deferred compensation

Time to rethink long-term incentives for executives?

July 25, 2012: 10:18 AM ET

Deferred compensation is costly and cumbersome, yet may not do much to motivate senior management, says a new study.

FORTUNE -- Shareholders' "say on pay" has grabbed plenty of headlines in recent months, but what do executives themselves say really motivates them (or doesn't)? In an unusual survey, researchers at PwC (formerly PricewaterhouseCoopers) and the London School of Economics and Political Science decided to find out. They asked 1,106 C-suite managers worldwide to take a detailed quiz.

Some of the results aren't quite what you'd expect -- and might inspire boards' compensation committees to make some adjustments in the way they design pay packages for senior managers.

Consider, for example, this question, aimed at gauging executives' aversion to risk:

Which would you prefer as a one-off gamble?
a) A 50% chance of $5,250 (and a 50% chance of nothing)
b) A certain payment of $2,250
c) Indifferent to A) or B).

Just over half (51%) of those polled chose (b), the certain payoff, despite its relatively small size. Only about one in four (28%) chose (a), while the rest were indifferent -- and, the report says, "Contrary to popular perception, executives working in the financial sector were slightly more risk-averse than the general population."

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Even more surprising: Other queries related to risk, framed in such a way that analysts could gauge by how much respondents discounted future payments against current ones, revealed a Grand Canyon-sized gap between the way companies usually value long-term incentive payments and the value placed on those incentives by executives who receive them. Standard accounting practices at most companies discount deferred payments by 5% a year. Executives, however, discounted the worth of future payments by roughly 30% a year.

In the eyes of North American executives, in other words, each dollar that's set to be paid out three years from now -- the typical deferral structure endorsed by financial regulators -- is really worth only about 50 cents.

"That really startled me," says Scott Olsen, a PwC principal and longtime compensation consultant. "We've known for a while that people tend to prefer cash over equity, but that's partly because equity is priced for diversified investors while executives have more of their total net worth tied up in it, so it's a valuation issue. But this finding of how big a negative deferral is -- that's purely psychological. It's an illustration of the difference between financial theory and real-life economic decisions."

Want another illustration of that difference? How about this one: As long as executives believe their pay is equal to or higher than that of their peers at the same company, "it becomes almost irrelevant how much they are paid," the report says. Here is one of the quiz questions that established that:

Jean and Jacques are two friends leaving business school. Jean is offered a job as a senior manager at Company A with a total pay package of $187,500. Jacques is offered a similar job at Company B with a total package of $195,000. Jean subsequently discovers that average pay among A's executives is $180,000, while Jacques finds out that B's senior managers earn, on average, $202,500. Who is likely to be more highly motivated?

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Almost all the executives picked Jean, despite the fact that Jacques makes more money in absolute terms. "This issue of perceived 'fairness' shocked us a little bit," Scott Olsen says. "We tend to assume that people are rational and approach financial decisions logically, but clearly that is not always true."

Overall, the study reaches one big conclusion. If executives dislike risk, they dislike complexity even more -- despite the fact that, the report notes, "long-term incentive plans have become ever more complicated, often combined with clawback arrangements, net holding requirements, and performance-based deferrals of cash and bonuses."

The 30% markdown executives apply to future compensation, and their clear preference for equity or cash bonuses now rather than cash or shares later, means that if you simplify your compensation structure and remove some of the uncertainty from it, you can actually pay senior managers less in absolute dollar terms without putting a damper on performance -- especially if you're careful to pay everyone the same.

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