Incentivizing the Long Term

Corporate governance has issues with the long term. Increasingly, corporate management is forgoing long term investments in R&D and employee training in favor of short term increases in profitability. This is motivated by the decrease in average holding time of stocks (8 years in 1960 to 4 months in 2016) in conjunction with cultural shifts demanding more corporate responsibility towards serving the interest of shareholders. One impact is the increase in mechanisms intended to align executive actions with shareholder interests. For instance, in 1980, 19% of executive pay was in the form of equity. Today, that same figure has blossomed to around 60%. While attempts to align the incentives of executives with corporate growth through modifying the form of payment is commendable, the current realization incentivizes executives to promote short term returns in lieu of long term investments. In this post, I propose an alternative executive compensation system based on time delayed payment of a fixed percentage of corporate profits.

A naive way of incentivizing CEO performance is to set CEO income as a fixed percentage of corporate profits. For instance, let’s say we sign a CEO for a 1 year employment contract where payment is equal to 1% of total profits over that year, payed at the end of the year. The contract expires after that year, at which point it can be renewed under the same terms, given the CEO agrees to work for another year. While this directly incentivizes CEOs to increase profits as greatly as possible, this approach falls short in promoting long term sustainable growth. With an average CEO term length in fortune 500 hundred companies averaging 8 years, the above scheme only provides incentives for the CEO to ensure profitability for the duration of their tenure. For long term investments that don’t result in profitability increases until after tenure has ceased, CEOs have no significant incentive to dedicate funds to those ventures. While setting CEO income as a percentage of profit goes a long way to align executive interests with corporate growth, we’ll need another solution to ensure performance over the long term.

I propose a similar solution, where executive pay is pegged to corporate profits, but where payout of the employment contract occurs over a period of time longer than the employment itself. A simple example would be scenario where a CEO is employed via yearly contracts, like before. However, instead of being payed 1% of the profits of that year, the CEO is now payed 0.1% of the current year’s profits for a period of 10 years. This agreement is in exchange for one year of contracted work by the hired CEO. Even if the CEO leaves after the first year, they continue to receive payout at the end of each year for the next 9 years. If the CEO agrees to work for another year, they will sign a new contract with identical terms as the first. The payouts of the two contracts overlap each other. Therefore, at the end of the second year, the payout of the CEO will be 0.2% of profits. If the executive chose to stop working at that point, their payout would be 0.2% for the next 8 years, at which point the first contract expires. Then, for the next year, payout will be 0.1% – after which all contracts are expired and payout ceases.

Below, Graphs B, C, & D visualize the instantaneous payout rates of an executive whose work contract for each year entitles them to 0.1% of profits for the next 10 years. Each graph represents an executive who works for 5, 10, and 15 years, respectively.

GraphB

GraphC

GraphD

Below, Graph E visualizes the stacking behavior of the contracts of subsequent hires.

GraphE

Executive 1 leaves the company at year one. Executive 2 joins the company at year one and leaves at year six. Executive three joins the company at year six.

Here, as the contracts of an old hire gradually expire, contracts for the new hire are established. This results in a constant expenditure of 1% of profits towards executive compensation, regardless of the instantaneous rate of compensation for the current executive.

Some practical considerations should be made in real world implementations of this scheme. First, although the total income is the same in the time-delayed and non-time-delayed schemes, the instantaneous rate of payout to the current executive can be much lower in the time-delayed scheme than in the non-time-delayed scheme (which is constant). This can provide a disincentive for executives to accept these terms of employment because of the time-value of money: the income is less valuable to them if it is only accessible in the future. Additionally, initially low instantaneous pay rates may make it challenging for executives to maintain life styles built around an expectation of a traditional consistent level of executive pay, providing further disincentive for executives to accept these terms.

There are three feasible solutions to these problems: decrease the contract payout period, increase the total percentage of profits allotted for executive compensation, or guarantee a flat rate income in addition to profit-pegged payments. The first reintroduces issues with short termism, and the second has the potential to bloom expenditures on executive compensation to unacceptable levels. Among these solutions, the third is the most feasible. Although too high a flat rate would undermine the effectivity of the profit pegged mechanisms, it ought to be possible to strike a correct balance between the two in order to encourage long term thinking while accounting for the practical realities of employing an executive.

An additional consideration includes the frequency of payouts. In the above examples, the contracts assumed yearly payouts. However, it would be trivial to adjust the frequency to monthly or bi-weekly payouts, if desired.

Conclusion

Here, I present a system of time delayed, profit pegged executive compensation. Although some questions remain about the tuning of exact values, like the ideal frequency of payout or the proper amount of flat rate payment, this proposal does outline a system that effectively aligns incentives for executive compensation with long term corporate profitability.

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