(Reuters) - There are only two problems with the way incentive-based executive pay works: neither the incentives nor the people who are supposed to be motivated by them work properly.
Norway’s $915 billion sovereign wealth fund, the world’s biggest, took a stand on Friday against executive long-term incentive plans which attempt, with little success, to align the aims of company owners with those hired to manage.
“For us, long-term incentive plans should be removed from pay packages. The packages we want in the future are very different from what they are now. They are too complicated,” the fund’s Yngve Slyngstad said following release of annual results. “We want simplicity.”
Long-term compensation now accounts for about 60 percent of executive pay in the U.S. and Britain. Slyngstad, whose fund owns more than 1 percent of global market capitalization, is right to have doubts. As they now stand LTIPs are often an overly complex matrix which bestow windfall gains on executives for events largely outside their control while failing to properly bind them to their employers’ bests interests.
Slyngstad’s call for simplicity is correct, but tinkering with the existing system won’t help much. The typical web of goals in an LTIP is a bad joke for those who know Goodhart’s law, the economist’s axiom which states that “When a measure becomes a target, it ceases to be a good measure.”
In specific, the system fails because our whole executive pay edifice is built on two ideas; the efficient market hypothesis (EMH) and the existence of Economic Man, a mythic figure who always does what will make him the most cash.
The former idea misunderstands how markets work and the latter what makes people tick.
Other than that, the system, which has pushed executive pay in the U.S. to a bloated 276 times that of the typical worker while delivering historically poor shareholder returns and economic growth, is just grand.
That the majority of executive compensation comes in the form of shares in the company has its roots in the adoption by management gurus of the 1970s of the efficient market hypothesis, the idea the current market price of a stock is the best single predictor of the future cashflows it represents, and thus of the success of the company. (here)
If you lived through the past two decades and believe that, I have some dotcom stocks and a collateralized debt obligation to sell you.
EMH found itself betrothed to the allied idea of shareholder value maximization, that companies exist solely to enrich their owners and that the market is the guiding north star in navigating how best that can be done. The result: pay executives in shares and they will do what’s needed to make the shares more valuable.
There are huge problems with that but just to name one: the average investor is saving for the distant future and the average executive, seeing as how they only hold the job for a few years, doesn’t have one. Companies began to live quarter by quarter, investment and innovation in publicly held companies fell and a huge transfer of wealth to executives ensued.
That the market is largely driven by another set of agents, fund managers, who tend to feed bubbles in highly priced stocks in order to feather their own nests and protect their own jobs just makes matters worse, or, if you will, less efficient.
This brings us to Economic Man, the guy who always maximizes his own rational self-interest. For economists, naturally, this became synonymous with maximizing his financial utility, a useful idea if you want to pretend that your social science is something akin to physics but an idea which, put into practice in the boardroom, quickly turns to farce.
But since Economic Man exists, the management theory went, the more we pay him not only the better he will behave but the better an example of his type we will recruit. This attempt to deal with the inherent conflicts between principals, who own the company, and the agents they hire to manage it has been largely a bust.
“What agency theory fails to account for is the real psychology of incentives,” Alexander Pepper, a management professor at the London School of Economics and former longtime employee of accountants and consultants PwC wrote last year.
“Research conducted over the past 35 years has found little evidence of a significant link between executive pay and performance. Many executives I encountered during my years with PwC raised similar concerns; they found incentive packages too complex, too long drawn-out, and they didn’t properly appreciate the value of the rewards on offer.” (here)
The executive pay system needs more than a reworking of long-term incentives, it needs a complete reboot.
(The opinions expressed here are those of the author, a columnist for Reuters)
Editing by James Dalgleish