value equality?

OPTION A

OPTION B

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