Reward Value and SEO Amsterdam Economics performed an extensive review of the relevant academic literature and have built a database of 4,000 companies worldwide, going back up to 25 years, analyzing the relationship between executive incentive plans and short-term financial performance as well as long-term shareholder value creation. The full report is available upon request.
Incentives and behaviour
The academic literature explains that incentives influence the behavior of executives, but the resulting behavior is not necessarily in the interest of shareholders or other stakeholders.
The literature offers three different views on the determining elements of executive remuneration:
- the shareholder perspective;
- the ‘rent extraction’ perspective; and
- the institutional perspective.
The shareholder perspective holds that shareholders broker an optimal contract with company executives, to align the executives’ and shareholders’ interests. In practice, however, this optimal contract does not exist. Executives may be in a position to influence their incentive packages, allowing them to extract undue remuneration from the company (‘rent extraction’). Finally, institutional arrangements such as regulatory requirements or tax codes may affect executive remuneration.
Data analysis departing from these three vantage points shows that:
- short-term financial performance is a poor indicator of long-term value creation;
- market capitalization as a proxy for the value of the company is positively correlated to total executive pay, but executive share ownership is not correlated to long-term value creation;
- share price volatility can positively affect executive compensation but is negatively correlated to the long-term value creation of the company;
- cash bonuses and other non-equity incentives are more effective at driving better financial performance than equity incentives; and
- larger companies pay out disproportionally higher remuneration packages.
Corporate governance is a critical factor in ensuring appropriate executive remuneration. Non-executives should provide a safeguard against undue value extraction from the company. In addition, good governance increasingly requires moving beyond the traditional shareholder value paradigm toward the sustainable performance of the company in relation to employees, customers, and society at large.
There is credible evidence in the literature for each of the three perspectives, as well as for the critical role of corporate governance. The data moreover clearly confirms the literature. The analysis shows.
- short term financial performance is a poor indicator of long-term value creation
- stock returns are positively correlated to total compensation, but executive share ownership is not correlated to long-term value creation
- stock volatility positively affects executive compensation but negatively affects firm performance
- cash bonuses and non-equity incentives are more effective at driving better firm performance than equity incentives
- larger companies pay out disproportionally higher packages
Short term financial measures are relied on as a proxy for performance measures, in part because global accounting standards allow like-for-like comparisons between different businesses.
Before ESG measures can be integrated and accepted into any new model, a similar uniformity is needed. This needs work. Measuring and reporting on sustainability is currently performed in a variety of different methods by a number of different organizations, such as MSCI, Sustainalytics and S&P.
Green Paper - Reward Value
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