The significance of financial incentives The majority of participants in Stage 1 regarded financial incentives as important, but not critical, to business success. Of the two participants in the study who rated financial incentives as very important, one, an executive director and evidently by inclination an entrepreneur, had joined his company during its start-up phase and had helped to grow the business up to and beyond the point of flotation on the London Stock Exchange. The other, a non-executive director, was on the board of a company that had been through a major turnaround, during which time executives had been incentivised with a high-profile private-equity style incentive plan. In other cases, the prevailing view was that most executives are driven by a sense of achievement, of being part of a successful management team, of working in a place where they are in tune with the organisation's values and objectives, and of building a great company, summarised in the words of one participant as ‘winning’. According to this majority view, only a small number of executives are primarily motivated by potential monetary gain, perhaps no more than 10 per cent or 20 per cent according to one HR director.
Nevertheless, financial incentives clearly do matter. Executives want to be valued and to be treated equitably or (as a number of them put it) ‘fairly’. Financial incentives are, according to one non-executive, ‘a necessary but not sufficient condition for motivating executives’. An HR director explained: “the behaviour of the vast majority of people, including senior executives, can be influenced by financial incentives”. Another CEO said that intrinsic factors, like achievement, teamwork, status and power, are fundamentally important but only come into play once you are at or above a minimum threshold for financial reward.
Financial incentives serve a number of purposes: in particular, to provide opportunities for creating wealth, as a retention mechanism to discourage executives from looking for employment elsewhere (or at least to increase their transfer price, and thus to deter other companies from targeting them), to strengthen engagement and encourage sustained performance, and as a means of ‘keeping score’. The last of these appeared to be especially important in the case of CEOs. Chief executives, competitive by nature, want to know how they are doing relative to their peers. Remuneration is an obvious way of measuring this, as a proxy for wider measures of success. Only two interviewees mentioned the importance of aligning the interests of shareholders and executives, even though this is the primary reason for long-term incentives according to principal agent theory. In contrast, the use of LTIPs as a retention mechanism was mentioned most frequently.
Short-term incentives (annual bonuses) were generally regarded as very effective by executives and non-executives alike. Participants described them, in comparison with long-term incentives, as having much better ‘line of sight’, meaning that the connection between successful actions and reward was more obvious. Long-term incentive plans, on the other hand, were generally seen as at best only partially effective; indeed, many of the executives in our study felt that LTIPs failed to meet their main objectives. Various reasons were given for this. Commonly cited was the complexity of most LTIPs. One CEO put it rather elegantly as follows:
“Deferred share schemes are basically somewhat poorly understood, and pretty arbitrary. In the old days share options were easily understood, but pretty arbitrary. These new schemes are extraordinarily complex . . . and still pretty arbitrary. That's the issue”.
The same CEO described how a divisional finance director had opted not to join a long-term incentive plan because he had miscalculated the possible benefits, yet had still managed to influence another executive in his decision to sign up to the plan because his colleague misunderstood the advice the finance director was giving him. A non-executive placed the onus on companies to communicate the value of LTIPs in terms that executives can understand.
A specific problem that participants identified with LTIPs was the use of comparative performance measures, such as relative total shareholder return (TSR). As one CEO said, “I don't know how to manage relative TSR . . . you don't wake up in the morning trying to manage something relative”. With comparative performance targets, the choice of benchmark companies becomes critical. An unusually good or bad profit or share price performance by another company can have a disproportionate effect on the basket of comparator companies, especially when no payments are made for below median performance. Takeovers of companies in the comparator group can be particularly distorting. This is the precise opposite of the ‘line of sight’ argument for short-term incentives; in the case of LTIPs, executives frequently cannot see any causal link between their actions and reward outcomes.
The challenge is that investors are driven by relative measures. They are selecting stocks based on relative performance by category and are worried about beating the average in the shape of an index. However, an HR director pointed out that the starting positions of managers and investors are not the same: “Most shareholders hold a portfolio and are therefore insulated against the capricious nature of shareholder returns. We as executives are not”. Another participant in the study said, “Investors shouldn't inflict relative performance conditions on companies. They should say, ‘well that's our challenge to manage’ ”.
The strong consensus among the executives who were interviewed was that using absolute performance conditions, designed carefully and linked to each company's particular strategic objectives, could significantly enhance the motivational effect of LTIPs. The most appropriate financial metric to use, such as TSR, earnings per share or earnings before interest and tax, would vary from company to company, but in every case, the merit of having an absolute measure trumps relative metrics.
Participants in the study cited a number of other problems with LTIPs. In particular, one participant talked about the insistence of the Association of British Insurers, a trade association representing institutional shareholders, that no LTIP payment should be made unless performance was at or above the median level, which he referred to as ‘the tyranny of the median’. For reasonably solid defence stocks which are, as another executive put it, ‘incrementally creating value through incremental good decision-making over time’, this may result in no LTIP payments. The way LTIPs are often configured appears to favour volatile stocks, where large amounts of value are created in one performance period even if it is lost again in the next period.
The effect of non-paying LTIPs is not merely neutral – it can be positively demotivating to hold an incentive instrument that you believe will never pay out, a characteristic of loss aversion (Kahneman and Tversky, 1979). An HR director with particular experience of this problem described it in the following way: “If you get reward wrong it is a much bigger de-motivator than it can ever be a motivator. It's like walking around a china shop with a sledgehammer in your hands”.
Motivation and fairness The relationship between intrinsic and extrinsic motivation provoked some discussion. The prevailing view among participants in the study was that, for senior executives, certain intrinsic factors, especially an orientation towards achievement, were important primary sources of behaviour. Power status and intimacy teamwork were also mentioned as significant factors. In general, however, intrinsic needs or drives were not seen as substitutes for extrinsic rewards – a substantial minimum level of remuneration must be provided. One CEO put it like this:
“Once you are at a threshold level on the financial structures, a level which is felt to be fair and appropriate to the market, then [intrinsic factors] become really important . . . but if you are at a significant discount on the monetary part then the other things will not make up for it”.
A number of non-executives commented that very large awards should not be necessary to engage and motivate executives. One company chairman, commenting specifically on the US market, said: “I do not believe, nor have I ever observed, that $100 million motivates people more than $10 million, indeed more than $1 million”. In practice, intrinsic and extrinsic rewards are evidently closely intertwined. The relationship between the two is complex and hard to unravel. As well as providing material benefits, extrinsic rewards are also important sources of information for executives, signals which executives can use to measure their value relative to their peers, how highly they are valued by their company boards, and even in some cases their self-worth.
A significant number of interviewees talked, on an unprompted basis, about fairness. For most of the participants in the study, fairness was primarily a relative concept: as equity theory predicts, one way in which rewards are evaluated is by drawing comparisons with other people (Adams, 1965). Who these referent persons were was not always clear. Executives talked generally about their peers. One CEO referred to second best options: “fairness is relative to other things I might do as opposed to other organisations”. Only one participant, also a CEO, thought fairness was a wholly irrelevant concept in the context of executive pay.
Key findings from Stage 1 Evidence from Stage 1 supports the proposition that senior executives systematically undervalue long-term incentives. The principal shortcomings of LTIPs that were identified by participants in Stage 1 as being, first, complexity: you cannot be effectively motivated by something that is too complicated to understand; in particular, with relative performance metrics too much is outside the control of executives, and for many companies, it is difficult to pick an appropriate group of comparator companies. Second (described earlier as the tyranny of the median), the fact that there is typically no payout at all for average performance creates the risk of a ‘feast or famine’ incentive, where companies with volatile earnings and share prices do better than steady performers. Third, participants recognised the significance of subjective valuation issues, including temporal discounting.
One of the ways in which financial incentives are important is that they provide a mechanism for ‘keeping score’, allowing an agent to assess how he or she is doing relative to their peers and signalling how they are regarded by their principals. The directness of the link between effort, performance and reward was also remarked upon, encapsulated in the phrase ‘line of sight’. This corroborates the significance of instrumentality, whether an individual can see a link between effort and performance, one of the elements of expectancy theory. A critical issue here was relative performance conditions, where the vesting of awards depended not only on the financial performance of the executive's own company (within the executive's line of sight) but also on the relative performance of comparator companies (outside the executive's line of sight).
Executives also recognised the existence of a trade-off between intrinsic and extrinsic motivational factors. This was captured in the statement made by one of the participants in the study that a financial incentive is: “a necessary but not sufficient condition for motivating a senior executive”. Once above a threshold level of earnings, other factors, including status, power and the need for achievement, assume greater importance.
The final issue related to social comparisons. A notable feature of Stage 1 was the number of executives who talked about the importance of ‘fairness’. Social comparison is evidently an important driver of human behaviour across the whole spectrum of society (Tyson and Bournois, 2005), regardless of income or wealth.
The results of Stage 1 are summarised in Table 1. Three major themes are identified. First, the financial cost of an LTIP may be greater than the value perceived by executives because of the way people subjectively assess risk, discount future events and estimate valence. A related point is that the complexity of many LTIPs means that they are often poorly understood by executives, which impacts upon the perception of their value: a person cannot be effectively motivated by something that is too complicated to be readily understood. Second, the relationship between intrinsic and extrinsic motivation is neither linear nor orthogonal: while financial incentives are necessary, they are not sufficient for motivating senior executives; above an upper threshold level of earnings, extrinsic rewards may crowd out intrinsic motivation; below a lower threshold, intrinsic motivation may be affected by demoralisation costs. Third, social comparisons are critically important; one way in which rewards are evaluated by individuals is by drawing comparisons with the rewards of other people.
Table 1. Key themes and exemplary quotes from Study 1
| Themes || Definition || Exemplary quotes |
|Subjective valuation issues and complexity||The financial cost of an LTIP may be greater than the value perceived by executives because of the way people subjectively assess risk, discount future events and estimate value. A person cannot be effectively motivated by something that is too complicated to be readily understood.||“LTIPS are an amount of money with a very high discount attached to it”. “I think it is inevitable that people attach a lower discount to near term systems”. “We are paying people in a currency they don't value”. “From the perspective of executive perception the rewards from an LTIP are difficult to assess and worse can be measuring the wrong thing”. “The complexity of most deferred share schemes means that they are basically somewhat poorly understood”. “The direct motivation is not there on a day-to-day basis . . . because of complexity”. “Relative TSR is meaningless . . . because there is no line of sight”.|
|The relationship between intrinsic and extrinsic motivation||A financial incentive is a necessary but not sufficient condition for motivating senior executives. Above an upper threshold level of earnings extrinsic rewards may ‘crowd-out’ intrinsic motivation. Below a lower threshold, intrinsic motivation may be affected by ‘demoralisation costs’.||“There are a small number of people who are only motivated by the monetary gain, maybe 20%”. “Once you're above a threshold level on the financial structures . . . then other stuff [becomes] really important”. “The role of money is . . . as a way of keeping the score”. “If the amounts are large enough they can make one lose sight of the intrinsic”. “It seems as if there is a law of diminishing returns”.|
|Social comparisons and fairness||One way in which rewards are evaluated by individuals is by drawing comparisons with the rewards of salient others.||“Internal relativity [is] a big issue”. “The only way I really think about compensation is ‘do I feel fairly compensated relative to my peers?’ ”“I believe this is true especially amongst corporate executives who appear to be very sensitive to differentials with perceived peers”. “This is definitely true in my experience as an HR director”.|