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Using Insights From Behavioural Economics to Redesign Executive Compensation

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Not a week goes by without yet another story which describes how executive managers have abused their compensation, most notably income generated via target-dependent bonuses. Ranging from investment bankers to insurance brokers, the public opinion has generally converged on the fact that the remuneration of top employees requires redesign.

As their pay-off is contingent upon the achievement of mostly short-term goals, many current bonus structures set the wrong incentives for guiding executives' behaviour. A particular noteworthy example concerns executives at Fannie Mae, who manipulated their accounting records for years to gain higher bonuses, with little regard for the future. More recently, Stephen Elop's €18.8 million pay-off in the Microsoft/Nokia takeover and his role in the merger is under increasing scrutiny, with no definite outcome for the foreseeable future.

Due to increasing financial volatility and growing worries regarding the behaviour of top managers, shareholders and stakeholders (worldwide) hold a vested interest in redesigning the executive pay structure, which should ideally be aimed towards aligning the executive's behaviour with the interest of both parties.

Traditionally, interventions for behavioural change are aimed at prompting changes in cognitions, such as the provision of new information or changing incentives [1] in order for senior managers to make better informed decisions. One current approach proposed by the European Union attempts to limit - by law - the variable component to twice the base salary for all bank employees whose total compensation exceed $680,000 per year. This particular proposal has been contested by the U.K.'s Chancellor of the Exchequer, George Osborne, who has sued the European Union over the planned introduction of a bonus cap in 2014. Some financial institutions, such as Sweden's Handelsbanken (since 1973) and Dutch Rabobank have struck a different path, going so far as to completely abolish variable pay for their executive boards.

Whether it's limiting bonus payments or abolishing them altogether, both these approaches presume that senior managers will analyse these changes and then act in ways that reflect their best interest. In addition to the great resistance towards these approaches in the business community, the inherent assumption of overarching rationality in managerial decision-making makes the effectiveness of these particular interventions rather doubtful. In contrast, a different way to tackle the negative behavioural effects of current designs of bonus structures could stem from the field of behavioural economics, which integrates insights from psychology into economics. Two research findings with very robust evidence are of particular relevance to a redesign of executive pay: loss aversion and present-self vs. future-self inconsistencies.

In their landmark study [2], researchers Daniel Kahneman and Amos Tversky have shown that individuals dislike losses more than they like gains of an equivalent amount. This finding has been substantiated by a large amount of follow-up research, and to date represents one of the most robust discoveries in behavioural economics, even demonstrated in distinct neural systems in the brain [3]. Most current bonus schemes offer rewards to senior managers when they achieve particular short-term goals - an alternative could be to frame incentives as a charge that will be imposed if managers fail to achieve these goals [4]. Hence, rather than a small base salary component with larger optional pay components, salaries could be redesigned by providing managers with a higher base salary, from which pay can be deducted if managers fail to reach set goals. By simply reframing the financial stimulus as a foregone loss (a 'rebate') rather than a gain (a 'bonus'), managers could be more incentivized to reach goals set by shareholders. The effectiveness of framing prospects in terms of losses and gains has been shown to actively change behaviour in a recent study by Volpp et al [5]. Participants were more likely to meet weight loss targets if framed in terms of loss aversion (deducting money if goals are not met) rather than a bonus structure (gaining money if goals are met).

A second potential approach is concerned with the suggestion that humans have very high discount rates for payoffs that are more immediate in comparison to payoffs in the more distant future, called 'hyperbolic discounting' [6]. Studies have shown that individuals may prefer to receive $10 today rather than $12 tomorrow, leading them to discount the future very strongly when present sacrifices need to be made. Interestingly, this discount rate is much lower for events separated by larger time frames, provided both occur in the future. Accordingly, there may be little difference in individual preferences over receiving $10 next week or $12 next month. Applied to executive compensation, one could envisage a scheme which, rather than paying out cash at the moment of reaching the previously defined goal (for example, at the end of the fiscal year), instead transfers the variable pay into an account which cannot immediately be accessed, for example in mutual funds. Exploiting hyperbolic discounting, this could make managers more long-term oriented and provide incentives to be more aligned with shareholders' long-term interest.

If we want to avoid bonus scandals, the culture of bonus payments requires a redesign. Using insights from behavioural economics can provide new perspectives on how variable pay can be reshaped to improve executive behaviour and better comply with shareholder's interest. However, due to the limited motivational scope that financial incentives can set, given the mixed results these can achieve [7], as well other confounds which may have impact bonus structures, such as strong (organisational) cultural forces, experimental laboratory trials and randomized control trials are necessary to evaluate how useful the concepts of loss aversion and present-self vs future-self inconsistencies can be. It is my great hope that bonus scandals will become far less frequent if we take the psychology of managerial decision-making into account and adapt how executive managers are paid.

References:

[1] Dolan, P., Elliott, A., Metcalfe, R., & Vlaev, I. (2012). Influencing financial behavior: from changing minds to changing contexts. Journal of Behavioral finance, 13(2), 126-142.

[2] Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica: Journal of the Econometric Society, 263-291.
Laibson, D. (1997). Golden eggs and hyperbolic discounting. The Quarterly Journal of Economics, 112(2), 443-478.

[3] Tom, S. M., Fox, C. R., Trepel, C., & Poldrack, R. A. (2007). The neural basis of loss aversion in decision-making under risk. Science, 315(5811), 515-518.

[4] Dolan, P., Hallsworth, M., Halpern, D., King, D., Metcalfe, R., & Vlaev, I. (2012). Influencing behaviour: The mindspace way. Journal of Economic psychology, 33(1), 264-277.

[5] Volpp, K. G., John, L. K., Troxel, A. B., Norton, L., Fassbender, J., & Loewenstein, G. (2008). Financial incentive-based approaches for weight loss. JAMA: the Journal of the American Medical Association, 300(22), 2631-2637.

[6] Laibson, D. (1997). Golden eggs and hyperbolic discounting. The Quarterly Journal of Economics, 112(2), 443-478.

[7] Promberger, M., & Marteau, T. M. (2013). When do financial incentives reduce intrinsic motivation? Comparing behaviors studied in psychological and economic literatures. Health Psychology, 32(9), 950.