In one survey of 500 global executives, respondents reported that they expected their companies would cut long-term growth investments by 17 percent if faced with a 15 percent decrease in revenue, even if that decrease was temporary and due to external factors like currency fluctuations.¹ But this short-term orientation is contrary to investors’ priorities. 75 percent of US stocks are owned by long-term investors, who have the greatest impact on companies’ share prices. Those investors overwhelmingly favor decisions that lead to long-term value creation, even if that causes temporary shortfalls in earnings.² 

Transformational innovation that fuels long-term growth is therefore not just important for tomorrow’s performance, but today’s share price. To illustrate this, look no further than Ford, General Motors, and Volkswagen, all of which saw their share prices surge by upwards of 40 percent in 2021 (in Ford’s case, by 136 percent to a 20-year high) as they announced multi-billion-dollar investments in electric vehicles and broader long-term transformation programs. This was despite the fact that 96 percent of new vehicles sold in the US in 2021 used internal combustion engines.

Alongside these and other factors, a critical and often overlooked issue that significantly impacts the volume of resources that companies allocate to transformational innovation is the design of senior leaders’ compensation packages. Senior executives are the custodians of companies’ resources; the volume that transformational innovation efforts receive is a direct function of their resource allocation decisions. Those decisions are shaped by their compensation packages, which too often disincentivize investments in transformational innovation. Time and again, we’ve seen this hamper the execution of even the most ambitious innovation strategies.

 

Why Compensation Models Fail to Incentivize Investment in Transformation – and Can Even Punish It

Traditional compensation models typically rely on four core components. Two of these are fixed: Salary (inclusive of benefits), and pension contributions. Two are variable and subject to performance conditions. These are the annual bonus, which is awarded in cash subject to in-year performance conditions, and the long-term incentive plan (LTIP), which sees the executive awarded equity providing achievement of performance conditions defined today and assessed in several (typically three) years’ time.

Exhibit 1 shows a traditional executive compensation package (this is a simplified model that does not reflect granular variation in design across companies and countries, but many executive compensation packages broadly resemble this). At first glance, the model contains a component for incentivizing transformational innovations that drive long-term value creation – specifically, the LTIP. What’s more, this component has the highest face value. But it has proven to be ineffective. Research has repeatedly shown that there is little relationship between long-term value creation and the existence or value of a long-term equity incentive plan within senior executives’ compensation packages, for companies across industries and geographies.  There are a number of reasons for this, which include:

Competing Incentives, Operating on the Same Resource Variable. The executive has a single block of resources, but two incentives – the annual bonus and the equity LTIP – which are subject to distinct metrics. These metrics put the incentives in tension and at risk of distortions, because allocating resources to one means potentially trading off the other, as transformational innovations often don’t generate short-term core business returns. Consider the executive team of one of the automotive companies mentioned above. Deciding how much to invest in autonomous vehicle platforms is not obvious when doing so involves focusing less on delivering profitable vehicle sales this year, which annual bonuses are tied to. Given competing priorities, executives, being human, bias towards the one that provides the more immediate reward. 

Aggressive Annual Bonus Performance Targets. The cash bonus is often tied to in-year core business performance targets (for example, relating to revenue growth and/or profitability) that are so aggressive and resource intensive that little scope remains for meaningful resource allocation to transformation. This is partly a result of the significant emphasis boards place on short-term performance, and partly because this year’s core business performance targets were extrapolated from last year’s, which were similarly aggressive and resource intense. The presence of an incentive to encourage long-term transformation will have little effect if executives have few resources left to allocate to it.

Psychological Discounting of LTIPs. Although the LTIP is ostensibly the biggest compensation component, executives psychologically discount it to such an extent that its perceived value ends up being less than that of the annual bonus. LTIP vesting times and performance conditions do not make the executive an owner of company shares today, but merely a potential owner of company shares in several years’ time. The executive therefore discounts the value of the LTIP for risk, because whether or not the company’s share price (as an example of a typical metric that LTIP performance conditions are based on) will achieve the target required by the LTIP in three years’ time depends on factors that are uncertain and uncontrollable. 

The executive also discounts the value of LTIPs for time, because a dollar of stock three years in the future is perceived to be worth less than a dollar in the executive’s pocket today. Exhibit 2 illustrates this psychological discounting, based on research conducted by one of the coauthors, with a sample of 756 executives drawn from a panel of 12,860 executives from around the world.^3,4 When risk and time are both accounted for, executives may discount the value of a three-year LTIP by as much as 75 percent, giving the bonus a perceived value that is more than the LTIP even if its face value is only half as much. Investing in transformation is not intuitive when the perceived value of the reward for doing so is comparatively low. 

LTIP Performance Conditions that Risk Long-Term Value. At the extreme, LTIPs are not only inefficient at incentivizing executives to pursue transformation, but can actually disincentivize them to do so. The performance conditions and all-or-nothing nature of LTIPs can incentivize the pursuit of short-term actions that benefit executives to the detriment of long-term shareholder value. For example, an executive whose LTIP is about to vest might choose to pass on a unique and time-limited opportunity to acquire a company with a business or technology that could accelerate a transformation program, if doing so risked a temporary dip in the company’s share price such that the LTIP’s performance conditions would not be met.  

Relatedly, performance conditions set several years ago can age badly, falling out of sync with the requirements of a business environment that might have changed in unexpected ways over the multi-year time horizon of an LTIP (consider, for example, the unlikelihood of achieving performance conditions set in 2017, at the height of the Covid-19 crisis in 2020). For these reasons, LTIPs can end up having the opposite of their intended effects. They can distort and overpower the executive’s intrinsic motivations to “do the right thing”, and can even mean they are in effect penalized for acting in ways that create long-term shareholder value, if doing so is inconsistent with performance conditions required for the LTIP to vest. 

These factors mean the current compensation model fails to incentivize and even risks being punitive to executives who invest for the long-term. Collectively, they have the effect of diverting resources disproportionately towards near-term performance, as shown in Exhibit 3.

Fixing Executive Incentives and Resource-Allocation Processes to Enable Investment in Long-term Transformation

A more effective model would mitigate the issues outlined above by first dividing total company resources into two discrete, appropriately balanced tranches – one for optimizing short-term core business performance, and the other for fueling long-term transformation – based on a commonly agreed-upon vision and set of goals for each. This can be achieved via a “future-back” strategic planning process. Second, it would swap out the ineffective LTIP in favor of restricted stocks that incentivize the efficient use of resources earmarked for transformation. See Exhibit 4 for a summary.

1. Introduce Future-Back Strategic Planning and Resource Allocation. Executive teams and boards of directors need to “right-size” resource allocation for driving short-term core business performance and long-term transformation and growth. In other words, they need to align on what constitutes an acceptable level of short-term core business performance on the one hand, and the required pace and scale of transformation on the other, and the resource split required for each of those two priorities.

To achieve such a split requires a longer-term strategy than is found in many organizations, where “strategy setting” is a planning exercise that only looks one to three years out, assumes a degree of stability that is absent in markets facing disruptive change, and doesn’t contemplate more significant changes to market and business model choices required for long-term viability. Companies need to instead look beyond their traditional planning horizons and develop more complete perspectives on how their markets are likely to evolve. We call this type of thinking “future-back.” When done well, it ensures alignment between the board and the executive team, while providing clarity as to the short-term core business performance conditions that the annual bonus is tied to – which will likely be more modest than in previous years, given the deliberate allocation of resources to transformation. 

This addresses the first two issues outlined above, of competing incentives operating on the same resource variable, and aggressive annual bonus performance targets that leave little scope for meaningful resource allocation to transformation.

2. Swap Out LTIPs in Favor of Restricted Stock. Splitting resources and tying the annual bonus to short-term performance targets commensurate with the tranche for short-term core business performance shields executives from the potential downsides of investing in transformational innovation. This is because using resources intended for long-term transformation no longer requires the executive to potentially trade-off short-term performance required to maximize the annual bonus. However, encouraging executives to truly make efficient use of transformation resources means not only eliminating downside risk, but also ensuring meaningful upside potential for doing so. As outlined above, performance-related LTIPs are ineffective in doing this. To align the long-term interests of executives with those of shareholders, companies should shift the future-facing component of compensation from LTIPs to restricted stock. These are non-transferrable shares that must be held for multiple years, consistent with the long time horizons of strategic transformation programs.