Problems with performance pay

It's been a few years since I read in depth about reward and motivation. I basically got to the point where I think most performance-related pay is junk, as are most of the 'reforms' advocated, because there is little attempt to engage with the psychology obviously sitting behind all these idea.

Over the summer I read a couple of books (this one and this one) by Sandy Pepper and it's reignited my interest. He comes at these issues from a similar perspective and his books are a treasure trove of further reading ideas.  He's very much of the view that mainstream agency theory, and the executive designs that flow from it, are flawed and that to correct them we need to take account of human psychology. His work is also useful in that he undertook a large-scale survey of executives to gain a better understanding of how they think about incentives. His research confirmed that executives sharply discount deferred rewards. Another couple of fascinating nuggets from the research are that younger executives are less risk averse but higher time-discounters and that financial services executives were both *more* risk averse than those working in other industries and high time-discounters.

Notably Pepper comes down in favour of short-term, simple cash-based incentives. This is a long way from the conventional wisdom - even in the ESG world - that we should be pitching at long-term equity-based incentives with lots of targets (including ESG KPIs).

Anyway, I won't try and summarise his arguments here, so below are just a handful of snippets from The Economic Psychology of Incentives that I particularly liked.

"[I]nvestors are driven by relative measures. They are selecting stocks based on relative performance by category and are worried about beating the average in the shape of an index. However, an HR director pointed out that the starting positions of managers and investors are not the same: 'Most shareholders hold a portfolio and are therefore insulated against the capricious nature of shareholder returns. We as executives are not.'"

(this is a point I was sort of getting at in my third bullet in this blog)    

"The effect of non-paying LTIPs is not merely neutral - it can be positively demotivating to hold an incentive instrument which you believe will never pay out. An HR director with particular experience of this problem described it this way: 'If you get reward wrong it is a much bigger de-motivator than it can ever be a motivator. It's like walking around a china shop with a sledgehammer in your hands.'"

"[B]oards of directors, acting on behalf of shareholders, increase the size of long-term incentive awards to compensate them for the perceived loss of value when compared with less risky, more certain and more immediate forms of reward. In other words, I argue that part of the explanation for the inflation in executive compensation is a consequence of the form in which compensation is provided."

"[I]s it possible to to alert certain features of long-term incentives in order to increase their perceived value? For example, complex performance criteria appear to increase the level of risk and uncertainty in long-term incentives and hence reduce their perceived value. Executives might be more effectively motivated by receiving smaller rewards which do not have complex performance conditions attached. Most radically, might it prove to be both more effective and efficient ti arrest the trend of placing increasing reliance on high-powered long-term incentives."