Applying Economic Psychology to the Problem of Executive Compensation

Abstract

The conventional design of executive compensation plans is based on an outdated model of executive agency. By undertaking a detailed examination of the psychology of executive incentives, empirical work described in this article has provided a better understanding of the relationship between executives’ pay and their motivation. Four key points emerge. First, executives are much more risk averse than financial theory predicts. Second, executives are very high time discounters, thus reducing the perceived value of deferred rewards. Third, intrinsic motivation is much more important than admitted by traditional economic theory. Fourth, executives are more concerned about the perceived fairness of their awards relative to peers than in absolute amounts. Our research suggests that companies would be better off paying generous salaries, and using annual cash bonuses to incentivize desired actions and behaviors. Executives should be required to invest their bonuses in company shares until they have sufficient “skin in the game” to align their interests with shareholders. As far as possible, the use of equity plans, especially complex, high-powered, performance-based plans, should be kept to a minimum.