Misaligned incentives and idealised investors

Some quick thoughts on 'alignment' in executive pay

One of the things in corporate governance that has always troubled me is the notion of ‘alignment’ in executive pay, through the use of equity incentives. There are two elements to my scepticism towards the idea, the first is psychological, the second relates to the nature of the investor(s) directors are aligned with.

On the psychology, a decade or so back I took an extended detour into the literature around reward, motivation and performance. This is a hugely interesting area and I don’t really have any fixed views (anymore), but you can boil many of the arguments down into two main views of human psychology. The behaviourist camp essentially argues that if you want more of X you reward people each time X is achieved/delivered. You can see easily how incentive schemes fit into this.

On the other side of the debate, those focused on intrinsic and extrinsic motivation argue that human behaviour is more complicated and that rewards can even ‘crowd out’ existing intrinsic motivation. There are some interesting examples around this. (Incidentally, there is also a concept in behaviourism called ‘reactance’ where rewards can be perceived negatively if seen as controlling. Bear in mind that discussion of incentives in the original agency theory literature talked about their ‘bonding’ effect.)

As I say, I don’t really have strong views on this and believe some mixture of the two perspectives. Incentives clearly can work, but they need to be tied to specific, measurable outcomes. I believe (drawing more on the behaviourist view) that rewards probably also need to delivered close to the outcome achieved to have any kind of incentivising / reinforcing effect. That actually points away from the shift to long-term incentives / grants and the use of clawback etc. The latter point is important - what might be desirable to achieve just outcomes might undermine the incentive itself.

For these reasons my overarching view is that fiddling around with remuneration design is a huge waste of everyone’s time. In an ideal world we’d just pay people a salary and perhaps a bonus for truly exceptional performance. The reality is that remuneration is already far too complex, both in design and reporting, but path dependency means it’s too much effort currently to go back to a simpler model.

What I did not come across when I was reading around the topic was the notion of alignment of interests. This seems to be taken by many governance people as a self-evident outcome of the provision of equity incentives but I just didn’t see it cropping up. If rewards do achieve alignment I believe it is alignment with a task, or the outcome from it, not with any notional principal.

But even if we assume incentives work exactly as intended, the question remains: aligned with whom? Which leads to my second problem with the idea of alignment - the identity of the notional principal.

As we know, in many public companies the largest shareholders are highly diversified index funds that have no attachment to any particular company, sector or geography. The interest of even the index funds’ underlying beneficiaries in any one company is negligible. But the executives are aligned with the equivalent of an investor with a one stock portfolio. In fact executives might be the only actors in shareholder-oriented governance who aren't diversified.

In common with the discussion around fiduciary duty (whether for directors or investors), there is also an underlying assumption about the interests of the notional principal - that these are best served by seeking to increase the value of the firm. This is, of course, a way of simplifying objectives, but a lot gets thrown out in the process.

The simplification required reminds me, once again, of Seeing Like A State. In seeking to reduce complexity, governance reaches for abstraction, creating a fictional non-diversified shareholder with a single objective, to raise firm value. But the process of creating simplicity and clarity discards much of reality. Real investors differ in allocation, time horizons, objectives and values. Executives are notionally aligned with an idealised investor that does not exist. (Perhaps, then, it’s not a bad thing if the incentives don’t work anyway…)

Here’s an appropriate excerpt from Scott to conclude.

Let us pause, however, to consider the kind of human subject for whom all these benefits were being provided. This subject was singularly abstract. Figures as diverse as Le Corbusier, Walther Rathenau, the collectivizers of the Soviet Union, and even Julius Nyerere (for all his rhetorical attention to African traditions) were planning for generic subjects who needed so many square feet of housing space, acres of farmland, liters of clean water, and units of transportation and so much food, fresh air, and recreational space. Standardized citizens were uniform in their needs and even interchangeable. What is striking, of course, is that such subjects— like the “unmarked citizens” of liberal theory-have, for the purposes of the planning exercise, no gender, no tastes, no history, no values, no opinions or original ideas, no traditions, and no distinctive personalities to contribute to the enterprise. They have none of the particular, situated, and contextual attributes that one would expect of any population and that we, as a matter of course, always attribute to elites.

The lack of context and particularity is not an oversight; it is the necessary first premise of any large-scale planning exercise. To the degree that the subjects can be treated as standardized units, the power of resolution in the planning exercise is enhanced. Questions posed within these strict confines can have definitive, quantitative answers.

The same logic applies to the transformation of the natural world. Questions about the volume of commercial wood or the yield of wheat in bushels permit more precise calculations than questions about, say, the quality of the soil, the versatility and taste of the grain, or the wellbeing of the community? The discipline of economics achieves its formidable resolving power by transforming what might otherwise be considered qualitative matters into quantitative issues with a single metric and, as it were, a bottom line: profit or loss. Providing one understands the heroic assumptions required to achieve this precision and the questions that it cannot answer, the single metric is an invaluable tool. Problems arise only when it becomes hegemonic.