Risk Aversion & Executive Pay

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In an economy where compensation is increasingly driven by “pay-for-performance” strategies, executive pay is no different. According to the 2012 EAA National Executive Compensation Survey, base salary accounts for approximately 75% of the total compensation package in Northeast Ohio. In theory, by focusing on variable pay, such as bonuses and other short term incentives, organizations are able to more closely tie executive pay to performance. However, a new international report by PricewaterhouseCoopers suggests that for many of the executives surveyed, certain types of variable pay, namely those associated with high levels of uncertainty, may not be an ideal driver of performance.

In terms of bonuses, the study cites only 28% of participants opting for a riskier, but higher yield bonus structure over a potentially lower dollar base-pay figure of pre-determined value. Taking the inquiry to a more psychological level, the same study then presented participants with several other reward structures of increasing complexity. Once again, the results clearly point to a strong desire for certainty and clarity over total value. Sixty-six percent of participants expressed a preference for a rewards plan based on internally controllable measurements such as profit, over a plan utilizing external factors such as shareholder returns.

A third element that often appears in executive compensation plans, i.e. long-term incentives, further emphasizes this characterization of executives as risk averse overall, but with the caveat that there are clear geographic and perhaps culturally based exceptions to this trend. The study points out, perhaps unsurprisingly, that developing countries tend to demand more immediate compensation rewards, while places like the UK and USA are more willing to wait for these long term incentives to receive their reward.

Both for the sake of internal equity as well as to ensure compliance with external regulations, establishing a clear connection between the value an executives adds to the company and the compensation they receive is a critical and growing trend in executive pay. However, the PwC study suggests that organizations would do well to pay close attention to the level of risk they are asking their executives to take on in their total compensation packages in order to strike a balance that optimizes executive performance.

Additional Resources

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