The psychology of executive remuneration

Executive pay across industries is facing criticism surrounding high salaries. This condemnation is especially true in the financial services, both in wake of the financial crisis and in light of an increase in their share of the wage bill. Indeed, the pay gap in the UK has widened significantly over the past thirty years. Someone in the 90th percentile in 1979 earned 2.5 times more than someone in the 10th percentile, now he earns 3.7 times more. 60% of the increase among the top 10% of earners is accrued to those working in the financial sector.

Much of this increase takes the form of a bonus. Originally, bonuses (performance pay) were designed to align the incentives of the executive with that of shareholders. It was meant to eliminate the principal-agent problem by aligning executive incentives to increasing company value. By reaching a certain benchmark, executives were given additional remuneration. This bonus was often given in the form of stock options or shares, which was meant to further goal alignment. Yet, this has not necessarily worked as meant. Performance pay has led executives to take unnecessary risks. Bonuses have been continuously paid even when institutions are failing. Salaries became a way for executives to judge themselves against their peers, rather than used as a judgment of company performance. 

There are two main problems with this theory, however. One stems from an incorrect view of human motivation. The second problem is associated with payment relativity.

Money is not the only motivation for workers. While bonuses have long been used to incentivize performance, large bonuses when performing cognitive tasks are actually counter-productive to performance. Research has shown that while financial incentives can motivate people to work, very large bonuses can hinder performance by causing stress involved in attaining it, the fear of not receiving the bonus and focusing attention on the bonus rather than the job at hand. 

The problem of compensation relativity is two fold. First of all, executives judge themselves against one another, and compete for highest salary. This leads to higher compensation demands, without the performance to back it up; meaning there is sometimes inconsistency between economic value added and pay. Payment relativity is also problematic when peer group comparisons are used to determine pay. Pay groupings are meant to provide information on appropriate salaries, providing boards with benchmarks, but often result in the inflation of executive compensation when peer groups with higher salaries are chosen. 

A third issue surrounding performance surrounds the idea of crowding out. Monetary incentives have been found to impact the intrinsic motivation of people, as motivation now comes from something external. As a result, people perform less well after monetary incentives are given. This is true regardless of the form of the remuneration (base pay versus bonus).

The regulation of executive compensation is an area currently being considered by regulators, central bankers and more. While regulators are focusing on the structure of pay packages from an economic perspective, they must also be careful to consider the psychology and utility of remuneration before altering the structure of executive payment.