Photographer: Ivan Bliznetsov/Getty Images

We’re Paying CEOs All Wrong

It’s about how, not how much.

Fred Whittlesey, a compensation consultant for more than three decades, would like his colleagues to take more seriously the weird ways our brains work. In a 2009 paper, he argued that when corporate boards decide how to pay chief executive officers, it’s best to heed behavioral economics, which shows that people are irrational when interpreting and acting on financial data.

Whittlesey, now 58, was blunt. Existing compensation plans had “no empirically demonstrated validity.” Rather, they were a hodgepodge of reactions to “accounting rules, tax law, shareholder requirements, and legal considerations.” Missing from the equation: any assessment of how millions in cash and stock motivate the executive brain—or don’t.

Seven years later, Whittlesey’s theories have yet to win adherents. “It’s gotten worse,” he says, from his office in Seattle. “There’s less attention paid to behavior than ever before.”

CEO compensation is shaped by regulations and broad, decades-long trends. In the 1990s pay experts favored the use of stock options, until a soaring market made some paychecks obscenely large. Then awards of stock that vest over time became popular. Now, according to consulting firm Hay Group, a full third of pay is triggered only if CEOs hit performance targets. Increasingly, that target is simply a higher stock price.

Investors like this arrangement because it suggests that executives have the same goals they do. Yet it flies in the face of what little we know about behavior and pay. Consider a CEO whose board promises her a $5 million pot if company shares rise a certain amount over three years. Behavioral economists argue that the executive won’t weigh the true value of the award because of a psychological quirk called “hyperbolic discounting,” or our tendency—demonstrated in dozens of academic studies—to prefer a dollar today to two dollars some time from now. In theory, this means the board could extract the same effort from the CEO with, say, $3 million doled out at closer intervals.

Huge grants of stock are likely inefficient, says Michelle Edkins, global head of BlackRock’s investment stewardship team. “We still haven’t addressed this fundamental issue of how do we measure whether these plans, which cost shareholders a fair bit, are actually driving and rewarding the behaviors that we think they do?” she says. Steven Slutsky, a principal at PwC, agrees. “You’re not getting the bang for the buck you think you are, because the executive will mentally discount that future value,” he says. “Our research shows long-term plans are nowhere near as effective as people think.”

That’s counterintuitive. Many critiques of CEO pay focus on the pitfalls of short-term thinking, with examples of leaders hitting their quarterly numbers to the detriment of their company’s overall health. But the behavioral economics approach argues that short-term incentives can improve long-term performance, if designed carefully.

“You want executives to focus on a company’s longer-term needs, but how you choose to focus them is critical,” Slutsky says. Executives are more likely to put priority on their annual bonuses, which arrive sooner and are more often tied to measures over which they have some control, such as profit and efficient use of capital, he says. Over time, improvement in those metrics should mean a higher stock price.

Even if this makes sense academically, don’t expect U.S. companies to start creating innovative pay structures. The 2010 Dodd-Frank financial reform law, which gives investors a nonbinding vote on pay practices, has had a homogenizing effect. The compensation disclosures that public companies must file with the Securities and Exchange Commission now average more than 9,000 words, the length of a novellette. “An unintended consequence of transparency is that you don’t want to stick out at all,” says Dan Laddin, a founding partner at New York-based Compensation Advisory Partners.

Few investors have the time or inclination to read those reports, especially those who own shares in hundreds of companies. That’s swelled the power of proxy advisers such as Institutional Shareholder Services and Glass Lewis. They provide recommendations on corporate governance votes, with sets of best practices that take little account of any business’s specific circumstances. To avoid the black eye of a failing vote on CEO pay, companies have changed plans to reflect the advisers’ preferences, and they’re all starting to look the same. More than half the CEOs in the S&P 500 index received compensation last year that was at least in part linked to stock returns, a metric preferred by ISS. “When you’re looking at companies at different stages of the corporate life cycle, when you’re looking at the different personalities, at different stages of their careers, who run these businesses, there’s no way that makes sense,” Laddin says.

Still, he’s hopeful things will change and says businesses owned by private equity firms, outside of the public eye, are more willing to experiment. “I think the pendulum is going to swing back toward driving behaviors,” he says. “But it’s going to be the brave companies that do it first.”

The bottom line: Behavioral economists say boards could pay CEOs less by giving them more near-term incentives.

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