Making executive pay work: The psychology of incentives

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Making executive pay work: The psychology of incentives

At a glance

This study, which PwC conducted with Dr. Alexander Pepper at the London School of Economics and Political Science, looks at the views of over 1,100 senior executives in 43 countries, across varying senior organizational roles, companies and industries.

Video: Scott Olsen discusses the psychology of incentives

This study, which we conducted with Dr. Alexander Pepper at the London School of Economics and Political Science, looks at the views of over 1,100 senior executives in 43 countries, across varying senior organizational roles, companies and industries. We analyzed the responses of our participants by gender, by age and by country.

What we found is that there is an emerging consensus, at least in Western economies, that there is something askew with the current model of executive pay. Executive pay has risen dramatically over a period when, in hindsight, the Western economic model has not been at its most successful.

The debate about executive pay has focused on whether shareholders are getting what they want, whether current levels of executive pay are acceptable to society, whether remuneration committees are doing their job properly.

But surprisingly little attention has been paid to perhaps the most important constituency: executives themselves.

The study focuses on the attitudes of executives, who are one of several "stakeholders" in the executive pay arena.

The results reveal a number of common behavioral traits, which show clearly that executives don’t necessarily think in the way that many incentive methods assume.

Key Findings

Executives are risk-averse.

Executives are no different than other groups of people in that they are basically risk averse.  And executives, like investors, demand a premium for more risky forms of pay. The return to investors for this "premium" is a greater degree of alignment between company performance and executive pay outcomes.

Complexity and ambiguity destroy value

Fifty percent more executives choose a clearer pay package than a more ambiguous one of the same or potentially higher value. Two-thirds more executives prefer an internal measure they can control (such as profit) as opposed to an external relative measure (such as total shareholder return

The longer you have to wait the less
it's worth

Executives value deferred pay significantly below its economic or accounting value - a deferred bonus is typically discounted by around 50% over three years

It's all relative - fairness is fundamental

Most executives would choose to be paid less in absolute terms but more than their peers -  only a quarter choose a higher absolute amount, but which is less than their peers

People don't just work for money

Participants would take a 28% pay cut for their ideal job, however this is far less than the discount they believe others would take for their "ideal job" (60%).This indicates that there is a bias against reducing one's current earnings, irrespective of their job content, but also indicates that improvements in job content (more interesting work, greater fulfillment) may reduce the pressure to continuously increase pay levels.

The key motivation of a long-term incentive plan is recognition

Fewer than half of executives think that their long-term incentive plan is an effective incentive but two-thirds of participants value the opportunity to participate in their firm’s long-term incentive plan The research shows that while the tangible, economic value of long-term incentives to executives may be far lower than the cost companies bear to provide them, these plans nonetheless provide intangible value to participants. Among these intangible benefits are the feeling of being part of an "elite" group within the organization and the feeling of sharing in the company's success.