Equity compensation incentives induce short-sighted management by chief marketers
Compensation packages that include incentives tied to a company’s stock price can be powerful motivators for corporate leaders.
But these motivations can also produce some serious unintended consequences, according to a new study by Natalie Mizik, a professor of marketing at the University of Washington Foster School of Business, and Martin Artz of the University of Muenster.
Their analysis of data on public firms over two decades reveals that equity incentives can tempt chief marketing officers (CMOs) to engage in short-sighted marketing management—such as cutting R&D and advertising spending—in an effort to inflate current earnings and enhance the firm’s stock price. This myopic management boosts their personal earnings at the expense of their company’s long-term performance.
“Myopic management is a serious problem and a threat to firms because it entails inefficient decision-making, which leads to a decline in future firm performance,” says Mizik, the J. Gary Shansby Endowed Chair in Marketing Strategy at Foster. “Our findings highlight the pitfalls and limitations of overreliance on equity in managerial compensation packages.”
The financial crisis of 2008 trained a piercing spotlight on executive compensation and its effects on the behavior of top corporate management. Critics have drawn a direct link between escalating executive pay packages and deteriorating business ethics, widespread excesses and abuses of power, and a disregard for the welfare of customers, employees and shareholders.
Mizik and Artz set out to examine the effects of executive compensation structure on a specific type of misbehavior: myopic management of marketing activities with the intent to temporarily inflate earnings.
The researchers examined data—extracted from ExecuComp, Compustat, Thompson Reuters and other sources—on public firms and their leadership teams. They focused on CEOs and CMOs, who are most responsible for decisions on marketing, sales, advertising and innovation expenditures. These functions tend to be frequent targets for real earnings manipulation.
Deploying sophisticated methods of analysis, Mizik and Artz were able to identify causal effects of equity compensation incentives on management behavior and firm performance.
Managing for personal gain
These effects were significant and sustained.
While CEO equity incentives appeared largely unrelated to myopic marketing management, the same kind of equity incentives offered to chief marketing officers strongly predicted the incidence and severity of short-term earnings manipulations involving deflating spending on marketing and R&D.
This kind of myopic manipulation has been shown to have negative long-term consequences on a firm, including significant declines in market valuation, innovation and future profitability. But it does effectively boost current earnings, often resulting in temporary a bump in stock price.
Mizik and Artz demonstrate that CMOs in the study took advantage of the artificially inflated stock valuations that their earnings-enhancing decisions had created. They exercised more stock options and sold more of their personal equity holdings in the years when myopic marketing management occurred and was more pronounced.
“Contrary to the arguments that the presence of a CMO in the organization can help maintain customer focus and support for marketing departments,” Mizik says, “CMOs not only fail to prevent myopia, but further exacerbate the problem as the market-based portion of their personal compensation increases.”
Alter the incentives
Despite the ubiquity of executive compensation packages featuring equity incentives, Mizik says that myopic marketing management is not inevitable.
She suggests that some of the proposals advanced to prevent the kind of excessive risk-taking that led to the financial crisis of 2008 can work to curb myopic management as well. Firms could continue to pay their c-level executives based on stock price performance, but defer the payout until after the executive’s retirement, thus reducing the temptation to act on short-term impulses to augment equity compensation. Or they could tie executive compensation to long-run performance metrics such as customer satisfaction or brand equity.
Another deterrent to myopic management may come in the form of regulation expanding disclosure of non-financial performance indicators that are relevant to firm value.
In 2015, the Securities and Exchange Commission (SEC) proposed a “pay versus performance” disclosure rule, which would give shareholders the opportunity to assess executives’ pay relative to their performance—and the performance of the firm they lead. To date, though, it remains one of several compensation-related provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 that have yet to be enacted.
“This is yet another potential solution to address the misalignment of executive incentives and firm performance,” Mizik says. “It remains to be seen whether the ‘pay versus performance’ or the other proposals will be implemented, and whether they can help remedy the managerial myopia problem.”
“How Incentives Shape Strategy: The Role of CMO and CEO Equity Compensation in Inducing Marketing Myopia” earned Mizik and Artz the 2020 Robert D. Buzzell Best Paper Award from the Marketing Science Institute.