Fool’s Gold – The problem of incentive fatigue

31st July 2012

As the latest round of banking revelations continue – from Libor scandals to allegations of money laundering – few would blame the public for wondering how financial incentives designed to maintain high levels of company performance could have backfired so badly. Just as Michael Phelps, the 27-year-old American swimmer who won eight gold medals in Beijing, has so far struggled to match that performance in London, might executives be suffering from incentive fatigue?

Like Phelps, the years leading up to the financial crisis were highly profitable. Executive pay began an astronomical rise as far back as the 1970s and persisted until the onset of the crisis helped rein them in. This trend was particularly apparent in the 1990s where "annual growth rates that reached more than 10%", according to a 2010 study from the Massachusetts Institute of Technology.

With the amount of money being spent on retaining executive talent within these businesses it might be assumed that shareholders received tangible benefits from their leadership. Unfortunately, this all too frequently failed to be the case.

In a 2009 comparison of executive pay and stock performance by Michael J. Cooper, Huseyin Gulen and P. Raghavendra Rau the authors suggest that the more a company paid its chief executive the worse the outcome has been for shareholders:

"The negative relation between incentive compensation and stock performance we document is inconsistent with the efficient market, optimal incentives, and risk shifting hypotheses… Our results seem most consistent with the hypothesis that over-confident managers accept large amounts of incentive pay and with the hypothesis that investors over-react to these pay grants and are subsequently disappointed."

Given these findings should the question now be: do incentives really make a difference to performance? Or, to run a little further with our Olympic metaphor, are gold medals no longer enough to inspire Phelps to victory?

Daniel Pink, the American author and journalists, tackled this subject in his latest book "Drive: The Surprising Truth About What Motivates Us". He claims that current incentive structures suggest that firms "still operate from assumptions about human potential and individual performance that are outdated, and rooted more in folklore than in science".

Worse, these companies persist in using old models to motivate employees,  despite mounting evidence that such measures usually don't work and often do harm.

"Pink makes it clear that financial incentives only work in small amounts, and quickly lose effectiveness," says Mindful Money psychoanalyst Ken Eisold.

The problem for investors is finding out how to spot a business model that is overpaying management at the expense of shareholders.

On the small print below advertisements for financial products it is traditional to find the phrase "Results reflect past performance and do not guarantee future results". Yet whether investors actually heed this is open to question. After all past performance is one of the few metrics open to a retail investor when analysing these instruments.

Just as the punter who wants to put a fiver on Saturday's 400m individual medley would have struggled to look past Phelps' 14 golds when placing their bet, so too investors find it hard to put stellar performance to one side when deciding where to put their savings. But there are risks to this strategy.

The rise of behavioural economics, which looks at social, cultural and emotional factors behind financial decisions, and a retreat from the Greenspan doctrine of efficient markets have made the way a business is run a much more pressing concern for investors. While unravelling the various factors at play in motivating employees is always likely to be a problematic task it is nevertheless important to consider the culture of a business as well as its balance sheet.

Perhaps a boardroom's approach to executive remuneration can offer investors a way of gauging how a company is likely to treat its shareholders.

Furthermore, if policymakers are weaning themselves off the delusion of spontaneous efficiency in markets, then they too might be able to address the damaging legacy of excessive remuneration packages doled out to senior management. After all, a top-heavy structure without sufficient support has only one way to go.

 

More on Mindful Money

Reforming and restoring big finance

Motivation and Inspiration – The key to Economic Success

Will the Olympics see the UK economy go for gold?

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