Last week’s article in Bloomberg Business Week “We’re Paying CEOs All Wrong” extended my work in Behavioral Economics and Equity Compensation to executive pay and then upward to CEO pay. I am flattered that the first two paragraphs of the article discussed my ideas although I thought it unnecessary to highlight that I have done this for “more than three decades” and then to cite my age.
Bloomberg only referenced one of the 13 concepts of behavioral economics discussed in the 2009 article (co-authored with Kiran Sahota) that should be influencing our design of equity compensation programs for all employees, not just CEOs. But the one described is critical: hyperbolic discounting.
This well-validated theory supports the notion that more emphasis on short-term incentives could be better for the long-term. This of course flies in the face of the zeitgeist of executive pay which has shifted the majority of executive pay to multi-year stock-based compensation – restricted stock units and performance share units – plus additional programs such as stock ownership guidelines and retention guidelines. Add to that the trading restrictions that executives face both from SEC rules and media attention to an executive sale of stock as “bailing out” and it’s no wonder that executives pay attention to stock price above all else. Or do they?
With that much at risk over long periods of time, and the high turnover rates of executives, we should expect an executive to discount the value of those contingent shares, says the field of behavioral economics, to a level that the incentive value dissipates and even disappears. Contrast those discounted values to base salary, annual incentives, and the payoff from change in control agreements, and we should expect that executives (1) manage for the short-term despite the long term incentives and (2) are incented to have the company acquired.
For a recent example of the latter, see the LinkedIn CEO’s gains from the Microsoft acquisition which I estimated here.
We’re paying CEOs all wrong and there is a basis for that claim in the tenets of behavioral economics, but as long as the proxy advisory firms continue to use say-on-pay to hammer Compensation Committees with the “shareholder alignment” theme and that translates into stock, stock, and more stock, it is unlikely to be fixed.
My favorite quote from the Bloomberg article was not mine – Dan Laddin of Compensation Advisory Partners was quoted saying “I think the pendulum is going to swing back toward driving behaviors,” he says. “But it’s going to be the brave companies that do it first.” Until Compensation Committees figure out what’s wrong with the “S” in “total shareholder return” there will be no progress made on CEO pay.