Behavioural Influence of Executive Pay Plan - Coursework Example

Behavioural Influence of Executive Pay Plan The Mining and FTSE plan at RTZ is an employee reward plan based on employee share ownership. It allows for participation in enterprise results in an indirect way viz. by receiving dividends or by appreciation of employee owned capital or a mix of both. Such a plan is not directly linked to company profits but it is linked to company profitability which enables the employees to gain indirectly from the added value. The company is adopting the Economic Value Theory (EVT ) to reward executives. In the past this theory was used to assess business and investment strategy. Now EVT principles are being used for evaluating and rewarding executives. The new plan is in line with the concept that "rewards increase intrinsic forms of motivation more strongly than they increase extrinsic motivation" (Gotschalg 3). While economists tend to place importance on money as a strong motivator, behavioural scientists tend to consider it weak. Pendleton, A. notes in his book: "achieving change in employee attitudes and behaviour has often been an important objective of those introducing employee share ownership schemes. It is thought that share-owning employees will feel greater commitment to the firm and a greater sense of identity with its aims"(154). The idea of inculcating a higher sense of ownership among employees to enhance overall company performance seems to be the underlying reason for this new plan. Whether there is a direct relationship between share ownership and greater employee motivation and commitment is debatable. It is however likely that ownership which encompasses employee participation can make the employees react in a positive manner. "Consistent with incentive theory, the evidence also shows that firms and workplaces with shared compensation practices have a higher incidence of shared decision-making/information sharing practices" (Conyan and Freeman 1). From the employee perspective, making employees stakeholders, can induce a higher sense of responsibility among them and give them a sense of greater role in decision-making. However if this expectation is not met, it could then lead to a sense of frustration and discontentment. The other reason for employee discontent could be related to share value. If it falls for reasons that employees perceive as beyond their control it could work as a demotivator and impact employee morale. Aptly pointed out by Cooper and Rousseau: As the destiny of employees becomes more tightly integrated through ownership via financial participation, issues of work/life separation (shared futures with the fortunes of the organization) and the very meaning of work will be raised. What will be the consequence for employees in terms of role confusion, wellbeing and stress levels, work values, commitment, cooperative versus competitive behaviours The confusion in identities also comes hand-in-hand with an increasing diversity of psychological contracts at work-or certainly the attitudinal stances within these contracts towards HRM policies aimed at a performance culture, and shared risk policies and practices (Sparrow 2000a). Not all employees seek increased financial participation or involvement in their organization. The assumptions of generic improvements in motivation, commitment, and engagement with the commercial process that seem to underlie much of the popular discussion of employee ownership are by no means proven. Indeed, there are more grounds to expect wide individual differences in the in the attractiveness of such a concept, and the relevant outcomes noted above ( 52). The new reward system is bound to influence employee perceptions and impact behavioural factors which will influence motivation, performance and morale. This is discussed below. Commitment and Recognition versus Individual Goals Mitchie, Oughton and Bennion note that "the positive effect that involvement and participation policies have on motivation and commitment may be enhanced and made more effective and significant if they are underpinned by and combined with employee ownership" (8). The EVT theory supports this stand since it makes shareholders more interested in corporate governance. Economic theory which depicts the role of labour and role of capital in the creation of value by broadening ownership of capital, claims that once there is increased ownership productivity will also increase. It will help an employee to identify his own interests with that of the company. Even research suggests that "employee financial participation schemes, as well as encouraging a participative style of management, are more likely to lead to better organizational health, seen in lower absenteeism and staff turnover rates, and in an improved employee relations climate."( Reilly, Cummings and Bevan) By offering shares as rewards to the directors and senior executives, it is possible that the employees feel an increased ownership and a sense of pride and recognition leading to a higher commitment to company goals. Senior executives especially would take more interest in market fluctuation and share performance because the overall performance now impacts them directly. In line with Herzberg's theory the opportunity for ownership could work as an intrinsic motivator and increase employee commitment. This assumes significance when one is talking of the top management in the company who belong to the top most level in the pyramid and are driven to work by a need for self actualization and not so much by money. People commonly argue that money is a primary motivator. It's not. Surveys repeatedly show that other factors motivate more. For example, a survey by Development Dimensions International published in the UK Times newspaper in 2004 interviewed 1,000 staff from companies employing more than 500 workers, and found many to be bored, lacking commitment and looking for a new job. Pay actually came fifth in the reasons people gave for leaving their jobs. The main reasons were lack of stimulus jobs and no opportunity for advancement - classic Herzberg motivators"( Chapman). The above argument works very well if employees value ownership since it gives them increased autonomy and control over their work which will have a positive impact on employee commitment. In this sense it satisfies the need for affiliation and for those who perceive ownership as bringing greater income, job security or control over job and workplace, the reward system could work as a motivator to improve company profitability. However, if an employee does not value ownership then economic theory also says that employees are risk averse and company risk is better managed by a broad base of shareholders who can diversify risk with other holdings, rather than employees who already have human capital tied up in the firm. Risk is further increased if participants rely on company shares as a principal benefit. Given this view point, there is a chance that increased ownership may have no impact on performance. This is in line with what Conyan and Freeman note: " the less risk averse the employee, the higher is the optimal sharing rate between the owner and the employee because the employee is more willing to bear the relevant risk. Similarly the less effort averse the employee, the higher is the optimal sharing rate, since that employee will be more willing to put out the requisite effort"(9). Hopelessness and Resentment The bonus under the Mining plan is offered through combination of cash and share ownership and only through the latter under the FTSE plan. The structure of the plan is such that if the business environment is facing a downturn it can have a despairing effect on employees. So even the money in question is not a guarantee. According to Herzberg's motivation theory existence of money (extrinsic motivator) may not motivate but absence of this can cause demotivation. If the industry and country's economic performance are poor, the chances of losing money by way of reduced share value could work as a de motivator. It would then not even satisfy "hygiene needs" and may cause turnover problems. The biggest concern that one may have with this plan is that it does not seem to offer bonus for individual performance. It offers bonus based on factors over which the employee has no control viz. those related to industry and country's economy. It is therefore probable that it does not work as a motivator for improved individual performance especially by those who do not care for ownership. No matter how well an employee performs his bonus will not be linked to his individual performance so such employees will never push for higher targets. Under the new scheme both the FTSE plan and Mining plan, the effort to remove subjectivity and introduce industry benchmarks to calculate rewards can have a both positive and negative impact. The fact that under the Mining Plan an international standard is used and employees rewards are tied to performance of mining companies in other countries can lead to a sense of being treated and rewarded unfairly. The FTSE plan may be more acceptable in that sense, since it is connected with economic environment of the country that the employees work in. This is in line with the John Stacey Adam's equity theory, which assumes that an individual forms a subjective judgement about fairness of reward received relative to his inputs and in comparison with rewards of others. Since the reward system offers higher bonus to those at higher levels regardless of their performance it may lead to resentment among those who believe they performed well and perceived that they did not receive reward commensurate with their performance. So the incentive scheme which offers equal share (quartile system of percentage shares) regardless of individual performance can cause a sense of hopelessness to an extent that employees may hold back work. As noted by Brown and John it will be the "Prisoner's dilemma" where each worker holds back effort " in order to free ride off his/her colleagues" (8) Further they also also point out: "A dilution of free rider problem seems to arise whenever it is hard to monitor a single person's contribution..An externality is present because any one's person's reward depends on everyone else's effort."(qtd. in Brown and John 8) .Defensive Behaviour and Frustration The reward system is also based on the simple carrot - stick approach where money in the form of pay or bonus is used to motivate employees. Clearly everyone gets a carrot regardless of individual performance. The stick metaphor for reduction in bonus could work as a strong motivator but can also give rise to defensive and retaliatory behaviour. This may be especially true at bonus for junior level staff who will feel no control to impact share price. It could lead to indifference and a failure to take risks in decision making at senior levels. Additionally, if the business performance was good and the employee had a savings plan in mind he is now tied down under the new scheme since he cannot sell his shares to invest elsewhere. The employee's own savings plan is now not under his control. It becomes a snag in employees wanting to achieve individual goals leaving them frustrated. Employee Morale The mood will be upbeat when share prices rise and will dip when share prices fall. In the first case employee morale will be high and could motivate them to either work better or contrarily induce a sense of complacency . Considering the cyclical nature of industry such a situation is likely. As noted in PWC about the mining industry : "The beleagured companies of the late nineties have seen a reversal of fortunes over recent years." (20). Success of Plan in Scenario A and Scenario B Whether offering share ownership really achieves its objectives, needs to be evaluated. Presented below is an insight into whether the two new plans are achieving their objectives. The following criteria is followed to proceed with the anlaysis: Director and senior executive salary is assumed at 150,000 per annum and Jr. Executives (180 other employees under Mining plan) at 50,000 per annum while their bonus as half of directors and senior staff Average shareholder return is based on percentage listed against comparator companies and the quartile considered It is assumed that under the mining plan shares are divested by employees in the fourth year and in the third and fourth year under the FTSE plan The dividend is assumed at 10% of the share value Findings The objective of linking rewards of directors and senior executives to that of the shareholder is achieved under both Mining and FTSE plans. The plans also eliminates subjectivity by using industry comparator and the quartile system. To encourage long term ownership of shares the plans have a lock in period but whether long term share holding gets encouraged or not will depend on individual employees. It is possible that employees divest their shareholding as soon as the lock in period gets over. However the lock in does ensure that there is no extreme dilution of shares. A summary of analysis under Scenario A and B is given in Table 1. The detailed calculations are presented in Table 2 and 3. Table 1: Summary of Analysis Average four year return Scenario A Scenario B Mining Plan FTSE Plan Mining Plan FTSE Plan Share holder 12% 14% 16% 13% Director 24% 45% 33% 34% Senior Executives 24% 23% 33% 17% Junior Staff (180 other employees) 15% 0% 23% 0% It appears from the above table that returns under Mining plan are lower under scenario A and higher under scenario B since in scenario B RTZ's share performance falls in the 1st quartile in year 3 and never falls in the 3rd quartile in the four years. While in scenario A share performance is not so good and falls in the second and third quartile every alternate year. The situation is reversed under FTSE plan. In this sense shareholder wealth is linked to employee rewards. If shareholder wealth increases for e.g. from 12% -16% under mining plan the employees' rewards also increase. Same is the case under FTSE plan. A steady return begins to reveal itself only from the fourth year onwards which indicates that the plan does take into account the long term and cyclical nature of the industry. Returns in year 4 are indicative of the returns likely to exist going forward The FTSE plan shows steep swings. With a shift of just one percentage point in shareholder return it shifts quite drastically for the employees. This implies that the link between change in shareholder's wealth is not equitable with the change in employee rewards. The fact that FTSE plan does not offer any cash bonus but rewards only through shares adheres well to the objectives of the plan for the senior staff and directors. FTSE plan caters only to directors and senior executives. In that sense it does not tie the bonus of the 180 other employees (assumed to be junior staff) with shareholder wealth and to that extent defeats the objective of the plan. Table 2: Mining Plan Scenario A Scenario B Mining Plan Criteria Yr 1 Yr 2 Yr 3 Yr 4 Avg 4 years Yr 1 Yr 2 Yr 3 Yr 4 Avg 4 years 1 Avg Share holder return As per case 14.0% 9% 14.0% 9% 11.5% 14% 14% 21% 14% 16% 2 Director / Snr Exec Salary Assumption 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 3 Quartile Given 2 3 2 3 2 2 1 200% 4 Bonus Percentage Based on Quartile 40% 20% 40% 20% 40% 40% 60% 40% 5 Bonus Based on Quartile 60000 30000 60000 30000 60,000 60,000 90,000 60,000 6 Cash in same year Half of Bonus 30,000 15,000 30,000 15,000 30,000 30,000 45,000 30,000 7 Vested amt for 3 yrs Half of Bonus 30,000 15,000 30,000 15,000 30,000 30,000 45,000 30,000 8 Dividend At 10% of share value 3,000 4,500 7,500 6,000 3,000 6,000 10,500 10,500 9 Total Payout 6+8 for 1st three yaers and 6+7+8for year 4 33,000 19,500 37,500 51,000 35,250 33,000 36,000 55,500 70,500 48,750 10 Bonus as % of salary Total Payout/Salary 22% 13% 25% 34% 24% 22% 24% 37% 47% 33% 11 Junior Exec Salary Assumption 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 12 Quartile Given 2 3 2 3 2 2 1 2 13 Bonus Half of Dir. 20% 10% 20% 10% 15.0% 20% 20% 30% 20% 23% 15 Total Payout(cash Bonus) 13*11 10,000 5,000 10,000 5,000 7,500 10,000 10,000 15,000 10,000 11,250 16 Bonus as % of salary (15/11)*100 20% 10% 20% 10% 15% 20% 20% 30% 20% 23% Table 3: FTSE Plan Scenario A Scenario B FTSE Plan Criteria Yr 1 Yr 2 Yr 3 Yr 4 Avg 4 years Yr 1 Yr 2 Yr 3 Yr 4 Avg 4 years Avg Share holder return As per case 14% 14% 14% 14% 14% 14% 9% 21% 9% 13% 1 Director Salary Assumption 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 2 Quartile Given 2 2 2 2 2 3 2 3 3 Bonus Based on Quartile 67% 67% 67% 67% 67% 33% 67% 33% 4 Cash in same year As per case 0 0 0 0 - - 0 0 5 Vested amt for 2 yrs 3*1 100,050 100,050 100,050 100,050 100,050 49,950 100,050 49,950 6 Dividend At 10% of share value 10,005 20,010 20,010 20,010 10,005 15,000 15,000 15,000 7 Total Payout 6+4 for 1st 2 years. 6+7+5 for next 2 yrs 10,005 20,010 120,060 120,060 67,534 10,005 15,000 115,050 64,950 51,251 8 Bonus as % of salary Total Payout/Salary 7% 13% 80% 80% 45% 7% 10% 77% 43% 34% 9 Senior Exec Salary Assumption 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 10 Quartile Given 2 2 2 2 2 3 2 3 11 Bonus Half of Dir, 33% 33% 33% 33% 33% 17% 33% 17% 12 Cash in same year As per case 0 0 0 0 - - 0 0 13 Vested amt for 2 yrs 11*9 33,350 33,350 33,350 33,350 33,350 16,650 33,350 16,650 14 Dividend At 10% of share value 3,335 6,670 6,670 6,670 3,335 5,000 5,000 5,000 15 Total Payout 12+14 for 1st 2 yrs and 12+14+13 for next 2 yrs 3,335 6,670 40,020 40,020 22,511 3,335 5,000 38,350 21,650 17,084 16 Bonus as % of salary (15/9 )*100 3% 7% 40% 40% 23% 3% 5% 38% 22% 17% Concerns among Directors and Major Shareholders The Directors will be concerned about the company's share performance against competitor's since their bonus is based on that.Major shareholders as expected will surely have concerns about the company's share value and the returns it offers. Scenario A Under the mining plan major shareholders will show discontentment with performance of the company because of the average return over four years. They will clearly prefer the FTSE plan since it brings them higher returns. What they miss out on is that small change in their return makes steep percentage point changes in employee rewards hence as a percentage of bonus employees may either be very well rewarded under FTSE plan or very poorly rewarded. The Directors too will prefer the FTSE plan in scenario A since it brings them higher returns.The option of divesting in the third and fourth year under FTSE will be welcomed by Directors since it will increase their total payout from 13% in year 2 to 80% in year 3 and 4 and give them flexibility in planning their investment. Similarly under the mining plan the option to divest in year 3 jumps their bonus from 13 % to 25% (year 2 to 3) and from 25% to 34 % (year 3 to 4).Whether to divest or not will be another concern of the directors. Scenario B In Scenario B the shareholders will prefer the mining plan to FTSE plan since it gives them a higher average return of 16%. For Directors there is not much change in the average return between the two plans. However under FTSE plan in year 3, their bonus jumps from 10% to 77% and in year 4 the bonus is 43% of the salary. Directors may find the FTSE plan risky since it offers no cash incentive like the mining plan but if the company performs well directors stand to gain a lot under FTSE plan.Once again to divest or not will be a key concern of the directors. Works Cited Brown, S., John, G. "Wages Supervision and Sharing. England". University of Leicester and Brunel University. April 2001. 6 November 2005. Cameron, H., Goldsmith, T. "Mine Enter the Dragon Review of global trends in the Mining Industry in 2004". June 2005.PricewaterhouseCoopers. 5 November 2005. Chapman, A. "Frederick Herzberg's Motivation and Hygiene Factors". 2001-4.6 November 2005. Cooper C.L., Rousseau DM. Trends in Organization Behaviour Employee versus Owner Issues in Organizations. England: John Wiley and Sons Ltd., 2001. Gotschalg, O. "Rewards and Firm Performance, A look into the motivation black box." Jan 11, 2005.INSEAD, London Business School.2 November 2005.< file:///C:/Documents%20and%20Settings/Owner/Local%20Settings/Temporary%20Internet%20Files/Content.IE5/ZEG7JH4L/RewardsandFirmPerformance_LBS_handout(1)%5B2%5D.ppt#441,1,Rewards and Firm Performance A Look into the Motivation Black - Box> Martin J. Conyan and Richard B. Freeman. "Shared Modes of Compensation and Firm Performance: UK Evidence Center for Economic Performance LSE", Oct 2002. Centre for Economic Performance, LSE.5 November 2005.< http://ideas.repec.org/p/cep/cepdps/0560.html> Mitchie, J., Oughton, C., Bennion, Y. "Employee Ownership, Motivation and Productivity" Nov 2003. The Work Foundation, Birkbeck, University of London.5 November 2005.< http://www.efesonline.org/LIBRARY/Employees%20Dirct%20Report.qxd.pdf> Pendleton, A. Employee Ownership, Participation and Governance A study of ESOPS in the UK.London: Routledge.2001 Reilly P, Cummings J, Bevan S. "Share of the Spoils: employee financial participation". IES Report 373. April 2001. Read More