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Innovation is a complex systems problem; the reasons executive teams underinvest in transformation are manifold. They might not recognize the need to, or might be paralyzed by the absence of perfect information about disruptive opportunities, which only materializes after those opportunities have been captured by faster-moving competitors. Some are hampered by misunderstandings about what drives enterprise value creation. Many tell us things like, “We limit investments with long payback times because the market expects strong quarterly earnings.”
75 percent of U.S. stocks are owned by long-term investors, who overwhelmingly favor decisions that lead to long-term value creation, even if that causes temporary shortfalls in earnings.
Transformational innovation that fuels long-term growth is therefore not just important for tomorrow’s performance, but today’s share price. To illustrate this, look no further than Ford, General Motors, and Volkswagen, all of which saw their share prices surge by upwards of 40 percent in 2021 (in Ford’s case, by 136 percent to a 20-year high) as they announced multi-billion-dollar investments in electric vehicles and broader long-term transformation programs. This was despite the fact that 96 percent of new vehicles sold in the US in 2021 used internal combustion engines.
Alongside these and other factors, a critical and often overlooked issue that significantly impacts the volume of resources that companies allocate to transformational innovation is the design of senior leaders’ compensation packages. Senior executives are the custodians of companies’ resources; the volume that transformational innovation efforts receive is a direct function of their resource allocation decisions. Those decisions are shaped by their compensation packages, which too often disincentivize investments in transformational innovation. Time and again, we’ve seen this hamper the execution of even the most ambitious innovation strategies.
Why Compensation Models Fail to Incentivize Investment in Transformation – and Can Even Punish It
Traditional compensation models typically rely on four core components. Two of these are fixed: Salary (inclusive of benefits), and pension contributions. Two are variable and subject to performance conditions. These are the annual bonus, which is awarded in cash subject to in-year performance conditions, and the long-term incentive plan (LTIP), which sees the executive awarded equity providing achievement of performance conditions defined today and assessed in several (typically three) years’ time.
Exhibit 1 shows a traditional executive compensation package (this is a simplified model that does not reflect granular variation in design across companies and countries, but many executive compensation packages broadly resemble this). At first glance, the model contains a component for incentivizing transformational innovations that drive long-term value creation – specifically, the LTIP. What’s more, this component has the highest face value. But it has proven to be ineffective. Research has repeatedly shown that there is little relationship between long-term value creation and the existence or value of a long-term equity incentive plan within senior executives’ compensation packages, for companies across industries and geographies. There are a number of reasons for this, which include:
Competing Incentives, Operating on the Same Resource Variable. The executive has a single block of resources, but two incentives – the annual bonus and the equity LTIP – which are subject to distinct metrics. These metrics put the incentives in tension and at risk of distortions, because allocating resources to one means potentially trading off the other, as transformational innovations often don’t generate short-term core business returns. Consider the executive team of one of the automotive companies mentioned above. Deciding how much to invest in autonomous vehicle platforms is not obvious when doing so involves focusing less on delivering profitable vehicle sales this year, which annual bonuses are tied to. Given competing priorities, executives, being human, bias towards the one that provides the more immediate reward.
Aggressive Annual Bonus Performance Targets. The cash bonus is often tied to in-year core business performance targets (for example, relating to revenue growth and/or profitability) that are so aggressive and resource intensive that little scope remains for meaningful resource allocation to transformation. This is partly a result of the significant emphasis boards place on short-term performance, and partly because this year’s core business performance targets were extrapolated from last year’s, which were similarly aggressive and resource intense. The presence of an incentive to encourage long-term transformation will have little effect if executives have few resources left to allocate to it.
Psychological Discounting of LTIPs. Although the LTIP is ostensibly the biggest compensation component, executives psychologically discount it to such an extent that its perceived value ends up being less than that of the annual bonus. LTIP vesting times and performance conditions do not make the executive an owner of company shares today, but merely a potential owner of company shares in several years’ time. The executive therefore discounts the value of the LTIP for risk, because whether or not the company’s share price (as an example of a typical metric that LTIP performance conditions are based on) will achieve the target required by the LTIP in three years’ time depends on factors that are uncertain and uncontrollable.
The executive also discounts the value of LTIPs for time, because a dollar of stock three years in the future is perceived to be worth less than a dollar in the executive’s pocket today. Exhibit 2 illustrates this psychological discounting, based on research conducted by one of the coauthors, with a sample of 756 executives drawn from a panel of 12,860 executives from around the world.3,4 When risk and time are both accounted for, executives may discount the value of a three-year LTIP by as much as 75 percent, giving the bonus a perceived value that is more than the LTIP even if its face value is only half as much. Investing in transformation is not intuitive when the perceived value of the reward for doing so is comparatively low.
LTIP Performance Conditions that Risk Long-Term Value. At the extreme, LTIPs are not only inefficient at incentivizing executives to pursue transformation, but can actually disincentivize them to do so. The performance conditions and all-or-nothing nature of LTIPs can incentivize the pursuit of short-term actions that benefit executives to the detriment of long-term shareholder value. For example, an executive whose LTIP is about to vest might choose to pass on a unique and time-limited opportunity to acquire a company with a business or technology that could accelerate a transformation program, if doing so risked a temporary dip in the company’s share price such that the LTIP’s performance conditions would not be met.
Relatedly, performance conditions set several years ago can age badly, falling out of sync with the requirements of a business environment that might have changed in unexpected ways over the multi-year time horizon of an LTIP (consider, for example, the unlikelihood of achieving performance conditions set in 2017, at the height of the Covid-19 crisis in 2020). For these reasons, LTIPs can end up having the opposite of their intended effects. They can distort and overpower the executive’s intrinsic motivations to “do the right thing”, and can even mean they are in effect penalized for acting in ways that create long-term shareholder value, if doing so is inconsistent with performance conditions required for the LTIP to vest.
These factors mean the current compensation model fails to incentivize and even risks being punitive to executives who invest for the long-term. Collectively, they have the effect of diverting resources disproportionately towards near-term performance, as shown in Exhibit 3.
Fixing Executive Incentives and Resource-Allocation Processes to Enable Investment in Long-term Transformation
A more effective model would mitigate the issues outlined above by first dividing total company resources into two discrete, appropriately balanced tranches – one for optimizing short-term core business performance, and the other for fueling long-term transformation – based on a commonly agreed-upon vision and set of goals for each. This can be achieved via a “future-back” strategic planning process. Second, it would swap out the ineffective LTIP in favor of restricted stocks that incentivize the efficient use of resources earmarked for transformation. See Exhibit 4 for a summary.
1. Introduce Future-Back Strategic Planning and Resource Allocation. Executive teams and boards of directors need to “right-size” resource allocation for driving short-term core business performance and long-term transformation and growth. In other words, they need to align on what constitutes an acceptable level of short-term core business performance on the one hand, and the required pace and scale of transformation on the other, and the resource split required for each of those two priorities.
To achieve such a split requires a longer-term strategy than is found in many organizations, where “strategy setting” is a planning exercise that only looks one to three years out, assumes a degree of stability that is absent in markets facing disruptive change, and doesn’t contemplate more significant changes to market and business model choices required for long-term viability. Companies need to instead look beyond their traditional planning horizons and develop more complete perspectives on how their markets are likely to evolve. We call this type of thinking “future-back.” When done well, it ensures alignment between the board and the executive team, while providing clarity as to the short-term core business performance conditions that the annual bonus is tied to – which will likely be more modest than in previous years, given the deliberate allocation of resources to transformation.
This addresses the first two issues outlined above, of competing incentives operating on the same resource variable, and aggressive annual bonus performance targets that leave little scope for meaningful resource allocation to transformation.
2. Swap Out LTIPs in Favor of Restricted Stock. Splitting resources and tying the annual bonus to short-term performance targets commensurate with the tranche for short-term core business performance shields executives from the potential downsides of investing in transformational innovation. This is because using resources intended for long-term transformation no longer requires the executive to potentially trade-off short-term performance required to maximize the annual bonus. However, encouraging executives to truly make efficient use of transformation resources means not only eliminating downside risk, but also ensuring meaningful upside potential for doing so. As outlined above, performance-related LTIPs are ineffective in doing this. To align the long-term interests of executives with those of shareholders, companies should shift the future-facing component of compensation from LTIPs to restricted stock. These are non-transferrable shares that must be held for multiple years, consistent with the long time horizons of strategic transformation programs.
Restricted stock programs are gaining momentum. In the U.S., the Council of Institutional Investors has begun to advocate for their use in executive compensation plans.
All this means that they are not subject to significant psychological discounting for risk and time. Rather, because they already own the stock, executives are incentivized to behave in ways that will maximize its value until they can sell it. Their actions will increase or decrease the value of an asset that they already own, as opposed to one they might never receive. Given this increased certainty, restricted stocks are typically expected to have a face value of around 50 percent of the LTIPs they replace. Restricted stock can either be awarded to the executive as a component of their annual compensation package, or companies can create an even more powerful sense of ownership by mandating that they buy restricted stock with some part of their annual bonus.
Though definitive data on their effectiveness is still some years away, restricted stock programs are gaining momentum. In the U.S., the Council of Institutional Investors has begun to advocate for their use in executive compensation plans.5 In the UK, research has found widespread support for them among both investors and executives.6
Major forward-thinking companies that have recently replaced their LTIP programs with restricted stocks include BT and Burberry, both of which gained near unanimous support from their investors for doing so. Commenting on its then proposed transition to restricted shares in its 2020 annual report, BT noted that it was abandoning traditional LTIPs because “conventional three-year financial or total shareholder return targets may not support the right management behaviors to do the right thing given the longer-term nature of our investment plans.”7 Similarly, Burberry’s 2020 annual report noted that it expected its adoption of restricted stock to “encourage management to focus on executing the transformation strategy, provide the flexibility to make the right investments at the right time, and discourage the use of levers to increase revenue and profit in the short-term at the expense of the long-term shareholder experience.” 8
Senior executive compensation packages that discourage long-term resource allocation can hinder even the most promising innovation strategies. To overcome this barrier to corporate renewal, companies should aim to “right-size” resource allocation between the core business and long-term transformational innovation via future-back strategic planning. Second, they should make their executives actual long-term shareholders, eschewing LTIP performance conditions that are variously uncontrollable, complex, gameable, and irrelevant in favor of restricted stock plans that align executives’ interests with those of other shareholders.
Because the future stock price, which is the ultimate goal of transformational innovation (or at least a proxy of it) is inherent in the restricted stock, the restricted stock itself “does the talking” and incentivizes the efficient use of resources for transformation. This more closely mirrors the “skin in the game” compensation philosophy of startups, whereby founders and executives already own equity which they are incentivized to maximize the value of. These two actions can help companies execute the kinds of ambitious transformation strategies that lead to sustainability and renewal.
About The Authors
Alexander Pepper is a Professor of Management Practice at the London School of Economics and Political Science. email@example.com
- Babcock, A., Williamson, S. K., and Koller, T., 2021. How Executives can Help Sustain Value Creation for the Long Term. McKinsey on Finance, Number 77, June 2021
- Darr, R. and Koller, T., 2017. How to Build an Alliance Against Corporate Short-Termism. McKinsey & Company, January 2017
- Pepper, A., 2015. The Economic Psychology of Incentives: New Design Principles for Executive Pay. Palgrave Macmillan
- Pepper, A., 2021. The Behavioural Economics of Executive Incentives. NHRD Network Journal, 14(2), pp.186-192
- Council of Instituional Investors, 2022. Corporate Governance Policies. March 7, 2022
- The Purposeful Company Steering Group, 2020. The Purposeful Company Study on Deferred Shares: Progress Review, September 2020
- BT Group plc Annual Report 2020
- Burberry Annual Report 2019/20