Long-Term Executive Incentives Improve Innovation and Corporate Responsibility

Executive compensation is fixed and needs reform. But, most of the calls for reform focus on the wrong dimensions. They focus on the level of pay, or the ratio of executive pay to median worker pay – even though the evidence suggests that low ratios are linked to lower future performance. As I have argued in the Wall Street Journal and World Economic Forum, the most important dimension is the horizon of pay – whether it depends on the short-term or long-term.

We certainly want executives to act in the interest of society, and for a more equal society. But, the way to increase equality is not to bring CEOs down, but to induce them to bring others up. Treating stakeholders (workers, customers, suppliers, the environment) well is costly in the short-term, but the evidence shows that it pays off in the long-term. So the best way to encourage purposeful behavior is not to scrap equity incentives (thus decoupling pay from performance), but extend the horizon to the long-term.

The trouble is that it’s hard to find causal evidence of the effects of long-term compensation. This is because long-term compensation is not randomly assigned. If long-term compensation were correlated with superior long-term performance, it could be that incentives caused good performance – or that executives who knew that long-term prospects were good were willing to accept long-term incentives to begin with. An excellent paper shows that total stock ownership is associated with superior future performance, and the relationship is likely causal, but they do not look specifically at vested stock ownership, not restricted stock ownership which the CEO is forced to hold for the long-term.

An insightful new paper by Professors Caroline Flammer (Boston University’s Questrom School of Business) and Pratima Bansal (University of Western Ontario’s Ivey School of Business) addresses this causality issue. It studies shareholder proposals that not only are on executive compensation, but specifically advocate the use long-term incentives (rather than advocating, say, cutting pay) – restricted stock, restricted options, or long-term incentive plans. However, simply looking at all proposals wouldn’t get round the causality issue. It could be that shareholder proposals arise due to a large engaged blockholder, and it could be the blockholder – not long-term compensation – that improve future performance. So, Caroline and Tima use a “Regression Discontinuity Design”. They compare proposals that narrowly pass (with 51% of the vote) to those that narrowly fail (with 49% of the vote). Whether you narrowly pass or narrowly fail is essentially random, and uncorrelated with other factors such as the presence of blockholders – if there were large blockholders, they would likely increase the vote from 49% to (say) 80%, not 51%.

They find that proposals to increase long-term compensation improve long-term operating performance, regardless of whether you measure it using return on assets, net profit margin, or sales growth. Interestingly, operating performance decreases slightly in the short-run, highlighting the fact that long-term orientation requires short-run sacrifices. But, the long-run benefits outweigh the short-term costs – firm value rises overall.

What’s the mechanism by which this happens? Skeptics might think that long-term CEOs might fire their workers – this is costly in the short-term (due to severance pay) but saves wages in the long-term. This is not the case. There are two channels, both of which are beneficial to society – so the rise in firm value is also socially optimal:

  • Innovation improves. Firms increase R&D. Moreover, they are not simply spending money blindly – this higher R&D expenditure leads to
    • More patents
    • Higher-quality patents (measured by citations per patent)
    • More innovative patents (measured by the distance from firms’ existing patents)
  • Corporate responsibility improves. Firms’ CSR ratings improve significantly, as measured by KLD ratings of a firm’s stewardship of four stakeholder groups: employees, the environment, customers, and society at large. The effects are strongest for employees; one of my own papers shows that employee satisfaction in turn improves firm value

The goal of any pay reform should be to act in the long-term interests of society.  Leading compensation expert Kevin Murphy forcefully argues that politicians’ desire to cut the level of pay is not driven by social considerations (given there is no evidence that cutting pay levels improve behavior), but jealousy and envy, or the desire to appear tough. Ironically, despite emphasizing the importance of thinking long-term, politicians’ proposals to regulate the level of pay are incredibly short-term. There will be an immediate gain in public approval from appearing tough, but the long-term benefits of instead making compensation more long-term are much more important.

As an aside, Caroline previously used Regression Discontinuity in an excellent paper, published in Management Science, which shows that CSR proposals (again, those that pass by a small margin) significantly increase shareholder value and profits. This is a powerful result, since many naysayers argue that CSR is at the expense of shareholder value. Instead, businesses and society are in partnership with each other, not in conflict. As I argued in my TEDx talk, “to reach the land of profit, follow the road of purpose”.

 

2 replies
  1. Sam
    Sam says:

    This is exciting! So, if the paper you quote is right, long-term incentives can directly improve CSR. This is different from (your admittedly excellent) work showing that good CSR leads to better company performance, in the sense that there you can tell a CEO ‘if you have good CSR, you will do well’, but you can’t tell them ‘the only way to do well is with good CSR’. In other words, you give an optional method for boosting performance that they may choose not to accept.

    Reply
    • Alex Edmans
      Alex Edmans says:

      You’re right Sam, that’s an astute connection. While my work shows that good CSR (at least in terms of employee welfare) improves firm value, it takes 4-5 years before the stock market fully notices the effect. Thus, even if a CEO understands the benefits of CSR, she may not invest in it if she’s being evaluated according to short-term earnings. Hence, to implement CSR, it’s important to also increase the horizon of her equity, as Caroline and Tima show

      Reply

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