Video transcript: The Psychology of Incentives 2024

Transcript

Back in 2012, PwC published “The Psychology of Incentives”, a research project conducted together with the London School of Economics. This pioneering work explored the trade-offs that individuals make between risk, reward, time and fairness, and sought to understand the implications for pay and reward. The research came at a time at which companies were adapting to new pay regulations following the global financial crisis, and so the findings spoke very much to a debate which was live at that time in many boardrooms.

One of the key findings was that some features of incentive plans result in many executives discounting incentives to a fraction of their economic value, driving a wedge between the perceived value and their actual cost. 12 years on, we took the decision to return to this research and explore what's changed. As in 2012, we're in the midst of a debate around executive pay. Today, the debate is about competitiveness of UK remuneration packages in a global market for executive talent. But whilst the context today is different, the question of how best to structure incentives remains as important as ever.

Our new Psychology of Incentives research surveyed UK executives to understand whether there are opportunities to design remuneration strategies that are more highly valued by executives, more effective and provide more market competitive pay that is more cost efficient for employers.

In 2012, 60% of executives thought their firm's long term incentive plan was an effective incentive. Today, that figure has reduced to just 41%. There are three areas in particular which contribute to the perceived value of incentives being much lower than the economic value:

• The first is risk aversion. 60% of executives are risk averse and would choose fixed pay over an uncertain bonus of a higher value.
• The second is the discount that executives apply to deferred remuneration. In our 2024 research, executives applied a discount of 18% per annum, similar to the 20% per annum discount applied in 2012. In practice, this means that executives discount a three year deferred bonus award by about a half or shares subject to a two year holding period by about a third. It appears that familiarity with executive incentive plans has not, over time, resulted in executives applying a more economically rational discount.
• The third is performance metrics. Executives were generally not keen to have their pay linked to a single metric, whether that be a market metric such as TSR or a financial metric. Most preferred to be assessed on a balanced scorecard of financial and non-financial metrics. Indeed, many would prefer to receive a smaller fixed amount than to participate in an incentive based on a single financial or relative TSR metric that carries a higher risk of an all or nothing outcome.

Our report draws out three lessons for companies looking to improve the efficiency of their spend:

• One, to remove unnecessary restrictions and conditions within existing structures. For example, if deferral or holding periods aren't required by regulation, could these be removed? Are they bringing a benefit to the company that's greater than the discount that executives will apply because of them?
• Two, to offer a range of incentive structures and use these selectively, either for different populations of employees or according to the business context each year. For example, time-based share awards in a period of uncertainty or stock options at the start of a transformation plan.
• And finally three, to consider the case for employees having flexibility to select their remuneration balance. Our results show that different groups of employees have different appetites and preferences at different stages of their careers. And just as personalisation of reward already exists for flexible benefits, there's an opportunity to do the same for incentives. Now, this is unlikely to be operable at the most senior levels of an organisation, where it might have unintended signalling effects. But below the executive tier, there's potential to use choice to improve the motivation of executives, to improve the efficiency of corporate spend on these plans and it's a path which a handful of companies have already followed.