The Psychology Of Incentives | PART TWO
LONG TERM INCENTIVES
In Part One we examined the impact of behavioral psychology on incentives in general. A plethora of academic studies have shown that:
- Executives are risk adverse and prefer a smaller guaranteed amount to a possible bonus of higher value; and
- Employees do not place the correct value on future incentive payments – they value them significantly less than they should; and
- The age and geographic region of employees influence the perceived value of the incentive.
Further, we stated that HR personnel must not only be a strategy swami, a finance guru, an operations rock star but also a behavioral psychologist Jedi in order become an incentive ninja.
In Part Two we want to concentrate on the influence that behavioral psychology exerts on Long Term Incentives (“LTI”)
LTI has always been lauded as the correct, optimum and appropriate reward vehicle to align the interests of shareholders and executives. Further, encouragement for the increased use of LTI in the reward mix is being encouraged by regulators and other regulatory bodies. A significant amount of behavioral psychological research and experiments have been conducted which are pertinent to LTI and we have consequently been forced to only select a few for this article.
Inclusivity Recognition Need
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.
Behavioral psychology therefore states that it is not the amount of money which executives’ value with an LTI, but simply the fact that they have been selected to participate in the scheme. The company could therefore reduce the number of shares granted, decrease the potential gain to the executive and drastically reduce the cost to the company – WITHOUT decreasing the attraction of the LTI to the executive.
Behavioral Agency Theory
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 pretty 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?
LTI design features
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 recognize 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
- Where the principal has information to verify agent behavior, the agent is more likely to behave in the interest of the principal. Given this, it is essential that quantitative objectives are set. For example, it is extremely easy for the principal to verify agent behavior if the performance condition for vesting is that EBITDA must increase by 10% annually compounded over a rolling 3-year period. Verification is however difficult if the condition is to “Live the culture of the company”. We have been saying this for years – any goal, objective or performance condition should have a calculable ROI (return on investment) and be “self-liquidating”; where the cost of the vesting shares represents a percentage of value added for the company.
- Behavioral Agency Theory states that there is a strong connection between goals, commitment and performance where the goals are specific, difficult, attainable and self-set and then mutually agreed. Simple design advice which we would agree with.
- 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.
Perhaps the best advice we can offer is that your LTI should not be based on copy-cat influences (“what others are doing”). There is also no “off the shelf “scheme which you can “plug and play”.
Your LTI design must be aligned with the company culture and promote the achievement of the business strategy but of equal importance, the design of the LTI must be aligned with the other elements of remuneration namely, guaranteed pay and short-term incentives (“STI”) to ensure a holistic, cogent and integrated total rewards offering. The total rewards offering should incentivize employees by driving individual performance and enhancing the Employee Value Proposition.
In Part 3 we will concentrate on the impact of behavioral psychology on STI.