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Alex Edmans
February 23, 2016
Performance-based pay has come under fire since the global financial crisis.
And indeed, the evidence does suggest that incentive-based pay can be damaging
in many settings. This research is summarized in a recent article from Dan
Cable and Freek Vermeulen of London Business School. However, very little of
the research they cite was actually conducted on business executives. The
research that has been conducted on business leaders suggests that financial
incentives can work and quite often do.
And while it s true, as they write, that large bonuses and stock options have
been held responsible for overly risky behavior and short-term strategies, I
know of no peer-reviewed evidence that the crisis was actually due to poor
incentives, and their article cites none.
Cable and Vermeulen do present evidence that performance measures often only
capture one element of a worker s job, and thus have a distorting effect on
their work. For example, paying teachers according to student test scores may
induce them to teach to the test. Financial incentives only work in jobs
where there s some kind of comprehensive performance measure that weights all
the different dimensions appropriately. Clearly, for lots of jobs, no such
measure exists.
But, for executives, you do have such a measure the long-run stock price. In
the long run, every executive decision will eventually show up in the stock
price. The stock price captures not just current profits, but expected future
profits, growth opportunities, balance sheet strength, corporate culture,
customer satisfaction, relations with stakeholders, and so on, and weights them
by their relative importance for firm value. Although critics have often called
the stock price reductive, research shows it s more comprehensive than the
caricature. For example, research I ve conducted has shown that, if executives
treat workers responsibly, this eventually boosts the stock price the 100
Best Companies to Work For in America outperform their peers by 2-3% per year.
Others have found similar results for other intangibles, such as customer
satisfaction, environmental stewardship, and patent citations.
Of course, the key words are in the long run. Cable and Vermeulen are correct
that executives may cook the books in the short-run but the effects of such
transgressions will be felt in the long-run. For example, earnings restatements
lead to a -9% return. Given the current levels of equity compensation, this
would cost the average CEO $4.5 million but it would cost zero if he had been
given a flat salary. The flipside of rewards for good performance is they allow
punishment for poor performance but a CEO with a fixed salary gets off
scot-free even when shareholders are suffering (particularly if performance is
not bad enough to lead to firing). For example, JC Penney s CEO, Ron Johnson,
suffered a 97% pay cut in 2012 due to poor performance. Jimmy Cayne of Bear
Stearns lost over $900 million from the collapse of Bear Stearns.
Thus, while poorly designed incentives (e.g. those with short vesting periods,
or paying according to quarterly earnings) can backfire, to completely scrap
equity will throw the baby out with the bathwater. The solution is simple to
extend the vesting period to the long-term. And, this is another difference
between executives and other workers. You can t pay regular workers according
to performance in 5 to 10 years time, because they need money now to live on.
Executives are so highly paid that they re not hurt by having a significant
proportion of their income deferred.
And not only do we have a comprehensive way to measure CEO performance, there
is also evidence that suggests performance-based pay for CEOs does have
benefits.
A paper in the Journal of Finance found that firms that give CEOs high equity
incentives outperform those with low equity incentives by 4-10%/year. Moreover,
the outperformance is over the long-term, not due to short-term tricks, and is
most apparent in firms where it would be easiest for managers to coast (due to
factors like weak governance, weak competition, or high managerial discretion).
Cable and Vermuelen argue that executives are intrinsically motivated, and that
extrinsic motivators like performance-based pay will only crowd out these
intrinsic motivators. But the evidence suggests that unincentivized executives
may simply pursue the quiet life and allow the status quo to persist,
avoiding hard tasks like major reorganizations, hard negotiations, or unpopular
decisions. Indeed, a study in the Journal of Political Economy showed that CEOs
with few incentives (in this case, due to takeover protection) did fail to
close down old plants or create new plants they just coasted, and
productivity and profitability suffered.
In addition to motivating the executive once she arrives, incentives are useful
in attracting motivated executives to begin with. Offering a contract that
guarantees that your pay will never fall, no matter how bad your performance
is, will attract coasters who desire the quiet life. A study showed that the
introduction of incentive pay boosted productivity by 44%. While half of the
increase stems greater effort by existing workers, the remaining half stems
from coasters leaving and more motivated employees replacing them.
But, rewards are not only instrumental to incentivize performance but also
to signal what is important to the organization. Consider the Nobel Prize,
which comes with a $1.5 million award. The incentive effect of the cash is
likely zero the prize would have the same prestige without it. Moreover, why
have a prize at all? It s highly unlikely that any researcher would work less
hard without it. And, that s the same for best paper awards, all of which come
with cash sums. These prizes are not to incentivize, but to show what the
academic profession values, and thus shape the behavior of the broader research
community.
Moreover, knowing that the CEO s fortunes are tied to the firm s success is a
positive signal to workers, investors, customers, and suppliers. You d prefer
to be associated with a firm where the CEO is invested quite literally in
its success.
Alex Edmans is a Professor of Finance at London Business School, where he
specializes in corporate finance, behavioral finance, and corporate social
responsibility. He earned his BA from Oxford University and his Ph.D. from MIT,
where he was a Fulbright scholar.