Making executive pay work: the psychology of incentives.

Author:Ericson, Rick

Executive pay needs to be focused strongly on performance. It must meet external standards for competitiveness, efficacy and propriety. At the same time, it must be clear, valuable and compelling to executives. If not, then these large outlays may be largely wasted.

But while these design criteria appear to be intuitive and durable, in practice they result in fundamental conflicts, leading to ever-changing pay programs. And the views of pay watchdogs, regulators and corporate stakeholders can drive frequent program change and complexity as well. As a result, executive pay today often is not only unstable in form, but quite complicated, cloudy and contingent.

A new study by PwC and the London School of Economics and Political Science provides some concrete evidence that this state of affairs is remarkably costly and counterproductive. The study tests executives' views about compensation packages--specifically how they value different features of their compensation programs.

This should help companies make better choices about the structuring of senior managements' pay. They should get a better bang for their buck, all else being equal.

There has been much talk in boardrooms in recent years about this general sub ject--the "perceived value" of executive pay, and how it might compare unfavorably to actual cost. The study tested executives' views on a range of such flutters, working with Dr. Alexander Pepper of the London School of Economics. More than 1,100 executives from 43 countries were surveyed and a great deal of new guidance was collected about which pay policies are seen as valuable and which are not.

The results often are startling, suggesting that companies are shovelling enormous amounts of money into a fire by creating pay plans that are too complex, risky and deferred. If they want to stop doing that, they should pay close attention to what surveyed executives arc telling them.

Here are key findings along with examples of implications:

* Executives are Risk-averse. When given a choice, a large majority of executives chose a lower level of fixed pay over a higher expected value of variable bonus pay. Risk-aversion causes pay plans to be discounted to a greater extent than warranted. If a company is striving to keep pay competitive and at the same time is exposing executives to unusual risks, then the executive is paying this discount. Would the company sell complex debt or equity securities to investors at a very large discount from market value? Using a highly discounted medium to satisfy competitive wage norms is the same thing.

Beyond the headline, the global findings provided much detail. Executive risk-aversion increased with the stakes; with...

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