Blog Article

Rebalancing risk in executive reward

Posted by Eric Engesaeth

Eric Engesaeth

Daniel Kahneman probably wasn’t thinking about executive reward when he wrote about the phenomenon of ‘loss aversion’ (people’s tendency to fear loss more than they appreciate gains) in his 2011 book, Thinking Fast and Slow. But the theory helps to explain why an executive compensation package that carries little risk can have a higher perceived value than one where both the gains – and the risks of not achieving those gains – are higher.

Given that employers generally want to pay for performance, their challenge is to find that sweet spot where the perceived value of the package they’re offering is higher than that of the competition. The way to do this is to base the comparison on a single number: the certainty equivalent.

Comparing like with unlike
As a result of regulatory changes and economic conditions, clients are increasingly asking us to help them to calculate the certainty equivalent, so they can adjust their risk levels accordingly – and compete for (and keep) the best people.

The reason they come to us is that it can be tricky to make this calculation when you’re not comparing like with like. These examples illustrate what I mean:

  1. A non-listed company wants to keep its top people from going to the competition, so it compares how it rewards them with the rest of the market. But as it’s not listed, it can only compare base salary and bonus levels – and the rest of the market offers long-term incentives, too. So how can the company make a valid comparison?
  2. To conform to new regulation, a financial services firm is trading variable pay for fixed in its compensation packages. But as we know, $1 of variable pay isn’t worth the same as $1 of fixed. So how can it trade one for the other effectively?
  3. A retail company with high turnover of staff is rethinking its variable pay by partly swapping short-term incentives for long. How does it know what’s of equivalent perceived value to employees?

Bringing it back to the same denominator
Essentially, the same theory applies to all three scenarios. You can use Kahneman’s theory of loss aversion to calculate the certainty equivalent for each compensation element: for example, the certainty equivalent of $1 of fixed pay is $1, but could be 85 cents in the case of short-term incentive compensation, and 60 cents for long-term incentive compensation.

Obviously, there are multiple variables when you’re calculating something as complex as the relative risk inherent in a compensation package. But by bringing it back to the same denominator, you can make like-for-like comparisons – and use what you learn to make trade-offs within the package. And that, in turn, means you can make the package look as attractive as possible – which will help you win the war for top talent.

Dr. Eric Engesaeth is head of executive reward for Hay Group in the Netherlands and associate professor at TiasNimbas Business School.

Interested in hearing more insights on executive reward? Click here to find out about our upcoming European executive reward conference in May.

 

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