Imagine that shareholders are hiring a new CEO for their firm. When hiring her, they communicate their goals to her, emphasizing the importance of the company’s long-term success. While confident in the new CEO’s ability, shareholders also want to incentivize her to perform well. To that end, they make a large part of her compensation based on equity in the company, overlooking the fact that equity may be based on short-term performance.
Given the new CEO’s incentives, you shouldn’t be surprised that she will concentrate on delivering short-term results, a behavior termed “short-termism.” She might divert resources away from anything that doesn’t pay in the short term. For example, imagine that the company outsources the delivery of its products. It might be profitable for the company to invest in its own fleet of trucks to streamline operations, but such an investment would cause short-run losses and only yield profit in the long run. Why would the CEO risk losing her job and bonus to invest in a new fleet? To inflate short-term profits, she would not invest in new technology that incurs costs now but improves performance in the long run. She would make decisions that aid her in meeting short-term profit targets at the expense of long-term success of the company.
Evidence supports short-termism: executives who receive this mixed signal say they would delay or sacrifice projects that create long-term value if they come at the expense of short-term gains. Short-termism could also affect the risks a company takes. A recent paper further illustrates the problem with using short-term incentives to motivate CEOs. In the paper, the CEOs are considered to have short-term incentives if their equity is scheduled to vest in an upcoming quarter (e.g., if they are set to fully own shares of the company in, say, the next year). The authors show that short-term incentives are significantly correlated with reductions in investment growth. Stock returns are more positive in the two quarters surrounding the equity vest but more negative in the following years. In other words, the CEOs act on the short-term incentives, making short-sighted decisions that sacrifice the company’s lasting success.
Executive compensation should be designed to attract, retain and incentivize executive talent for the purpose of building long-term shareholder value and promoting long-term strategic thinking. The US Council of Institutional Investors (CII) considers “the long-term” to be at least five years. Executive rewards should be generally commensurate with long-term return to the company’s owners. Rewarding executives based on broad measures of performance may be appropriate in cases where doing so logically contributes to the company’s long-term shareholder return.
In some cases, a CEO is replaced after the company’s stock underperforms for just a few quarters. CEOs are incentivized to say that they’ll invest for the future, as that’s what shareholders want to hear, but instead fixate on the present, since they want to be employed for the long run. As an incentive designer, you must structure CEO incentives to highlight that while you want good short-term results, you also care about long-term success. One way to make a CEO care more about the long run is by escrowing the CEO’s equity for a longer period. Escrow is a process whereby an asset is held by a third party on behalf of two other parties until the fulfillment of predetermined obligations. In the case of company management, an escrow ensures that the executives who receive equity as a bonus to their compensation would wait for the obligated period to pass before they could sell the stock.
The CII recommends:
For some companies, emphasis on restricted stock with extended, time-based vesting requirements—for example, those that might begin to vest after five years and fully vest over 10 (including beyond employment termination)—may provide an appropriate balance of risk and reward, while providing particularly strong alignment between shareholders and executives.
The goal of this suggestion is to reduce the weight that short-term outcomes receive relative to long-term ones. The restricted stock ensures that executives don’t have tunnel vision on short-term results and that they evaluate positive and negative long-term performance, just as shareholders do.
Another way to align the goals of shareholders and a CEO is to extend the guaranteed tenure—this alleviates the CEO’s concern of being replaced if the company underperforms in the short term. The problem with short-term tenure is well illustrated in politics. The length of tenure affects long-term considerations. Consider a governor who is deciding whether to invest in infrastructure, say, new bridges or trains. In the long run, it would prevent accidents and might even be very profitable, as a new train could bring tourists and their wallets to town.
But the governor has short-term incentives: the governor wants to win the next election in a couple of years. The governor recognizes that losing a reelection will probably be the end of their political career, so they have strong incentives to gear actions toward reelection. Given this strong short-term incentive, why would a governor invest in a new train that would take at least a decade to see its benefits? To build such a train, the governor would have to divert resources from projects with a shorter timeline and possibly even increase taxes. These policies would not make them popular among the people and would hurt their reelection chances. To add insult to injury, the new train would probably only be ready after they’ve been booted from office, and the successor would be the one who reaps the fruits of the project.
How can we fix the mixed signals that we’re giving to our politicians? The solution seems simple: get rid of the limits on the duration of tenure. Without having to worry about reelection every four years, the governor can focus on investing in the future, knowing that they will be there to enjoy the fruits. However, politics is an area in which extended tenure may not be such a great idea, as it may end up being costlier than the original problem. Even though a four-year tenure incentivizes short-term considerations, I personally prefer this system over the unconstrained alternative, for it means we live in a democracy in which the leader has to answer to voters.
Politics aside, incentivizing long-term success by extending tenure is typically not so costly. Consider how basketball coaches choose who’ll play in certain games. Do they send out their MVPs or give some game time to promising but inexperienced younger players? Giving playing time to such players would probably reduce the immediate success of the team but would allow the players to gain necessary experience. If the coach is facing the risk of a midseason firing, conditional on the first few games of the season, they would probably choose to play it safe and rely on the experienced players. If the coach knows that their position is guaranteed for the first season, they will invest more in improving the entire team and would probably see the efforts pay off in the long run.
TAKEAWAY: If you want to motivate long-term success, don’t incentivize (only) short-term success.