Alexander Pepper

Behavioral Agency Theory New Foundations for Theorizing About Executive Compensation

This article describes new micro-foundations for theorizing about executive compensation, drawing on the behavioral economics literature and based on a more realistic set of behavioral assumptions than those that have typically been made by agency theorists. We call these micro-foundations “behavioral agency theory.” In contrast to the standard agency framework, which focuses on monitoring costs and incentive alignment, behavioral agency theory places agent performance at the center of the agency model, arguing that the interests of shareholders and their agents are most likely to be aligned if executives are motivated to perform to the best of their abilities. We develop a line of argument first advanced by Wiseman and Gomez-Mejia and put the case for a more general reassessment of the behavioral assumptions underpinning agency theory. A model of economic man predicated on bounded rationality is proposed, adopting Wiseman and Gomez-Mejia’s assumptions about risk preferences, but incorporating new assumptions about time discounting, inequity aversion, and the trade-off between intrinsic and extrinsic motivation. We argue that behavioral agency theory provides a better framework for theorizing about executive compensation, an enhanced theory of agent behavior, and an improved platform for making recommendations about the design of executive compensation plans.

Leading professionals: A science, a philosophy and a way of working

This paper argues that complexity theory provides some unique insights into the management and leadership of professionals and other knowledge workers. It explains how the philosophy of servant-leadership, based on the writing of Robert K. Greenleaf, is particularly appropriate in the context of professional services firms. It considers some of the practical tools for managers and leaders found in the work of Joseph L. Badaracco Jr. Finally, it examines how a number of these principles have been applied in one part of PricewaterhouseCoopers, the authors own firm.

Fairness, envy, guilt and greed: Building equity considerations into agency theory

In this article we examine the extent to which fairness considerations are salient to senior executives, and consider the implications for agency theory, tournament theory and the design of top-management incentives. We look for patterns in a unique data set of senior executive preferences and seek explanations for these patterns using a model of fairness first advanced by Fehr and Schmidt in 1999. We propose a number of amendments to Fehr and Schmidt’s model. We challenge some of the standard tenets of agency theory and tournament theory, demonstrating why equity considerations should be taken into account. We add to the growing literature on behavioural agency theory.

Transformational change in a time of crisis

Purpose – This case study feature aims to describes how UBSs human resources (HR) organization radically transformed its practices to deal with the harsh operating environment that resulted from the financial crisis of 2007‐2009. It seeks to examine best practices from the operational successes of the new model, as well as pitfalls to avoid by assessing the effects of the swift changes on employee commitment.Design/methodology/approach – A case study illustrates the strategy UBS adopted to transform its HR organization, supported by the findings of a research study into employee commitment levels.Findings – The paper finds that the integration of several HR functions into one centralized organization led to the creation of a strategic HR function better able to manage a global workforce and act as a business partner to the organization at a lower cost. The radical nature of the change, however, negatively affected desirable employee commitment. Employees were less likely to engage in positive organizatio...

Applying economic psychology to the problem of executive compensation

The conventional design of executive compensation plans is based on an outdated model of executive agency. By undertaking a detailed examination of the psychology of executive incentives, empirical work described in this article has provided a better understanding of the relationship between executives’ pay and their motivation. Four key points emerge. 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. Our research suggests that companies would be better off paying generous salaries, and using annual cash bonuses to incentivize desired actions and behaviors. Executives should be required to invest their bonuses in company shares until they have sufficient “skin in the game” to align their interests with shareholders. As far as possible, the use of equity plans, especially complex, high-powered, performance-based plans, should be kept to a minimum.

Fairness as a precondition for profit-seeking

Scholarly work in a number of academic traditions has demonstrated that fairness is a key factor in determining whether employees are satisfied with their pay, especially when comparisons are made with the compensation of other team members. Yet fairness among senior executives, especially intra top-management teams, has not generally featured in theoretical accounts of executive rewards and incentives. Equity considerations play no part in agency theory or tournament theory.1 Some management scholars argue that fairness is germane to senior executives.2 However, empirical evidence about top managers’ attitudes to fairness has historically been limited.

New Design Principles for Executive Pay

In this book I have constructed a theory which links the performance of an individual senior executive, the performance of other executives who are part of the same top-management team and corporate performance. I have analysed the key elements of extrinsic motivation and explained the importance of intrinsic motivation. I have demonstrated how fairness, or inequity aversion as it is sometimes known, impacts on the perceived value of rewards and incentives. This chapter begins by summarising the main elements of behavioural agency theory, before examining the implications of the theory for the design of executive compensation strategies. It continues by explaining why these design principles are not enough in themselves to change executive pay practices, and comments on the necessity of institutional change if current concerns about executive compensation are to be adequately addressed.

Risk, Uncertainty and Time Discounting

In parallel with the widely reported inflation in executive pay around the world during the last 20 years, long-term incentives have come to represent an increasingly large proportion of total compensation. Although long-term incentives take many forms, they typically comprise a deferred award of company stock whose vesting is contingent upon the satisfaction of a time condition (e.g., that the holder is still employed by the company on the third anniversary of the date of award) and sometimes also on a financial performance condition (e.g., that the total shareholder return of the employing company outperforms that of comparator companies). In this chapter, I define long-term incentives broadly, to include share-based incentives such as stock options, restricted stock and performance shares, as well as equity-linked cash-based incentives, such as phantom options, and stock appreciation rights.

Behavioural Agency Theory

In Chapter 1 it was explained that agency theory has been the dominant theoretical framework for academic research on executive compensation since the mid-1970s. Agency theory is one of a number of theoretical approaches that have been taken by academics in trying to explain executive pay. The literature on senior executive reward is now very extensive, drawing on a variety of scholarly traditions, including economics, law, organisation studies, accounting and finance. In addition to the agency approach, theoretical frameworks include tournament theory, human capital theory, the managerial power hypothesis, institutional theory, political theories and theories about fairness.1 There have been a number of extended literature reviews and comprehensive summaries.2 Behavioural research is a relative new feature of this literature.

Long-Term Incentive Plans

In 1995 the Greenbury report1 recommended that UK companies should adopt performance-related long-term incentive plans (often known simply as “LTIPs”) for senior executives, preferring them to traditional share options. The report pointed out that stock options had a number of shortcomings: they sometimes led to windfall gains simply as a result of general movements in share prices and did not encourage directors to build up significant shareholdings in their employing companies. Reuters Group plc was the first UK listed company to adopt the new style of LTIP in 1993. Many other UK companies followed suit after 1995, influenced by the Greenbury report as well as the withdrawal of tax relief for share options granted over shares with a market value in excess of £20,000 in the 1995 budget. Since that time, LTIPs have become a major component of senior executive reward systems in UK listed companies. By 2012 long-term incentives comprised nearly 50% of the total earnings of executives in the FTSE 350, up from just under 40% in 2006.2