In Part One, we discussed the fact that executives do not value future payments that introduce risk and/or volatility to their remuneration – they would prefer to receive a higher basic pay now and, in any case, because of hyperbolic discounting, ascribe an outrageously low value to future possible incentive payments.
Given the above, one could safely assume that executives would dislike LTI? You would be wrong. In various surveys, over 50% of executives state that an LTI is an effective incentive and 66% stated that they valued the opportunity to participate in the scheme.
LTI’s have always been proposed as the ideal vehicle to address Agency Theory. These proposals and encouragement are coming from – coercive influences (regulators), copy-cat influences (everyone else is doing it) and best-practice influences (consultants/ advisors encouraging companies to do it). Concomitantly, one does need to examine whether the science is aligned with, and justifies these reasons given that copy-cat and best-practice influences are poor reasons for introducing an LTI.
Deferral of any reward is always espoused as best practice to align the interests of all stakeholder’s interest, which in turn will result in long term sustainable value creation. In Part One we demonstrated that hyperbolic discounting challenges this conventional wisdom.
Agency Theory states that by bridging the divide between the executive and the company, this will ensure that both are working towards a common goal and the implication is that both will strive to increase the long-term value of the company. Agency Theory further assumes that agents are rationale, risk averse and therefore effort and motivation are highly correlated.
Alexander Pepper and Julie Gore have explored the impact of Agency Theory on incentives in great depth and their seminal work is insightful reading- “Behavioral Agency Theory: new Foundation for Theorizing about Executive Compensation”.
Of great concern is that various studies have however shown that there is LITTLE correlation between LTI schemes which are designed on the agency methodology and/or which incorporate the agency philosophy, and the share price. If shareholders do not receive the benefit of a higher share price, why have an LTI at all?
Let’s confront the brutal facts. Risk aversion, geographic influences, hyperbolic discounting, low correlation to the share price and the perceived lower value attributed to future rewards, would lead one to question why an LTI should be introduced in the first place. However, one does need to be pragmatic and recognise that regulators, proxy voting companies and shareholders do advocate that a significant portion of an executive’s remuneration should be long term.
Given this, one needs to incorporate the findings of behavioral psychology into the design of the LTI. Some tips from the research would include inter alia:
Eisenhardt’s research found that: Where the contract between agent and principal is outcome based, the agent will behave in the interest of the principal. This is important information when designing LTI – the performance objectives must be outcome based or have some sort of performance condition attached to the vesting; and
The LTI design must attempt to encourage Agency Theory, but cognizance must also be taken of the Upper Echelons Theory. This theory states that Agency Theory works best where the agent has the ability (necessary knowledge, skill, and aptitude), motivation (intrinsic and extrinsic) and the right opportunities (the necessary work structures and business environment). Normally only executives or senior managers have all three and can influence the company’s performance by defining, contributing to and executing the strategy. Given this, LTI schemes should in general, be the preserve of executives or senior management and not all-inclusive.
In Part 3 we will concentrate on the impact of behavioral psychology on STI.
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