Are long‐term incentive plans an effective and efficient way of motivating senior executives?

• Author: Alexander Pepper,Julie Gore,Alf Crossman
• Published date: 01 January 2013
• DOI: http://doi.org/10.1111/j.1748-8583.2011.00188.x
• Date: 01 January 2013

Are long-term incentive plans an effective and

efficient way of motivating senior executives?

Alexander Pepper, The London School of Economics and Political Science

Julie Gore and Alf Crossman, University of Surrey

Human Resource Management Journal, Vol 23, no 1, 2013, pages 36–51

Research on senior executive reward has typically explored the connection between pay, performance and

the alignment of interests of executives and shareholders. This article examines the relationship between

reward and motivation, drawing on the psychological, behavioural economics and decision-making

literatures. Based on an empirical study of FTSE 350 senior executives, the research examines whether

long-term incentive plans are an effective and efficient way of motivating executives, taking into account

risk, time discounting, uncertainty and fairness. The article concludes that the way executives frame

choices, perceive value, assess probability, evaluate temporal effects and respond to uncertainty means

that long-term incentive plans (LTIPs) are generally not efficient and are often not effective in meeting

their objectives. It proposes that, in its current form, agency theory does not provide a sound basis for

modelling senior executive reward, and suggests five areas for development.

Contact: Dr Alexander Pepper, The London School of Economics and Political Science,

Houghton Street, London, WC2A 2AE, UK. Email: a.a.pepper@lse.ac.ukhrmj_18836..51

INTRODUCTION

In 1995, the Greenbury Report recommended that UK companies should adopt performance-

related long-term incentive plans for senior executives, preferring them to traditional share

options (Greenbury, 1995). The report pointed out that stock options had a number of

shortcomings: they sometimes led to windfall gains simply as a result of general movements

in share prices and did not encourage directors to build up significant shareholdings in their

employing companies. Reuters Group plc was the first UK-listed company to adopt the new

style of long-term incentive plan in 1993. After 1995, many other UK companies followed suit,

influenced by the Greenbury Report as well as the withdrawal of tax relief for share options

granted over shares with a market value in excess of £20,000 in the 1995 budget. Since that time,

LTIPs have become a major component of senior executive reward systems in UK-listed

companies. In 2009, LTIPs comprised around 38 per cent of the total earnings of executives in

the FTSE 100 and 33 per cent in the FTSE mid-250 (IDS, 2010).

While designs vary, in the UK, LTIPs typically take the form of an award of deferred shares

that vest over a 3 year period conditional upon the satisfactory achievement of a number of

financial performance targets. These are often relative measures, benchmarked against either an

index or the financial performance of a number of comparator companies, so that the extent to

which awards vest is dependent upon a company’s financial performance relative to the

market.

LTIPs have two primary objectives: first, to align the interests of executives and shareholders

in order to minimise both agency risk and the associated cost (the alignment objective); and

second, to recruit, retain and motivate senior executives to maximise their effort and give high

performance (the motivation objective). For some years, there has been disquiet about how

successful LTIPs are in meeting these two objectives. Criticisms by executives, investors or the

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doi: 10.1111/j.1748-8583.2011.00188.x

HUMAN RESOURCE MANAGEMENT JOURNAL, VOL 23 NO 1, 201336

© 2011 Blackwell Publishing Ltd.

Please cite this article in press as: Pepper, A., Gore, J. and Crossman, A. (2013) ‘Are long-term incentive plans an effective and efficient way of

motivating senior executives?’. Human Resource Management Journal 23: 1, 36–51.

public generally include the assertion that complex designs make LTIPs very hard to

understand, performance targets are undemanding or too demanding, the performance of

comparator companies has an undue impact on performance targets, and the total amounts

ultimately paid out are perceived to be too high. Evidence of this can be found in the

practitioner and business press, see for example PricewaterhouseCoopers (2006, 2007, 2008) and

The Sunday Telegraph’s Executive Pay Report (http://www.telegraph.co.uk/finance/jobs/

7728860/Executive-Pay-Report-2010-How-the-recession-has-shaped-boardroom-pay.html). One

of the paradoxes about LTIPs is that, self-evidently, these points of view cannot be easily

reconciled.

This article examines whether long-term incentive plans are an effective and efficient way of

motivating senior executives, while at the same time exploring other behavioural aspects of

senior executive reward systems.1It argues that it is short-sighted to focus on the alignment

objective without also considering the motivation objective, on the basis that the interests of

shareholders and executives cannot be aligned if executives are not properly motivated. It

proposes that more attention should be paid to the motivation objective and inequity aversion

by economists and other management theorists, and that the behavioural agency model

proposed by Wiseman and Gomez-Mejia (1998) should be developed further.

The rest of the article is organised as follows. First, we consider the literature on senior

executive reward and work motivation, developing a theoretical framework that underpins the

empirical work and constructing a set of three research propositions. Second, we describe the

research method, which comprised both a qualitative research stage (Stage 1) and a quantitative

stage (Stage 2). Third, we set out the results of the study, demonstrating how the outcomes of

the quantitative work carried out at Stage 2 corroborate the findings of the qualitative work

carried out at Stage 1. The article concludes by discussing the implications of our findings for

the development of agency theory as it applies to senior executive reward.

THEORETICAL ANALYSIS

The academic literature on senior executive reward is now very extensive, drawing on a variety

of scholarly traditions including economics, sociology, law, corporate governance, accounting,

finance, management and organisation studies. Recent literature reviews and summaries are

provided by Devers et al. (2007) and Gomez-Mejia et al. (2010: 117–140). Major theories include

agency theory (Jensen and Meckling, 1976; Jensen and Murphy, 1990), tournament theory

(Lazear and Rosen, 1981), human capital theory (Combs and Skills, 2003), the managerial power

hypothesis (Bebchuk et al., 2002), institutional theory (Balkin, 2008), political theories (Ungson

and Steers, 1984) and fairness theories (Wade et al., 2006). Filatotchev and Allcock (2010)

propose a contingency framework that conceptualises executive pay in terms of organisational

context, complementarity of governance systems and national institutional environments, but

this approach lacks theoretical parsimony (see Gomez-Mejia et al., 2005: 1512). Devers et al.

(2007) note that behavioural research is a relatively new feature of the literature on senior

executive reward.

The investigation described in this article takes agency theory as its starting point. Agency

theory is the dominant framework for examining senior executive reward (Bratton, 2005).

However, following Wisemanand Gomez-Mejia (1998), we challenge a number of the underlying

behavioural assumptions of agency theory, specifically those relatingto motivation and fairness.

Agency theory focuses on the separation of ownership and control, and hence on the

importance of incentive contracts to align the interests of shareholders and managers. The

underlying assumptions are that organisations are profit-seeking, that agents are both rational

Alexander Pepper, Julie Gore and Alf Crossman

HUMAN RESOURCE MANAGEMENT JOURNAL, VOL 23 NO 1, 2013 37

© 2011 Blackwell Publishing Ltd.