Does the compensation plan provide the right incentives?

Incentives are key to driving R&D manager behavior.  We have often discussed different approaches to improve financial incentives. A new article from McKinsey Quarterly has a unique take on how to evaluate compensations plans (Does the CEO compensation plan provide the right incentives?).  The premise is that in addition to the remuneration for the current year, the accumulated wealth from the entire tenure drives executive behavior.

Boards, shareholders, and journalists often look at a chief executive’s annual compensation plan to determine whether the company is offering the right incentives to increase shareholder value. But few consider another key question: how does the compensation that the CEO has already received over the years in the form of stock and stock options influence managerial decision making?

The authors compared the median total annual compensation of chief executives and comparing it with their median total accumulated wealth. Their analysis shows that median accumulated wealth is nine times the year-to-year compensation for a CEO of a large company.

Our research shows that for most CEOs in the United States, accumulated wealth effects are likely to swamp those of year-to-year compensation—meriting serious attention when boards evaluate how risk structures and incentives of executive pay packages align with the company’s strategy.

We have discussed the inability to tie pay to executive performance (See Problem with Financial Incentives). We have also talked about longer vesting periods to better align performance with pay.  This article gives a somewhat new perspective that longer vesting periods might actually have a negative impact because the accumulated wealth might start outweighing new compensation.

Another unique perspective in the article is the convexity of the compensation package. If the compensation package is shares, the wealth change is linear with the stock price.  Stock options on the other hand increase in value much more rapidly.

If the CEO’s portfolio contains only shares, it will tend to rise and fall one-for-one with a change in stock price. We refer to this as “low convexity.” If, however, the CEO’s portfolio contains a large number of stock options, and especially multiple tranches of out-of-the-money stock options, the payoff curve can become quite steep (high convexity). Convex payoff structures such as these provide more financial incentives for CEOs to take on promising—albeit risky—investments because the CEO stands to earn very large rewards if successful.

Hence, as we have discussed before, stock options encourage risk taking to get to the higher payoff.  More risk taking may or may not be advantageous for the company and the board needs to be cognizant of its implications.  The article does not address it, but we have discussed the inability of stock options to actually drive good behavior.

So what is the overall recommendation? Understand the accumulated wealth effect before deciding on a compensation plan.  This is especially pertinent for a longer term manager who is likely to have accumulated a large wealth.  Decide whether you want more risk taking before granting stock options.  Finally, benchmark with other companies and industries to decide the appropriate balance.

“Since this analysis is relatively new, and wealth effects aren’t routinely calculated and reported, we suggest boards do some benchmarking against peers to see if it raises questions about the financial incentives they have created for their CEO. Is risk in line with industry peers, and, more importantly, is it in line with the company’s strategic objectives? Have changes in the stock market changed the convexity of the CEO’s reward curve in a way that encourages excessive risk? If so, should the board change the mix of future annual pay grants to get the curve back in line with objectives? Should it reprice existing options to reduce convexity? If the CEO wants to sell or hedge some of his or her personal portfolio in order to reduce personal-investment risk, how will this change the incentives to perform?”