Knowledge Is Power: Executives Minimize Risks That Affect Their Compensation

FAYETTEVILLE, Ark. - In making business decisions, not all information is equal. For executives in high-tech industries, the kind of information sources used in making critical decisions is affected by the structure of their compensation package, according to University of Arkansas researcher Vikas Anand.

"Our results suggest that compensation is a potentially powerful tool that can assist organizations in managing their knowledge and information flows," explained Anand, assistant professor of management in the Walton College of Business. "They also indicate that the effect of compensation on information seeking is much stronger in high-tech firms, where information is a more critical resource."

Anand conducted the study with Luis Gomez-Mejia, professor of management at Arizona State University, and former University of Arkansas graduate student Paul Tiedet. It is one of the first studies to examine tools available to organizations to influence managerial information processing. He presented their results recently at the 2003 annual meeting of the Academy of Management in Seattle.

The researchers looked at the relationship between the design of executive compensation packages and the kinds of information sources the executives used in making key decisions. They identified three types of knowledge sources: market sources, such as customers and vendors; network sources, including consultants and colleagues in other organizations; and secondary sources, which include publications, the Internet and industry trade organizations.

Market sources of information support relatively risk-free strategies because they have ties to the organization’s core operations and can be accessed through established organizational processes. Strategies based on these sources are low-risk and typically build incrementally on existing strategies.

Network sources require more effort to access and are especially likely to be used to gain information not available through market sources. Network sources can provide unique, cutting-edge information that supports novel strategies that may be more risky because they depart from the industry norm.

Secondary sources are less well-organized and, especially in the case of Internet resources, require more time and energy to access. Their use is frequently associated with personal development and the need for information not available from any other source.

"We found that risk is the factor that determines the information sources executives use," Anand said. "For example, when base pay is low, executives bear tremendous risk because of their reliance on short-term variable pay, such as bonuses, to maintain their lifestyles."

For example, executives will avoid making risky decisions that could jeopardize their expected bonuses. In addition, they will make sure that their strategies are well vetted by traditional stakeholders, such as customers and vendors.

The two-stage study examined compensation and information sources of 207 CEOs and top executives in software manufacturing firms and a control group of 247 CEOs and executives in non-high tech firms. First, CEOs were contacted and asked to describe the compensation packages of their top executives. In the second stage, these executives were surveyed about their information-seeking behavior.

"We chose high-tech firms because overall information requirements are likely to be much greater than in other firms," Anand explained. "They are typically in emerging and growth industries, where knowledge is fragmented and rapidly becomes obsolete. There is a great need to obtain information from outside the organization and from non-business sources, such as universities or research institutes."

Executive compensation was classified as base pay, long-term incentives and short-term incentives. The impact of long-term incentives, such as stock options, is moderated by the vestment period, which is the period of time an executive must remain with the company before the options can be exercised. In this study, vestment periods ranged from zero to five years, with an average of 1.77 years for both the study and control groups.

Short-term incentives, such as bonuses, have a stronger interaction with executive base pay. If base pay is low, short-term incentives create a high degree of risk bearing. However, Gomez-Mejia points out that if base pay is sufficient to cover lifestyle expenses, short-term incentives are treated like "windfall gains" and do not increase risk bearing.

The researchers found that high-tech industry executives with a high amount of options and a long vestment period showed a substantial increase in the use of network sources. However, this was not true for the control group.

Anand attributes this difference to the fact that when the vestment period is long, the payoff from long term incentives appears to be very distant to executives. Thus they do not experience risk bearing and are willing to take risks in their strategies. Risky strategies, in turn, are supported by information from network sources.

As expected, high-tech executives with low base pay and high short-term incentives showed an increase in the use of market sources to mitigate their high risk. But contrary to expectations, these executives also relied heavily on network resources. Anand speculates that their high degree of risk bearing causes them to seek information from as many sources as are available.

Differences emerged between high-tech executives whose short-term incentives were tied to individual performance and those tied to firm performance. Incentives tied to firm performance did not influence information-seeking behavior. The researchers expected that short-term incentives tied to individual performance would increase the amount of information sought, but this was not the case. There was no increase in the use of market or network sources, but a large increase in the use of secondary sources.

"We speculate that this may be a response to increases in internal competition - created by the incentives — within the firm," said Anand. "If so, executives may be turning to sources that do not require reciprocity."