The Economic Psychology of Incentives

New Design Principles for Executive Pay

A. Pepper

• Publisher: Palgrave Macmillan
• Year: 2015
• ISBN:
  9781137409256
• Topic: Ciencias sociales
• Subtopic: Sociología

This book proposes a revised theory of agency, drawing on ideas from behavioural economics and built on more robust assumptions about human behaviour than the standard principal-agent model. The book proposes new design principles for executive pay, but also explains the difficulties in changing current executive pay practices.

1

Introduction

Agency theory has been a major component of the economic theory of the firm since the 1970s. It has also come to dominate academic thinking about executive reward. Agency theory asserts that the interests of shareholders (who, for these purposes, are the principals in the principal–agent relationship) and top managers (their agents) are different, and at times radically diverge. In order to align the interests of principals and their agents, boards of directors, acting on behalf of shareholders, create incentive contracts which reward executives financially if shareholders’ returns increase, but not otherwise; or so the theory goes. Agency theory also postulates the active monitoring of the actions of top managers by shareholders through a process which we now know as corporate governance.

The main thesis of this book is that standard agency theory is flawed, so that it is neither a good positive theory of senior executive reward (it does not explain what actually happens) nor a good normative theory (it does not provide helpful guidance as to what should happen). The book explores what happens if the behavioural assumptions on which agency theory is based are modified and brought more closely in line with actual behaviour.

Standard agency theory assumes that firms are profit seeking, that agents are both rational and rent seeking and that there is no non-pecuniary agent motivation. An agent’s utility is assumed to be positively contingent on pecuniary incentives and negatively contingent on effort, and effort is assumed to increase monotonically with additional reward. In practice we know that these things are at best partial truths: not all firms are profit seeking all of the time; some firms are sometimes focused only on survival; some firms have a social purpose; some firms recognise a wider group of stakeholders other than shareholders. Human agents are, in the words of Herbert Simon, “boundedly rational” rather than fully rational:¹ we estimate; we take mental shortcuts in calculations; we make mistakes; we forget things; we use language in ways which are far from clear.² Motivation is also a far more complex psychological phenomenon than standard agency theory admits. We are motivated by many things other than money: by doing a good job; the pleasure of giving; friendship; love; duty; religious belief. The relationship between intrinsic motivation, doing something for its own sake, and extrinsic motivation, doing something for reward, is not straightforward. Some experts believe that in certain circumstances increasing financial rewards “crowds out” intrinsic motivation.³

Economists have long argued that the lack of realism in some of their assumptions does not in itself undermine the scientific validity of their theories. Milton Friedman famously wrote that the test of a good economic theory is its ability to predict future outcomes, not any correspondence between its assumptions and mechanisms on the one hand, and reality on the other.⁴ This principle has become institutionalised in standard neoclassical economic thinking, although it increasingly seems rather odd: it is hard to imagine a natural scientist trying to advance a similar argument. When it comes to agency theory, however, we need not dwell on the merits or otherwise of Friedman’s argument because there is a further problem.

The origins of agency theory lie in a series of theoretical papers published in the 1970s.⁵ In 1990, empirical work by Michael Jensen and Kevin Murphy, both agency theorists, failed to establish a conclusive link between CEO pay and stock price performance.⁶ This caused a number of scholars to argue that companies would perform better if executives were provided with greater financial incentives, yet the logical flaw and sleight of hand here should be apparent. The principal–agent framework, which had begun as a positive theory about executive compensation (i.e., seeking to explain what happened in practice) was being turned instead into a normative theory (i.e., recommending what should happen) when the explanatory powers of the model were found to be wanting. Ten years after Jensen and Murphy’s empirical findings were reported, a meta-analysis of over a hundred empirical studies concluded that incentive alignment as an explanatory agency construct for CEO pay was at best weakly supported by the evidence.⁷ A subsequent literature review suggests that agency theory has apparently fared no better in later empirical research.⁸ We are driven to the conclusion that, when it comes to executive compensation and behaviours, agency theory is not a good predictor of outcomes, as well as being based on unrealistic assumptions.

In recent years Milton Friedman’s principle has been challenged by a number of behavioural economists and economic psychologists. Many trace the origins of this schools of thought to the publication of a seminal article by Daniel Kahneman and Amos Tversky in 1979 entitled “Prospect theory: an analysis of decisions under risk”,⁹ although arguably the roots of behavioural economics can be traced further back to Herbert Simon’s work on bounded rationality, Harvey Leibenstein’s work on x-efficiency and even to the American institutional economists writing at the end of the 19th and beginning of the 20th centuries.¹⁰ Intriguingly both Kahneman and Simon won the Nobel Prize in Economic Sciences for their work on the foundations of behavioural economics, even though neither of them would have described themselves as “economists”.¹¹

Behavioural economics is seen by some as a heterodox, even heretical, activity, which is not worthy of association with standard economic science, but this is increasingly an extreme view. Many behavioural economists are trying to integrate their work with the mainstream neoclassical tradition, in order to strengthen and enrich it. Matthew Rabin argues that behavioural economics is increasingly becoming “normal science”, in the sense in which that phrase is used by Thomas Kuhn in The structure of scientific revolutions.¹² That position is entirely consistent with the thesis of this book, that if the behavioural assumptions of agency theory are modified and made more consistent with actual observed behaviour, then a new set of predictions can be inferred by deduction. These can be tested empirically with, it is further believed, a better chance of being shown to be in accordance with the observable facts. The result is, arguably, a better (behavioural) agency theory, with greater explanatory power and more valuable applications for management practice.

The research

The research described in the following chapters took place during the period 2008–13. It was provoked by general disquiet about how successful long-term incentive plans (LTIPs) were proving to be in meeting their two primary objectives of aligning the interests of shareholders and senior executives, and of motivating executives. Criticisms included the assertion that complex designs made LTIPs very hard to understand (objections by executives and investors), performance targets were perceived to be undemanding (objections by investors) or too demanding (objections by executives), the performance of comparator companies had an undue impact on performance targets (executives) and the total amounts ultimately paid out were often perceived to be too high (some investors and the public generally). One of the paradoxes about LTIPs is that, self-evidently, all these points of view could not be easily reconciled.

The research began with an exploratory study, which was described in an article published in the journal Human Resource Management in January 2013, and which forms the basis of Chapter 2. This first article was followed by a more rigorous working-out of the theoretical implications of the revised set of assumptions about agent behaviour in a theoretical paper, which was published in the Journal of Management in 2012, and which forms the basis of Chapter 3. The ideas in Chapters 2 and 3 also owe much to the thesis which I submitted in part fulfilment of the requirements of the degree of Doctor of Business Administration at the University of Surrey in 2010.

An aside here, which I hope will explain the motivation behind this book and the way it has been framed. I am a late entrant to academia. Between 1981, when I left university for the first time, and 2008 I worked for PricewaterhouseCoopers (PwC; formerly Coopers & Lybrand) as an accountant, tax adviser and latterly as an HR consultant. Much of my time was spent advising companies on executive reward strategies and LTIPs. Accounting and tax law are essentially closed systems – decisions, and hence advice about decisions, are largely based on the interpretation of written codes. Reward strategies, on the other hand, are open systems, and best practices in pay design are informed by theories drawn from a wide range of academic disciplines, by empirical work, by prior experience and sometimes by original thinking. Given the open-ended nature of the issues I found myself facing as an adviser to companies on reward, I turned to the academic literature for ideas. The literature on executive reward is extensive, and written in many traditions, including economics, social psychology and management. I became increasingly fascinated by this literature, prompting me to go back to university to undertake a part-time doctorate at Surrey, and eventually, when the opportunity unexpectedly arose, to leave PwC altogether to take up an academic position at the London School of Economics. At the same time as I made this move, I was also becoming aware that the academic study of management, and management practice, often proceed in parallel universes. Unlike medicine and law, management practitioners generally carry out their activities without any recourse to the academic thinking which may be relevant to the decisions they are making. Equally, management academics spend far too much time studying phenomena that are not central to the day-to-day problems faced by practising managers. The result is a missed set of opportunities on both sides. Hence I decided to make building bridges between the study of management in academia and the practice of management one of the objectives of the latter part of my career.

That objective informs this book in a number of ways. I believe that more management research should be made relevant and accessible to practitioners: too often good ideas are buried in technical papers published in journals read only by other academics. At the same time, I have developed a dislike of the type of intellectually pre-digested practitioner material written by some academics, to be found particularly in bookshops in airport terminals. There are lots of highly intelligent business people, indeed many who might have been academics themselves had they chosen a different path earlier in their careers, who are perfectly capable of understanding complex social scientific ideas. This book is intended for them, as well as for academics and management students. While I have endeavoured to avoid unnecessary academic language and have included some of the more esoteric material in footnotes, equally I have not tried to simplify the text unduly.

To return to the agenda of the book – after completing the work that underpins Chapters 2 and 3, I was fortunate enough to attract the interest of some of my former colleagues in the Reward group at PwC. They agreed to support my research programme by providing funding for a research agency, Forbes Intelligence, to issue an electronic version of my survey instrument, which had been developed for the earlier study, to a panel of international executives, thus helping to construct a unique and extremely rich dataset. The empirical findings of this larger study were published in 2012 in a PwC report entitled “Making executive pay work – the psychology of incentives”,¹³ and subsequently in two other academic journal articles.¹⁴ These two articles form the basis of Chapters 4 and 6.

Chapter 5, which examines intrinsic and extrinsic motivation, and the “crowding-out” conjecture, is also based on the research carried out in conjunction with PwC and Forbes Intelligence, but has not previously been published. Empirical evidence for the crowding-out conjecture in the context of executive pay falls short of an adequate scientific proof, even though the conjecture is intellectually persuasive and consistent with other empirical research. Chapter 5, therefore, summarises the relevant literature, provides some relevant data from the study and makes a partial case in support of the conjecture, but for the time being it must be left to the reader to decide on the merits of the argument. Chapter 6 exam...

Table of contents

• Cover
• Title Page
• Copyright
• Contents
• List of Tables and Figures
• Preface and Acknowledgements
• 1. Introduction
• 2. Long-Term Incentive Plans
• 3. Behavioural Agency Theory
• 4. Risk, Uncertainty and Time Discounting
• 5. Intrinsic Motivation and the Crowding-Out Conjecture
• 6. Fairness as a Precondition for Profit Seeking
• 7. New Design Principles for Executive Pay
• Appendix 1: Questionnaire Used in the Main Study
• Appendix 2: Main Study Demographics
• Appendix 3: Mathematical Proof of the Importance of Fairness in Teams
• Future Research
• Further Reading
• References
• Author Index
• Subject Index