How Incentives for
Long-Term Management Backfire
MAY 06, 2016
To hear long-term investors tell it, company executives
have embraced short-term thinking like never before. Two obvious
pieces of evidence: The
use of earnings
for share buybacks that cost more than they’re worth, and
dividend increases that divert cash from long-term investment. Four
hundred seventy-one companies in the S&P 500 bought back stock last
year, and 372 companies expanded their dividends — actions undertaken
in spite of the need to invest heavily to keep up with global market
Why would executives, charged with sustainable value
creation, put so much focus on short-term maneuvers like distributing
earnings instead of reinvesting them? Why isn’t more of that cash
going into developing businesses for long-term gains — the big,
outsized gains that come from big bets on the future? Among many good
explanations is one that deserves more airtime: compensation design
changes stemming from recent reforms that, ironically, were meant to
benefit long-term shareholders.
This is a classic story of unintended consequences —
inadvertently short-circuiting long-term management — to the detriment
of companies, investors, and the economy. The normal culprits for
short-termism are short-term-minded hedge-fund managers and activist
shareholders, as well as CEOs worried about big bet investments with
uncertain paybacks. But one other big factor has been hiding in plain
sight: The efforts of corporate-governance activists and proxy
advisers, empowered by the “Say on Pay” votes mandated by Dodd-Frank
reforms, to stress transparency and pay for performance.
In the five years since the advent of Dodd-Frank
regulation, corporate governance groups, with their policies requiring
at least half of long-term incentives to be “performance-based,” have
pushed companies to replace options with multi-year, performance
plans. How could anyone object to such an effort? Hardly anyone,
except here is the rub: Performance plans require performance targets,
and in most companies, planning works in three-year cycles. The
logical performance period for long-term incentives is one that
matches those cycles. Three years has thus become the standard
performance window for measuring achievement.
So a three-year horizon — not even a presidential term
— has inexorably become the norm for investing hundreds of billions of
dollars of money aimed at creating “long term” value. With the best of
intentions, many proxy advisors and long-term investors have widely
blessed three years as appropriate, adopting three-year pay for
performance as their standard comparison. Today, four out of five S&P
500 companies use a three-year performance period in their long-term
But executives today, who are paid on this new “long
term,” typically with
partly on earnings-per-share performance, naturally think
twice about retaining earnings for projects beyond three years. Their
measurements conflict with their managerial inclinations, encouraging
them to use earnings booked today to immediately return cash to
The downside of this “shareholder friendly” approach is
evident at many companies. For example, one large technology company
embraced a strategy to win through new digital businesses. The board
chose earnings per share (among other financial metrics) to measure
and reward executives for long-term performance. As earnings goals
became harder to hit with internal growth, the company used most of
its money for share buybacks to achieve its three-year
earnings-per-share goals. The diversion of cash from investment slowed
long-term strategic success. Eventually, the company’s share price
Another company, in the agricultural technology sector,
chose free cash flow as the primary long-term incentive measure.
Facing headwinds to growth, executives delayed R&D and capital
investments to hit three-year free-cash-flow goals. In effect, the pay
plan rewarded them for sacrificing the long term.
Look no farther than GE to see how the hard wiring of
the three-year time period has taken hold in even the most well-run
companies. Jeff Immelt is transforming GE to make it a leader in the
“Internet of Really Big Things” and to loft GE into the top echelon of
software companies. This is a very long-term — decade-long — task.
But, surprisingly, Immelt’s pay plan largely focuses on one- and
three-year increments. The plan does make Immelt and his team
accountable for GE’s intermediate goals: repositioning GE’s portfolio
of businesses, simplifying its structure, making GE Capital smaller
and more focused, and emphasizing returns.
But what about incentive pay for motivating Immelt and
his team to execute the company’s “big bets” on digital
transformation? Little financial incentive exists.
What do we suggest as pay-program essentials for GE and
others going through massive change? Four things:
First, continue the common practice of annual plans,
generally paid in cash, based on annual financial goals and
short-term strategic objectives.
Second, continue three-year plans, generally paid in
stock and based on financial goals.
Third, add a new element: strategic milestones,
mostly nonfinancial and ranging from three to seven years, whose
achievement is required for executives to earn long-term payouts.
Fourth, to strengthen the focus on the genuine long
term, continue or add back stock options while also
stock-holding requirements so a meaningful portion of
stock incentives must be held to retirement or beyond.
Strategic milestones, a key element, would be part of
the new norm. They would be specific, objective strategic
achievements, having zero room for interpretation and would provide a
gauge of progress on the road to strategic success. These strategic
goals could be tied to restricted stock or next-generation options
that vest upon the attainment of key strategic milestones. The
combination of these actions would directly encourage executives to
extend their three-year gaze to as much as a ten-year horizon.
Here’s a hypothetical example of how they might work at
GE. One milestone might include completion of prototype-level
next-generation digital products. A subsequent milestone might be
delivering $10 billion in sales of the new product or service. A third
might be retrofitting a specified share of veteran customers with the
A handful of companies have already started to include
strategic milestones in their three-year long- term incentive plans, a
good first step. One technology company is focusing on consumer
adoption of new platforms. One retailer is focusing on improvements in
average dollars per transaction, the number of new and newly renovated
stores, and percentage international sales growth.
We expect a lot of long-term investors to cheer as such
change takes hold. Investors in this long-term class are those like
Larry Fink, CEO of BlackRock. Fink wrote in his
letter to CEOs: “We are asking that every CEO lay out for
shareholders each year a strategic framework for long-term value
creation.” In his letter, Fink added that he wanted to see company
bosses “more focused…on demonstrating progress against their strategic
plans than a one-penny deviation from their [quarterly] EPS targets or
analyst consensus estimates.”
With the changes we suggest, company outsiders would
see even more clearly how executives are executing a plan, and getting
properly paid, for winning over five and ten years. To be sure, we are
addressing only one difficulty arising with executive pay, and the
many unintended consequences from incentive pay have been widely
Still, we believe the right incentive structure,
appropriate governance, market, and managerial reforms, can
help motivate executives to take bold action for the future and reward
outsized long-term success with outsized rewards.
is a managing director at Semler Brossy Consulting Group. Jones, named
for the last three years to the NACD Directorship 100 as one of the
top hundred most influential leaders in boardrooms and corporate
governance, has been an executive compensation consultant for over 20
is a managing director at Semler Brossy. Burchman, who has been an
executive compensation consultant for over 30 years, has consulted on
executive pay and leadership performance for over 40 S&P 500 companies.
2016 Harvard Business School Publishing.