The Behavioural Economics of Executive Incentives

Abstract

The conventional design of executive compensation plans is based on an outdated model of executive agency. Behavioural economics has provided a better understanding of the relationship between executives’ pay and their motivation through detailed examination of the psychology of incentives. Four key points emerge from the research. 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. Research suggests that companies would be better off paying generous salaries and using annual cash bonuses to incentivise desired actions and behaviours. Executives should be required to invest bonuses in company shares until they have sufficient ‘skin in the game’ to align their interests with shareholders.