www.pwc.com/hrs                      Making executive pay work                      The psychology of incentivesA global s...
About our studyThis research was carried out by PwC1 in                                                       Participants...
Participants by region                           Participants by countryMiddle East (7%)                 North America   A...
‘ he results illustrate much of what’s wrong with executive pay –                                                         ...
“ clear and immediate reward for successes A motivates people. Promises that extend way into the future demotivate people....
Executive summaryKey findingsExecutives are               Complexity                 The longer you              It’s all ...
Design recommendationsPerformance pay has             Keep it short, sweet           One size does not              Money ...
It’s all about incentives
‘ lobally, there is an increasing trend for companies to turn G towards incentive pay, for a variety of reasons.’Incentive...
‘ s the saying goes, the definition of insanity is doing the same                                                         ...
‘ t’s surely valid to ask some challenging questions I about pay for performance, and in particular, LTIs.’
What do executives really think?12   Making executive pay work. The psychology of incentives
‘ re BRICs different from developed economies? Are men different from women? Do executives A from different sectors vary i...
Executives are risk-averse                                                                     Executives’ attitude to ris...
But while it’s true to say that the majority     The research confirms the widely heldof executives are risk-averse, a clo...
Complexity and ambiguity                                                                      destroy value               ...
Executives clearly wanted to understand            It’s interesting that executives in the BRICthe rules of the game. Fift...
The longer you have to wait,                                                                     the less it’s worth      ...
All Western   North                     Asia- Central  South                      Middle          Africa                  ...
It’s all relative –                                                                     fairness is fundamental           ...
Another take on fairness was tested             Half of respondents set the maximumthrough the ‘ultimatum game’.          ...
There’s more to work                                                                      than money                      ...
But the second consequence is that peopleclearly get anchored onto a current levelof earnings. The discount people wouldac...
LTIPs motivate throughrecognition as muchas incentive          The findings so far paint a grim picture          for long-...
Overall, nearly two-thirds of participants     LTIP effectiveness by countryagreed that they valued the opportunity       ...
What does it mean for reward?                                                               This research suggests that ma...
Performance pay has a cost – be sureyou’re getting valueOur research shows that executivesmaterially discount bonus relati...
Keep it short, sweet and simple                   Where performance pay is used, we                                       ...
There’s also a role for greater choice here.    But the strongest findings in this area relateWe’ve got used to the idea o...
Looking to the future                                                                    We see that performance pay still...
ContactsUnited Kingdom               IndiaTom Gosling                  Padmaja Alaganandan+44(0)20 7212 3973           +91...
www.pwc.com/hrsPwC firms help organisations and individuals create the value they’re looking for. We’re a network of firms...
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PwC-Studie: Zu komplexe Anreizsysteme motivieren wenig / "Making executive pay work - The psychology of incentives"

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Zürich (ots) - - Hinweis: Die PwC Studie "Making executive pay work - The psychology of incentives" kann kostenlos im pdf-Format unter http://presseportal.ch/de/pm/100008191 heruntergeladen werden - Entlöhnung - da ... / http://ots.ch/600ddf1

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PwC-Studie: Zu komplexe Anreizsysteme motivieren wenig / "Making executive pay work - The psychology of incentives"

  1. 1. www.pwc.com/hrs Making executive pay work The psychology of incentivesA global study intothe impact of payand incentives onsenior executives.
  2. 2. About our studyThis research was carried out by PwC1 in Participants 1,106conjunction with the London School ofEconomics and Political Science. 1,106 8%participants took part in the study, 81% 24%of whom were male and 19% female. 187 29% 7%worked in the financial sector (22% ofwhom were female). 9% 7% 16%The executives had a wide range of 1,106 executives from 43 countries participated in the studysenior roles in various sectors and werecategorised into three earnings’ bands of$350,000 and under (66% of participants),between $350,000 and $725,000 (24%of participants), and over $725,000 (10%of participants). 81% Male Female 19% 66% Earned $350,000 or under 24% Earned $350,000–$725,000 “PwC” refers to the network of member firms of1 10% Earned $725,000 or more PricewaterhouseCoopers International Limited (PwCIL), or, as the2context requires, individual member firms of the PwCwork. The Making executive pay network. psychology of incentives
  3. 3. Participants by region Participants by countryMiddle East (7%) North America Australia 62 (29%)Africa (7%) Brazil 56 China 59CEE(8%) France 44 Germany 38SOCAT India 83(9%) Mexico 30 Netherlands 55Asia Pacific Western Europe(16%) (24%) Poland 33Q10: Where are you based? Republic of Ireland 29Base: All respondents (1,106) Russia 45 South Africa 45 Spain 28 Switzerland 52 UK 75 US 147 Other 225 50 100 150 200 250 Q10: Where are you based? Base: All respondents (1,106)
  4. 4. ‘ he results illustrate much of what’s wrong with executive pay – T and there is plenty wrong – but also what works.’ There is an emerging consensus, at least in Last year, in conjunction with Dr AlexanderExecutive pay Western economies, that there is something deeply flawed about the current model of Pepper of the London School of Economics and Political Science, PwC carried outisn’t working executive pay. Put at its simplest, executive pay has risen dramatically over a period an initial study in the UK which was designed to test how company executives when, in hindsight, the Western economic value and react to different types of pay. model has not been at its most successful. The study was driven by a belief that the Surely something must be wrong? fundamental model of executive pay in the UK was flawed and that in order to fix the The debate about executive pay has focused problem, we had to go back to the basics on whether shareholders are getting of human behaviour. The resulting report what they want, whether current levels was a revealing indictment of many of the of executive pay are acceptable to society features of the current executive pay model. and whether remuneration committees are In particular, it provided insight into why doing their job properly. But surprisingly long-term incentives often just don’t work. little attention has been paid to perhaps the most important constituency: executives The next step for us was to discover if themselves. If executive pay were genuinely the same results hold true for executives motivating executives towards higher levels globally and this report explains the of performance, with benefits for all, there findings of a comprehensive study of would surely be less controversy about the executives across 43 countries. The subject. But is it? Does the current model results illustrate much of what’s wrong really work for the individuals it is meant to with executive pay – and there is plenty be motivating? wrong – but also what works. Some of the regional and country differences in attitudes hold valuable insights for leaders of multinational organisations. We hope it will prove an important contribution to the debate over executive pay.4 Making executive pay work. The psychology of incentives
  5. 5. “ clear and immediate reward for successes A motivates people. Promises that extend way into the future demotivate people.” Male Executive, Pharmaceuticals, USA
  6. 6. Executive summaryKey findingsExecutives are Complexity The longer you It’s all relative People don’t just The key motivationrisk-averse and ambiguity have to wait the – fairness is work for money of a long-term destroy value less it’s worth fundamental incentive plan is recognitionMost people chose Fifty percent more Executives value Most executives would Participants would take Fewer than half offixed pay over bonus of executives choose a deferred pay choose to be paid less a 28% pay cut for their executives thinka higher value – only clearer pay package than significantly below its in absolute terms but ideal job that their long-term28% chose the higher a more ambiguous one of economic or accounting more than their peers – incentive plan is anrisk bonus the same or potentially value – a deferred bonus only a quarter choose a The result is very effective incentive higher value is typically discounted higher absolute amount, consistent, globally, withExecutives in Australia by around 50% over but which is less than the lowest cut being 24% But two-thirds ofand the UK are most Two-thirds more three years their peers (India) and the highest participants valuerisk-averse, those in executives prefer an 35% (USA) the opportunity toBrazil and China most internal measure they Discounts are Fairness is much less participate in their firm’swilling to take on risk in can control (such as particularly high in important in Brazil and long-term incentive plantheir pay profit) as opposed to Asia and Latin America, China than in other an external relative with deferred payments territories, but you can’t measure (such as total being discounted by up generalise about BRICs, shareholder return) to two-thirds in the eyes as it is most important of executives in India6
  7. 7. Design recommendationsPerformance pay has Keep it short, sweet One size does not Money is only Be realistic abouta cost – be sure you’re and simple fit all – know your part of the deal – how variable pay cangetting value people and pay them and recognition be from year to year accordingly matters as much as financial incentivesPerformance pay is discounted Be thoughtful about where Be cautious about assuming Pay is as much about fairness Only a limited number ofcompared to fixed pay deferral and long-term your pay design will work and recognition as it is executives will be motivatedby around 10% for cash incentives are operated, and globally – attitudes to about incentives by highly leveraged andbonuses and 50% or more for restrict their use to where incentive pay are very volatile pay packages – lessdeferred bonuses and long- there is a clear payback different in developed and Simpler plans can achieve the volatility may mean you canterm incentives emerging markets recognition benefit with less pay less Whenever possible go for the discount to perceived valueBe sure the inefficiency simpler option – requiring Think about how to provide If incentives form the majorityof paying your people executives to hold shares choice and flexibility in of the total package, acceptthrough performance pay may be a better approach pay programmes – higher that they won’t be zerois outweighed by benefits than plans with complex perceived value may outweigh very oftensuch as the incentive to performance conditions the administrative costperform better or the costflexibility provided 7
  8. 8. It’s all about incentives
  9. 9. ‘ lobally, there is an increasing trend for companies to turn G towards incentive pay, for a variety of reasons.’Incentive-based pay for executives and This is not a uniquely Western The end result is that incentives andsenior management has become almost phenomenon. Globally, there is an performance-based equity are the payubiquitous over the past two decades. The increasing trend for companies to turn structures of choice. Long-term incentivetransformation in developed economies towards incentive pay, for a variety (LTI) plans have become evermorehas been largely driven by the desire to of reasons. Performance pay provides complicated, often combined with clawbackalign the interests of management and flexibility in uncertain times. Governance arrangements, net holding requirementsshareholders on the assumption that has gone global, and shareholders in and performance-based deferrals of cashexecutives will perform better if they many markets have become more active bonuses in response to shareholder andare heavily incentivised. The financial in pressing companies to link pay to regulatory pressures, and in an attempt tocrisis and subsequent recession in many performance. There’s an element of align pay to business performance.developed countries added another developing economies choosing to adoptdimension to the debate. The crisis has Western compensation practices in orderresulted in an intense scrutiny of executive to compete with Western employerspay, particularly in financial services. This that have entered their market. Andreinforced companies’ natural tendency employment market forces have also playedto seek to link pay and performance their part. The intense competition formore closely – and that inevitably means talented executives in the fast-growingthrough long-term, usually share-based, BRIC countries, for instance, has drivenincentive schemes. up reward packages and in those countries with high churn rates, long-term incentives are seen as a vital tool in retaining the best. The theme of the last decade has been global convergence – of pay levels and structures – for an internationally mobile group of senior executives. Making executive pay work. The psychology of incentives 9
  10. 10. ‘ s the saying goes, the definition of insanity is doing the same A thing over again and expecting a different result.’ The fundamental question, though, is The recent financial crisis and theBut do they work? whether incentives actually do the job they’re intended to do. perception that bonuses played a role in causing it has led to a renewed focus on performance pay. But even now, the Reward design tends to assume that people ‘solutions’ put forward are still based on the make rational decisions, but is that really assumption that performance-related pay the case? The issue of performance pay works, and that the answer is to structure has polarised academics for some time, it differently, to have more sophisticated but questions are increasingly being asked payout formulae and to defer pay over about its effectiveness. In those markets longer periods. that have used them longest it’s also becoming increasingly clear that there As the saying goes, the definition of is something seriously wrong with LTIs. insanity is doing the same thing over again Companies invest an enormous amount and expecting a different result. Given that into these plans, but the response from this ‘age of governance’ has not coincided executives can rarely be said to justify with a period of conspicuous success for the cost. the Western economies that gave birth to it, it’s surely valid to ask some challenging questions about pay for performance, and in particular, LTIs.10 Making executive pay work. The psychology of incentives
  11. 11. ‘ t’s surely valid to ask some challenging questions I about pay for performance, and in particular, LTIs.’
  12. 12. What do executives really think?12 Making executive pay work. The psychology of incentives
  13. 13. ‘ re BRICs different from developed economies? Are men different from women? Do executives A from different sectors vary in their attitudes?’Our latest research, in conjunction with Dr So we worked with Dr Pepper to extend So what did we find? Broadly, the researchAlexander Pepper at the London School of the study. The research involved asking supports the findings of the UK study,Economics and Political Science, seeks to senior executives to complete a structured although there are some fascinatingprovide the evidence that’s needed about interview questionnaire, based on well- variations by geography and gender. Ourhow executives – the group of people whose established techniques of behavioural report shows that there are many featuresperformance is meant to be improved by economics, which explored the trade- of deferred pay and LTI plans that are likelyincentive pay – react to incentives. offs that individuals make between risk, to limit their effectiveness. But there is also reward, certainty and time. Our panel of evidence that we shouldn’t throw the babyThis research follows on from a joint study participants comprised 1,106 executives in out with the bathwater; nearly half of theof around 100 UK executives, which led to 43 countries, within a wide range of senior participants said that their company’s LTIour 2011 research report and which led us roles, companies and industries. plan was an effective incentive, and two-to question the effectiveness of LTIs and thirds said they valued the opportunity toto set out a series of design principles that For the first time, we analysed the participate in it.companies should follow to get the best responses of our participants by gender,value for money. by age and by country. We also examined To get best value from these plans, it’s whether executives in the financial services important to base designs on evidenceWe wanted to find out if the results held sector – who are more familiar with the rather than conjecture, and to use ourglobally for all executives. Are BRICs financial technicalities of incentivised pay latest understanding of behavioural sciencedifferent from developed economies? – react any differently than executives in to come up with performance plans thatAre men different from women? Do other sectors. The results reveal a number actually do what they are meant to do.executives from different sectors vary in of common behavioural traits, which show Performance pay is with us – we need totheir attitudes? clearly that executives don’t necessarily make it work. think in the way that many incentive schemes assume. Making executive pay work. The psychology of incentives 13
  14. 14. Executives are risk-averse Executives’ attitude to risk was assessed It’s clear from the results that risk aversion“ t’s a given that employees will I with two questions which asked increases with the amount at stake, and act to maximise anticipated participants to choose between a smaller, certain amount of money and a 50% chance that people will tend to choose more certain but less generous amounts over reward. I will always choose of receiving a larger sum with a higher less certain but more generous outcomes. more over less, now over later, expected value (the amounts were adjusted to take account of the executives’ current When offered a smaller certain amount or a gamble for a larger sum, just over half of and certainty over uncertainty.” pay). The first question was framed as a all respondents (51%) chose the certain gamble, the second as a bonus opportunity: amount. This seems to be a universalMale executive, Malaysia preference; contrary to popular perception, executives working in the financial sector Attitude to risk were slightly more risk-averse than the Which would you prefer as a general population. one-off gamble? a. 50% chance of $5,250 (or nothing) Participants in Africa were the most risk- b. $2,250 for certain averse, with 61% choosing the certain sum. c. Indifferent to a) or b) This increased to nearly two-thirds (64%) when the amount was increased. There was Given that the annual bonus of a senior only one region – South America – where executive of a large company is around more participants chose the gamble over $45,000, which would you prefer? the certain amount, and even in this case a. 50% chance of receiving a bonus of their preference switched when a larger $90,000 (or nothing) amount was offered as a bonus opportunity b. $41,250 for certain rather than a salary. In all other cases, c. Indifferent to a) or b) the majority preferred the smaller, safer option, or were indifferent between the two choices.14 Making executive pay work. The psychology of incentives
  15. 15. But while it’s true to say that the majority The research confirms the widely heldof executives are risk-averse, a closer view that women are more risk-averse thanlook at the results give the clear message men. But there were also some surprises.that one size doesn’t fit all. Overall, more Executives over the age of 60 were thethan a quarter (28%) of participants were most likely to take a gamble, while thoseprepared to gamble a certain sum for a aged 40–60 were least likely to risk thepotentially higher bonus. In other words, a smaller, certain amount for the chance ofsizeable proportion of executives are active a bigger win. Perhaps this is because olderrisk seekers. executives are more financially secure and have fewer commitments. Few would bePrepared to take a gamble? surprised that executives in the developedPopulation Proportion prepared to economies of the UK and Australia are more swap a certain sum of risk-averse than in the rapidly growing $41,250 for a variable Brazil and China – but the Dutch appear to One size doesn’t fit all bonus of up to $90,000 like a gamble too.Overall 28% 40–60Women 23%Men 30% This reinforces the point that companiesUK and Australia 15% need to know their audience. Incentives are more likely to work for risk-takers, but not 51%Netherlands, 35%+Brazil, China everyone likes risk to the same degree. Our Those aged 40–60 were leastFinancial services 32% study shows that most employees demand a likely to risk the smaller, premium of over 10% to take pay in bonus certain amount for the rather than salary, meaning that bonus is chance of a bigger win a relatively expensive way of paying many executives. Companies need to be sure that what they get in terms of improved performance and increased flexibility of cost is worth what they’re paying. When offered a smaller, 28% certain amount or a gamble for a larger sum, just over half of all respondents (51%) chose the certain amount 60+ Executives over the age of 60 Only around a quarter (28%) of participants were prepared to gamble a were the most likely to take certain sum for a potentially a gamble higher bonus. Making executive pay work. The psychology of incentives 15
  16. 16. Complexity and ambiguity destroy value The study tested attitudes to uncertainty Given that the annual bonus of a senior“ don’t assign any value to my I with three questions. The first was framed executive in a large company is around share allocations. I consider as a straightforward gamble – a choice between a 50% chance of winning a $45,000 and the median long-term incentive award is around $67,500 a them in the same way as a certain amount, or a chance of winning year, which would you prefer? company lottery ticket.” the same amount where the probability was unknown but could be anything a. A guaranteed bonus of $45,000 payable in three years’ time between 25% and 75%. The second and b. A guaranteed bonus of 20,000 sharesFemale executive, Australia third questions were framed as share and deliverable in three years’ time. The bonus awards: current share price is $2.25 and in the past 12 months the share price has fluctuated between $1.12 and $3.37 Impact of complexity c. Indifferent between a) and b) You are invited to participate in a one-off gamble. Which of the following choices Given the same facts, which would would you prefer? you prefer? a. 50% chance of winning $5,250 a. A cash bonus of up to $52,500, which (or nothing) will be paid in three years’ time if the b. A chance P% of winning $5,250 where company’s earnings per share grow P is unknown but is expected to be at at least 3% more than the Retail somewhere between 25% and 75% Price Index c. Indifferent between a) and b) b. A bonus of up to 23,350 shares, deliverable in three years’ time, depending on the company’s relative total shareholder return over the period when compared against a basket of comparable companies c. Indifferent between a) and b)16 Making executive pay work. The psychology of incentives
  17. 17. Executives clearly wanted to understand It’s interesting that executives in the BRICthe rules of the game. Fifty percent more nations – where it’s often assumed a ‘hereexecutives wanted to know the probability and now’ culture pervades – tended toof the gamble they were taking than were prefer shares over cash. Of course, both theprepared to bet on a situation where the cash and the shares are deferred, so if theyprobability could be higher or lower. And have to be locked into the deferral, perhapsoverall, two-thirds more favoured a cash they are inherently more optimistic aboutplan based on a condition that was internal the upside that shares provide.to their organisation (earnings per share)over the more ambiguous share plan based Once again the over-60s belied the imageon relative total shareholder return. of conservative sexagenarians – they were far more willing to take on uncertainty inDislike of relative total shareholder return exchange for a higher upside. Only 29% ofwas most pronounced in those countries those aged between 60 and 64, and 32% of Cash or shares?that have lived with it the longest and so those over 65, chose the smaller cash bonussuffered its vagaries more than others, over shares. Prefer sharesnamely the UK, Netherlands, Switzerlandand Australia, although the Chinese and The message here is that uncertainty and Share Share Share ShareIndians were also less than keen. complexity are a turn-off for most people. In almost every case, participants selectedAttitudes to deferred shares versus deferred the less complicated option. The morecash were quite varied. Overall, there was complicated the reward, the more likelya slight preference for deferred cash, with they were to choose the smaller but more Brazil China India USaround a fifth more executives preferring certain award. Given that most LTI planscash over shares, although there were some are invariably complicated, there is asignificant differences by country. clear warning here that an unnecessarily Prefer cash complicated system is unlikely to produceCash or shares? the best results. But remember thatPrefer shares Brazil, China, India, US complexity is relative – if executives dealPrefer cash Australia, Netherlands, with the metrics and reporting information Switzerland, UK that are linked to their awards as a regular part of their job, it will appear simpler to them than it would to someone who only Australia Netherlands Switzerland UK comes across these measures when it comes to assessing their performance. It’s interesting that executives in the BRIC nations – where it’s often assumed a ‘here and now’ culture pervades – tended to prefer shares over cash. Of course, both the cash and the shares are deferred, so if they have to be locked into the deferral, perhaps they are inherently more optimistic about the upside that shares provide. Making executive pay work. The psychology of incentives 17
  18. 18. The longer you have to wait, the less it’s worth Executives’ attitude to time was assessed Given the same facts as above, which“ eople need to feel that their P using three questions that compared the would you prefer? efforts are being rewarded in a possibility of receiving a certain amount today, or a larger sum in three years’ time. a. 75% chance of receiving a bonus of $56,250 tomorrow, otherwise nothing concrete way.” Some of the questions were framed in such b. 75% chance of receiving a a way that it was possible to estimate the bonus of $90,000 in three years,Female executive, Poland discount rates that participants attach to otherwise nothing the deferred payments. c. Indifferent between a) and b) Impact of time on perceived value The results show that when there is You’re invited to take part in a one-off uncertainty about whether a payment will gamble. Which of the following choices be received, executives across the globe would you prefer? apply discount rates to deferred payments a. 75% chance of winning $2,250 that are massively in excess of economic tomorrow (25% chance of nothing) discount rates. This is an illustration of b. 75% chance of winning $5,250 in three the difference between financial theory years (25% chance of nothing) and real-life behavioural economics. c. Indifferent to a) and(b) Financial theory says that individuals should discount at rates consistent with Given that the median long-term the return on comparably risky cash flows, incentive award of a senior executive of which in this case should be near the ‘risk- a large company is around $67,500 a free’ interest rate of around 5% per annum year, which of the following choices would (used in accounting valuations of LTIPs). you prefer? The study, though, shows that executives a. 75% chance of receiving a bonus more typically discount at around 30% per of $37,500 tomorrow (25% chance annum – this is the economics of ‘eat, drink of nothing) and be merry, for tomorrow we may die’. b. 75% chance of receiving a bonus of $90,000 in three years (25% chance of nothing)18 Making executive pay work. The psychology of incentives c. Indifferent between a) and b)
  19. 19. All Western North Asia- Central South Middle Africa Europe America Pacific Eastern Central East Europe AmericaEstimated 31% 20% 31% 42% 26% 45% 37% 40%discount ratePerceived $0.50 $0.65 $0.50 $0.37 $0.56 $0.34 $0.43 $0.39value of$1 deferredpro rata overthree years* or example, with a discount factor of 31% pa a three-year phased deferral of $1 will have a perceived value of: $1 x (1/3) x [(1-0.31) + F (1-0.31)2 + (1-0.31)3] = $0.50Younger executives tended to discount at Shareholders, regulators and corporate Typical discountinga higher rate than others (those under the governance bodies have generallyage of 39 applied a 45% discount rate). assumed that deferred bonuses are aThey have more immediate financial needs powerful way of influencing behaviourand are more likely to value money today and aligning executives with shareholdersover money tomorrow; those between the and prudent risk-taking. These findingsages of 55 and 59 applied a rate of 22%. place a significant question mark over the effectiveness of the deferral model. 30%The discount rates applied also varied from The best-case scenario, in Europe, is thatcountry to country. The table above shows deferral results in a discount of one-the implied annual discount rate applied third in perceived value. But in emergingto deferred awards. The second row shows markets and the BRICs the discount is morethe resulting perceived value of $1 of like two-thirds. This seems to be a verybonus, which is paid out over one, two and heavy price to pay. A clear consequencethree years, the typical deferral structure is that as deferral increases, we shouldendorsed by financial services regulators. expect upward pressure on the level of compensation.This tendency to discount future awardsheavily is replicated across all sectors. The data also shows the dangers of pushingIt might be safe to assume that anyone a one-size-fits-all remuneration policyworking in the financial sector would be globally. Western companies expandingused to deferral and might be more likely into emerging markets need to be very Executives typically discount at aroundto discount at a reasonable rate, given careful about assuming that home-country 30% per annum – this is the economics ofthat they have a better understanding of deferral policies will travel well. ‘eat, drink and be merry, for tomorrow wediscounting than most, but this isn’t the may die’.case. The discount rates that participantsmentally apply to an amount received inthree years’ time are consistent for thoseworking in financial services and thoseworking in other sectors. Making executive pay work. The psychology of incentives 19
  20. 20. It’s all relative – fairness is fundamental One of the strongest messages to come out Jean subsequently discovers that“ t really becomes a problem when I of the research was that the overriding the average pay among A’s senior people start to talk. If you don’t concern for executives is whether their pay is comparable against their peer group. The management team is $180,000, while Jacques discovers that the average pay know what people earn, it’s not results suggest strongly that executives are among B’s senior management team a problem.” content as long as they are paid what they consider to be ‘fair’ within the hierarchy is $202,500. Who’s likely to be more highly motivated? of their own company, and comparablyMale executive, UK against those on a similar level in competitor companies, to the extent that it Participants almost everywhere agreed that almost becomes irrelevant how much they Jean was better motivated than Jacques. In are paid. It seems to be deeply ingrained other words, getting paid more than their within human psychology to compare peers was more important than getting ourselves with others. paid more in absolute terms. But there were exceptions. Only 35% of executives in The executives were asked this question: Central and Eastern Europe said that Jean was better motivated, while 45% favoured Jacques. Similarly, in China and Brazil, the Testing attitudes to fairness through higher absolute sum was felt to be more the relativity question motivating. Fifty-six percent of Chinese Jean and Jacques are two friends leaving said that Jacques would be more motivated. business school. Jean is offered a job to Could it be that executives in countries that join the senior management of Company are experiencing higher levels of economic A with a total reward package of growth are more interested in absolute $187,500. Jacques is offered a job on the wealth creation, and so concentrate more senior management of Company B with a on absolute amounts than relativity? total reward package of $195,000.20 Making executive pay work. The psychology of incentives
  21. 21. Another take on fairness was tested Half of respondents set the maximumthrough the ‘ultimatum game’. amount they’d offer equal to the minimum amount they’d accept – reflecting a strong sense of fairness. One-third were moreTesting attitudes to fairness through cautious – they’d accept less than they’dthe ultimatum game offer. In other words, they would play it safeAdam and Zoe are brought together in to make sure they got some reward. Onlyan experiment: 15% would play aggressively, offering less• Adam is given $100,000 and told than they’d accept. he can split this in any way he likes with Zoe. There was no major difference in the• Zoe can then choose to accept or reject attitude of men and women, or between Adam’s offer. those working in financial services and• If Zoe accepts the offer they both get other sectors. However, there were some Jean and Jacques their money. interesting country differences. China• If Zoe rejects the offer they both was the only country where more people Jean Jacques get nothing. would play ‘aggressively’ rather thanAdam and Zoe both know that the total ‘fairly’, consistent with their approach toamount is $100,000 and they both the relativity question. But those wishingknow the rules of the game. They can’t to generalise across the BRICs shouldnegotiate because they are kept separate take care – India was among the countriesthe whole time. with the highest proportion advocating a Total Total reward fair approach. reward $195k $187.5kParticipants were asked how much they But why does this matter for the designwould offer if they were Adam, and how and governance of pay? It’s important for Companymuch they would accept if they were Zoe. two reasons. The first is disclosure – in Company average averageThe economist’s answer is that Zoe should many countries there is a drive for greater $180k $205.5kaccept whatever she is offered, as even $1 is disclosure of pay on the basis that thisbetter than nothing. Equally, Adam should will lead companies to exercise restraint.only offer $1 and keep the rest. However, This research suggests the opposite,this goes against our instinct of fairness that disclosure will simply provide more Participants almost everywhere agreed that Jean was better(not a known characteristic of economic opportunities for cross-comparisons and motivated than Jacques. In other words, getting paid moreman). An offer of $1 is too derisory to consequent pay ratcheting. than their peers was more important than getting paid moreaccept, and maybe Adam would be wiser in absolute terms.to offer half the money, so he could be sure The second point is that complicatedthat he would at least get $50,000. But this incentive plans can sometimes result in anignores the fact that Adam has been given outcome that participants consider to bethe right to determine the offer. unfair, and unfairness is something that they remember, and resent. Making executive pay work. The psychology of incentives 21
  22. 22. There’s more to work than money Money is only part of the equation. People Participants were consistently more“ ersonal fulfilment is very P work for pay and benefits (the extrinsic idealistic on Franco’s behalf than when important. Money is a means rewards), but also because they want to, and find it fulfilling (the intrinsic rewards). thinking about their own position. On average, they estimated that Franco should to achieving what you want or A pair of questions were asked to test this take a pay cut of 60% for his ideal job, need, but never should be the theory, and were designed to identify how much money people would be prepared to but would only be prepared to take a 28% cut for their own dream job. The region ultimate goal.” give up for their ideal job. accepting the lowest discount was Africa, with 24%. Indians showed the biggest gapFemale executive, Brazil between fantasy and reality – they said Ideal job discount that Franco would accept a 70% pay cut, The first question asked participants but would only accept 24% themselves. to estimate the minimum salary that The US was where executives were most ‘Franco’, a senior executive at a large willing to give up pay for fulfilment – 35% listed company, would be prepared was the median pay cut they would accept, to accept in his dream job, a senior although a quarter said they would do their management role at a music college. The ideal job for half the current pay. second asked participants the maximum discount they would be prepared to accept The research has two interesting on their own current pay, if they were consequences. One is that increased offered their dream job. job satisfaction can be very valuable. Investment in making people’s jobs more interesting and fulfilling means you can pay them significantly less.22 Making executive pay work. The psychology of incentives
  23. 23. But the second consequence is that peopleclearly get anchored onto a current levelof earnings. The discount people wouldaccept for their ideal job was remarkablyconsistent across a wide range of roles,earnings’ levels, geographies andindustries. On the whole, people find itdifficult to imagine working for less thanabout two-thirds of their current earnings.Those in the investment banking industrywill understand this very well; pay hasfallen by around a third over the lasttwo years and employees are finding itdifficult to adjust. They may still be veryhighly paid, relative to other industries,but they’ve been asked to accept the levelof pay cut that most would only accept fortheir ideal job. Can banks really say thatthis is what they’re offering? This may be aworrying omen for the future.In a similar vein the results show thatcompanies (and investors and regulators) Increased job satisfaction can be very valuable.need to be realistic about how variable paycan truly be, year-on-year. If a decrease of Investment in making people’s jobs moremore than 25% represents a fracturing of interesting and fulfilling means you can paythe psychological contract in an executive’s them significantly less.mind, then it may be that thinking thattwo-thirds of the package can be trulyvariable is little more than fantasy.
  24. 24. LTIPs motivate throughrecognition as muchas incentive The findings so far paint a grim picture for long-term incentives. Many of their key characteristics – high risk, complex and ambiguous performance conditions, arbitrary and unfair outcomes, multi- year deferral – suggest that individuals will discount them to a fraction of their economic value. And our experience suggests this to be the case. Yet, intriguingly, the participants in our study had a more positive view. At the end of the survey they were asked three direct questions about long-term incentives: LTI effectiveness 1. Are you strongly motivated to participate in your firm’s LTIP? 2. Do you value the opportunity to participate in your firm’s LTIP? 3. Is your firm’s LTIP an effective incentive?
  25. 25. Overall, nearly two-thirds of participants LTIP effectiveness by countryagreed that they valued the opportunity Country Proportion ofto participate in their organisation’s LTIP. respondents agreeing that their firm’s LTIP is anFewer than 20% disagreed. By contrast, effective incentivefewer than 50% felt their firm’s LTIP was Overall 50%an effective incentive and almost a quarter China 65%positively felt it was not. UK 60% India 55%So, it appears that to some degree, LTIPs Brazil 53%are successful as a recognition tool US 48%(because those participating are seen Switzerland 38%to have a higher status) rather than as a Australia 38%meaningful direct incentive. Men were Netherlands 29%significantly more positive towards LTIPs Motivation through LTIPsthan women, perhaps reflecting the greater The unexpected outcome is for the UK –importance they attach to status. our consulting experience is that UK levels of frustration with LTIPs is very high. So isThe results show that the countries this a sampling error, or are LTIPs secretlywhere LTIPs are viewed as a most more loved in the UK than executiveseffective incentive are those that let on?haven’t experienced them as part of the 50%compensation mix for very long, and Overall, the findings aren’t encouragingwhere they do exist, they’re generally in a for the governance-driven complexities offairly simple form. Executives in countries the western LTIP model. When even on anwhere LTIPs have gradually become more optimistic basis only half of participantscomplex as a result of governance rules view the plans as an effective incentive,and shareholder guidelines are more jaded there’s surely much room for improvement.about their effectiveness: By contrast, only half felt that their LTIP was an effective incentive. Making executive pay work. The psychology of incentives 25
  26. 26. What does it mean for reward? This research suggests that many aspects of long-term incentive plans mean they are designed to fail. Executives are risk-averse, don’t like complexity and discount deferred pay. The pay systems we’ve adopted have many features executives dislike and don’t value – and we’ve had to pay executives more to compensate. If pay better reflected executive psychology, maybe it could be lower. Of course the key findings hide a wide degree of variation. For example, although on average executives are risk-averse, more than a quarter are risk-seeking, rising to nearly half in China. Time discounting is particularly severe in Asia-Pacific and in Central and South America, with deferral wiping around two-thirds off the perceived value of a bonus as opposed to one-third in Western Europe. Even generalising about emerging markets is a mistake – for example Indians are far more concerned about fairness than the Chinese. While the findings hold true in general, companies need to be aware of the exceptions. What recommendations can we draw for business leaders?26 Making executive pay work. The psychology of incentives
  27. 27. Performance pay has a cost – be sureyou’re getting valueOur research shows that executivesmaterially discount bonus relative to fixedpay, deferred pay relative to immediate pay,and complex or ambiguous schemes relativeto simple ones. Add it all up and incentivepay can easily be discounted by half,relative to fixed pay in executives’ minds.So paying in incentives rather than salaryis an investment. And like any investmentcompanies need to be clear about the pay- Incentive pay can easily be discounted by half, relative to fixed pay in executives’ mindsback. Is the payback better performance? Ifso, what’s the evidence you’re getting it? Is Economic or accounting costit about cost flexibility? If so, how much doyou need? Is it just that you’ve got to offer itbecause everyone else does? If so, have youtested that assumption? Salary Cash bonus Deferred LTIPIn too many cases performance pay is bonusdeployed with blind faith rather than coldanalysis. Companies should challengethemselves whether everyone who is in aperformance pay plan should be, and if sothen to what extent. -33% Perceived value TotalOf course, kicking the performance pay -50% Incentive pay compensationhabit can be hard, because how do youmanage without it? Well, maybe that’s theanswer – you manage. Making executive pay work. The psychology of incentives 27
  28. 28. Keep it short, sweet and simple Where performance pay is used, we If using performance pay has a cost, need to adopt the simplest possible form. deferring it just multiplies that. Our Regulatory constraints and shareholder research shows that on average, a simple guidelines make this challenging. phased three-year deferral (so beloved Sometimes there will be no choice but to of financial regulators) will reduce the adopt more complex arrangements than is perceived value of pay by one-half on ideal. But where there is choice, let’s take average. The impact in the BRICs is even the simpler path. more extreme with deferral wiping around two-thirds off the perceived value of pay. One size does not fit all – know your people and pay them accordingly The agency theory view is that deferral Different demographic groups have a makes executives think longer term. different attitude to risk, and cultural But it is difficult to see how something factors also have their part to play inThe pay systems we’ve adopted different geographies. This suggests that that has such low perceived value canhave many features executives be a significant influence on behaviour. a centralised incentive strategy simplydislike and don’t value – and Deferral does, of course, enable bonuses won’t work. Organisations should start to be reduced if performance declines, developing a deep understanding of thewe’ve had to pay executives and there are cost advantages, as well as a attitudes and preferences of their ownmore to compensate. sense of natural justice in this. But why not executive population. just pay less in the first place, but in a form executives value more? ‘Clone and go’ incentive strategies have become popular because of their This also helps with simplicity. Complex administrative simplicity and internal plans are a motivation killer. The idea that comparability, but this study shows there’s we can manage by incentives has led to likely to be a significant cost incurred for evermore complex metrics frameworks and standardisation. Organisations need to formulae. These have many consequences, think about how to adopt tailored reward most of them unintended. But a key one is programmes, where employee choice plays the further reduction in value they cause in a bigger role, without losing control. the eye of the executive. At one level this may mean more tolerance Relevance is another important factor of different regional or country practices. A – adopting performance conditions that hard-headed cost-benefit is needed. If more are perceived as relevant to executives’ flexibility makes pay programmes more jobs and within their influence improves effective, then perhaps this is worth the appreciation. Relative external metrics such extra administrative cost? as Total Shareholder Return, while good in theory, rarely motivate in practice. Using simpler plans based on long holding periods for stock may be a better way of aligning executives and shareholders than complex performance metrics.28 Making executive pay work. The psychology of incentives
  29. 29. There’s also a role for greater choice here. But the strongest findings in this area relateWe’ve got used to the idea of flexible to fairness. This comes across as criticallybenefits as a way of increasing the important for many executives. Of course,perceived value and flexibility of benefits’ fairness is easier to preach than to achieve,packages. Why not extend further? Some but must be an objective. This will requirecompanies already offer the choice between appropriate discretion in pay systems – andrestricted stock and options for example, the information and management maturitygenerally with results that suggest to apply it – to ensure fair outcomes.perceived value is improved. Could thisconcept be extended more widely through Be realistic about how variable paypay packages? Again, the trick will be to can be from year to yeardo this in a way that doesn’t just mean Even for their ideal job, executives will onlyspiralling complexity. But the potential gain accept a 28% pay cut – a finding that wasis considerable. remarkably consistent across the survey population. Yet, variable pay typicallyMoney is only part of the deal – and forms two-thirds of compensation for therecognition matters as much as most senior executives. Can it really befinancial incentives this variable? The evidence suggests not.Most executives said that they were This issue has caused much of the angst inmotivated by more than money. Investment the debate over executive pay. Maybe wein engagement and corporate culture can need to acknowledge that we’ve tried tosave a significant amount from the pay make incentives too big a part of the total.bill, through individuals’ willingness to Simpler, less leveraged packages, with lessaccept a pay discount for more fulfilment. volatile outcomes may be more valuable toRecruitment and retention decisions go executives and cheaper for shareholders.beyond the purely financial.Moreover, the recognition provided byparticipation in LTIPs seems to be more Simpler, less leveragedimportant to motivation than the financial packages, with less volatileincentive. Companies should think harderabout how they communicate this rather outcomes may be morethan working on evermore technical valuable to executives andLTIP designs. cheaper for shareholders. Making executive pay work. The psychology of incentives 29
  30. 30. Looking to the future We see that performance pay still has an important role to play. But itsMost of all, the design of use needs to be more discriminating. In some situations you’re better offperformance pay needs to be without it – the business case for its use needs to be clear.simpler and more relevant to We need to consign to the scrap heap the agency model approach tothe people whose behaviour executive pay, based on ‘rational economic man’, which has been soit’s meant to influence – unhelpfully influential in current Western pay systems.executives themselves. Most of all, the design of performance pay needs to be simpler and more relevant to the people whose behaviour it’s meant to influence – executives themselves.30 Making executive pay work. The psychology of incentives
  31. 31. ContactsUnited Kingdom IndiaTom Gosling Padmaja Alaganandan+44(0)20 7212 3973 +91 80 4079 4001tom.gosling@uk.pwc.com padmaja.alaganandan@in.pwc.comUSA South AfricaScott Olsen Gerald Seegers+1 646 471 0651 +27 (11) 797 4560scott.olsen@us.pwc.com gerald.seegers@za.pwc.comSwitzerland AustraliaRobert Kuipers Della Conroy+41 (0)58 792 4530 +61 (3) 8603 2999robert.kuipers@ch.pwc.com della.conroy@au.pwc.comGermany Hong KongKonrad Deiters Bruce CH Lee+49 89 5790 5931 +(852) 2289 5510konrad.deiters@de.pwc.com bruce.ch.lee@hk.pwc.comNetherlands BrazilJanet Visbeen Joao Lins+31 8879 26429 +55 11 3674 3941janet.visbeen@nl.pwc.com joao.lins@br.pwc.comMiddle EastChristopher Box+974 4419 2852christopher.box@qa.pwc.com Making executive pay work. The psychology of incentives 31
  32. 32. www.pwc.com/hrsPwC firms help organisations and individuals create the value they’re looking for. We’re a network of firms in 158 countries with close to 169,000 people who are committed to delivering quality in assurance,tax and advisory services. Tell us what matters to you and find out more by visiting us at www.pwc.com.This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication withoutobtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extentpermitted by law, PricewaterhouseCoopers does not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on theinformation contained in this publication or for any decision based on it.© 2012 PwC. All rights reserved. Not for further distribution without the permission of PwC. “PwC” refers to the network of member firms of PricewaterhouseCoopers International Limited (PwCIL), or, as thecontext requires, individual member firms of the PwC network. Each member firm is a separate legal entity and does not act as agent of PwCIL or any other member firm. PwCIL does not provide any servicesto clients. PwCIL is not responsible or liable for the acts or omissions of any of its member firms nor can it control the exercise of their professional judgment or bind them in any way. No member firm isresponsible or liable for the acts or omissions of any other member firm nor can it control the exercise of another member firm’s professional judgment or bind another member firm or PwCIL in any way.Design Services 27599 (04/12).

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