Long-term incentive, or pay-for-performance plans, encourage employees to achieve maximum profits or productivity by offering them increased pay packages for their successes.

A report by PayScale asserted that 56% of companies operating in 2012 used some kind of pay-for-performance incentives. In theory the idea seems perfect, an enticing motivation to work faster and more efficiently to meet company goals.

However, this may not be the case at all. Professor Micha el Beer of HBS examined long-term incentives at Hewlett-Packard. He discovered that in the early 1990’s, not one of the thirteen factions of the company in varying states that launched pay-for-performance programs lasted over three years.

A study by Glassman et al. found that even when the circumstances are perfect, long-term incentives can have negative consequences such dysfunctional behaviour, unethical conduct, and even employment discrimination. Those given these incentives can find themselves under such pressure to achieve their goals that they bypass rules, regulations, and even moral codes in order to succeed.

Enron, an energy company founded in 1985, is an early example of the temptation for money bypassing the law. In the middle of 2000, website, EOL, was implementing almost $350 billion worth of trades. However, Enron was using special purpose vehicles, or SPVs, to hide their debt, believing stock prices would continue to appreciate. The company paid its top five executives $282.7 million in 2000, just one year before its bankruptcy, introducing incentives for performance. The goal of its board of direct was to pay their high-level executives in the 75^th percentile of their competitors. This crumbled in 2001, in part because the incentives of executive stock options grants led many employees to hide the debt in unethical and fraudulent ways.

Alexander Pepper doesn’t believe pay packages for senior executives and CEOs are having their intended effect. As he worked at an accounting firm for 27 years, he noted that the systems he was helping implement were ineffective, so he went back to school to research why pay-for-performance isn’t the right system. “I was part of the system that I’ve subsequently come to say is not very effective,” he said.

It seems that quite apart from their employees, even high level executives can have misperceptions about the way they are paid, leading the incentives to be inefficacious. There are four key reasons why pay-for-performance for executives is not as beneficial as it seems.

1. Executives are averse to risk when it comes to their pay

When asked to choose between a risky payout of a much higher amount, or a guaranteed payout of less than half, 63% of executives will choose the guaranteed amount. Even with stock option payouts, executives will choose the money/stocks that are guaranteed. This seems counter-intuitive to the role of an executive, who would reach where they are by taking calculated risks with high rewards. While the risky payouts are very valuable, it appears that executives would prefer to have the sure thing.

2. Time wins over money

It seems the old saying “a bird in the hand” rings true even now. Behavioural economists have found that if an executive is asked whether they want a payout now, or wait a year for double the payout, they will take the money they can access immediately. This is called “hyperbolic discounting” and the way it relates to pay packages is that executives don’t value the idea of earning money in three to four years down the line – they want the money now.

3. It’s about what the other guy has

Executives, it appears, are happier to be paid far less for the same job, as long as it is more than their peers. As with Enron, who paid their executives in the 75^th percentile, 46% of executives would be happy with a lower pay for their work as long as it was higher than their competitors at other firms. Rather than wanting absolute money, such as a salary of $100,000, executives would prefer less money, say $50,000, as long as it was relatively higher to the salaries of other executives. It appears in this case, competitiveness wins out over greed.

4. Pay-for-performance doesn’t account for drive

In Pepper’s surveys, executives highlighted that there were more important motivation factors than the size of their pay package. Teamwork, achievements, and status, play key roles in how motivated they are to succeed. Executives claimed they would take a 28% pay decrease if it meant other aspects of their job improved. According to Pepper, this shows companies would be better with higher bonuses and salaries, as long-term pay packages are just not valued in the way they are intended. He also suggests the idea already implemented by some companies of investing bonuses in the company’s shares, allowing executives to align themselves more strongly with shareholder values as they find themselves amongst them.

Pepper’s research makes a controversial but interesting point: you can make significant change in a company by cutting pay-for-performance, and it will help your company change for the better, despite executives earning less.

Image Credit: Equilar