Psychology of Incentives Part 4

Behavioral Psychology Conclusion

Behavioral Psychology Conclusion

In this four-part series we delved into the world of behavioral psychology with the express intention to understand how this field of study influences incentives.

We stated in Part 1 that HR personnel is now required to be a strategy swami, a finance guru, an operations rock star, a behavioral psychologist Jedi to transcend and become an incentive ninja.

To recap some of the important observations of behavioral psychology:

Executives are inherently risk-averse. The majority would choose fixed payments over a possible bonus of higher value. Geographies influence the level of risk aversity.

Executives are prone to hyperbolic discounting where over a 3-year period they would discount a future payment by 50% instead of the correct 14%. Further, it is difficult to convince executives that their calculations are incorrect.
Executives are more concerned that their pay is comparable to a peer group than the quantum of the incentive.

Agency Theory states that it is essential that the executive and the company should be striving to achieve the same goals. Research has however shown that there is little correlation between schemes that incorporate Agency Theory and the share price.

If you reward executives for doing something, they lose interest in performing these tasks. Economists disagree and have found evidence of increased productivity.

One could be excused for now questioning the applicability of incentives – this is not the intention of these articles. Rather, the objective is to understand the science which influences employees’ perception of incentives so that these can be addressed. Further, any new incentive designs should incorporate, where possible, the tenets and findings of behavioral psychology.

Possible alternative incentive design

Perhaps – however any company who elects to introduce a new and radical incentive design may face headwinds because it is contrary to copy-cat influences (“what our competitors are doing’) and may erode the EVP – unless it is adroitly communicated.

Professor Alexander Pepper in his article, “The Case against Long-Term Incentive Plans” which was published in the Harvard Business Review, October 2016 issue states

” My research suggests, somewhat perversely, that companies would be better off paying larger salaries and using annual cash bonuses to incentivize desired actions and behaviors. Additionally, they should require leaders to invest those bonuses in company stock (or should pay the bonuses in the form of restricted stock) until a certain share of leaders’ net worth, or some multiple of their annual salary, is invested”

According to Pepper, if executives continue to hold substantial equity, their interests will be aligned with those of shareholders. This alternative incentive design would achieve that aim without the confusion and inefficiencies of long-term incentive plans.

Given Prof. Pepper’s statement and the previous analysis contained in this article, what would the ideal incentive scheme look like? We would contend that the following scheme would be an option:

1. Short Term Incentive (“STI”) scheme
  • 50% of the pay-out would be subject to a short deferral period.
  • The remaining 50% would be paid into the Long-Term Incentive (“LTI”) scheme.
  • The employer would double the employee’s payment to the LTI.
2. Long Term Incentive (“LTI”) scheme
  • No other LTI scheme would be introduced other than the vehicle to house the deferred pay-outs from the STI.
  • The employee would receive growth in the share price (or other measurement criteria) on both the employer and employee amounts in the LTI from the outset.
  • Vesting and exercise of the LTI are only permissible 1 to 3 years after the executive’s last day of employment.
  • Additional conditions could be introduced to allow the executive to partially exercise based on a minimum holding requirement.
The advantage of this incentive design includes inter alia:
  • The design ensures that all decisions taken by the executive are based on long-term value creation.
  • Negates the temptation to implement short-term initiatives which may boost the share price in the short term, but which may not be a driver of long-term value creation.
  • Aligns the design of incentives with the principles of Agency Theory.
  • Reduces the occurrence of hyperbolic discounting given that the value is not some intangible possible future amount but rather the quantum is known.
  • One of the issues which may be raised by executives (and especially CEOs) is that the actions of the new CEO may lead to a decline in the share price.
  • This methodology will ensure that adroit succession planning is done. The outgoing CEO will know that the actions of the new CEO may affect the value of his LTI and thus the new incumbent will be subject to a stringent and robust selection process; and
  • Further, so often a new CEO is appointed and writes down the value of assets. The suggested methodology will ensure that a “clean balance sheet” is left.
  • Clawback provisions seldom work. The computation of a clawback is fraught with difficulty and will often involve significant legal costs. This methodology has an in-built clawback and allows the market to determine the clawback and further, aligns the clawback amount with the interests of shareholders.

Conclusion

The alternative design presented above is radical but at the same time, it has been designed based on the lessons to be learnt from behavioral psychology. While it may be difficult to implement now, as the science becomes more entrenched in incentive design, there is little doubt that this is what the future of incentives may look like.

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