How Incentives for Long-Term Management Backfire

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 changes.

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.

Read the full article by Blair Jones and Seymour Burchman at the Harvard Business Review.