Strategy

A call to change incentives

Why Jeremy Levin says executive compensation and drug pricing must be delinked

As we enter the last few weeks of the 2016 election cycle, our industry is once again facing increasing scrutiny from politicians, the media and the public. From morphine and quinine 100 years ago, to EpiPen today, the outcry about drug price increases is not new. But the intensity is.

Recent drastic drug price increases have triggered intensifying calls for reform. As part of thoughtful reform, the industry must look at executive compensation and how it is linked to drug pricing.

The problem the industry faces today has been long in the making. Over the last 30 years, we have done our part in creating an environment that makes us vulnerable to the arguments of our critics. In 2004, P. Roy Vagelos, M.D., one of the all-time great CEOs, warned: "High prices for drugs without profound medical value are turning people against the industry."

Today, we continue to raise prices incorrectly and inappropriately in a fashion that is dislocated from value.

The most recent chapter in the long-running debate has begun to reveal to the public the obscure roles that PBMs, insurers, hospitals and others play in the economics of delivering healthcare. Through rebates, each of these parties profits from increasing drug prices and, accordingly, broad solutions must involve all players -- the pharmaceutical, biotechnology and generic companies as well as PBMs, insurers and hospitals.

However, there are a number of steps we innovator companies, who invest in the discovery and development of novel medicines, can take today.

Some will urge doing nothing, hoping the problem will go away. It won't. Nor will efforts to educate and explain what we are doing and how our efforts create value for individuals, society and our economy at large quell the outcry.

A very few forward-thinking innovator CEOs are confronting this fact head on. For example, Allergan plc President and CEO Brent Saunders announced on Sept. 6 that his company will limit price increases to single-digit percentages, and only once a year. This was a demonstration of leadership in one area, but the problem needs action on multiple fronts.

One neglected and often forgotten front is central to the debate: the requirement to address misalignment of management compensation with value creation.

Among innovators, value is driven by creating new medicines with the intent to cure diseases, and building sustainable pipelines to deal with the future expiry of drug patents. There is a very long and uncertain lag that occurs between new drug discovery, development and commercialization. Sometimes decades elapse, often the expenditure is enormous and always the success rates for novel medicines are low. Compensation needs to be aligned with this cycle.

Compensation models

We can learn from some segments of the industry where value is aligned with compensation. Since 2000, smaller biopharmaceutical companies have brought more than 450 new treatments and therapies to patients and now represent over 80% of the pharmaceutical industry's pipeline. In this segment, stock price and executive compensation are broadly tied to innovation. Executives are largely rewarded in a manner that drives long-term interests and better products.

Shareholders of private and public companies ensure that management compensation packages include substantial amounts of equity. If the company remains private, management is rewarded only if products or technologies advance so that a larger innovator buys them out. If the company goes public, the key value inflections of the stock are associated with success of the products.

In both cases, there is a direct link connecting the core value creation of the company to the compensation of the executive.

In contrast, in many larger innovators -- which as a group produce and sell the bulk of patented medicines -- executives are compensated based on the results of efforts to improve EPS, and other actions designed to accelerate short-term share growth. Many firms tie the majority of their executives' compensation to a measure called total shareholder return (TSR). If a company's share price does not appreciate in the short term faster than its competitors, the CEO's compensation does not vest.

Ultimately these executives are being paid under their company's compensation plans for short-term gains in stock price. Understanding this incentive structure, executives use a number of levers to ensure their compensation. For example, when there are no new products on the horizon that can contribute to the top line, some executives increase prices of old products and grant bigger discounts to middlemen such as PBMs. This is the most visible of all levers available to executives, and the one that is receiving the most public scrutiny.

This approach, even when set against an impoverished pipeline, is often accompanied by reduced R&D investment to improve cost structure. As if increasing prices and middleman discounts and reducing R&D were not enough, a third lever is often concurrently pulled -- stock buybacks to gain short-term increases in stock price and EPS, both of which drive compensation. From February to June 2016, stock buybacks soared to $33.2 billion, an all-time record for our sector. Moreover, many companies raised debt to finance their buybacks.

Stock buybacks create no long-term value for the industry overall and are an admission of failure to find investments in innovation. But just like price increases and the other short-term actions, stock buybacks drive executive compensation.

None of these levers are aligned with our industry's lifecycle timeline, nor do they innovate new products, increase productivity or lead to improved healthcare. Rather, in an industry that depends on long-term investment, such behavior solely rewards executives and short-term investors and does nothing for the pipeline, long-term investors and, most regrettably, for patient well-being.

The action item for innovators is clear: we need to ensure that executive compensation is more closely linked to the successful creation of breakthrough medicines and to real advances in healthcare. To implement this, we need to create compensation tools to reward successful pipeline investment, not just top-line growth and short-term stock appreciation.

These tools must include metrics to recognize the industry's multiyear product development life cycle. Executives inherit the previous management's investments, to their gain or to their loss. Instead, companies need to consider compensation incentives and, potentially, "claw backs" to reward or penalize those responsible for decisions made in the past, and to encourage handing on more robust and innovative pipelines.

Breaking the cycle

For several decades, many companies raised prices in the U.S. because they could; this was an easy path, and it was exactly what the incentive system encouraged. Laws and regulations were created to allow intermediaries -- the insurers and distributors -- to profit from price increases. But now we need to learn from these past decisions, and strike a balance where we not only develop rewards for sound financial management, but also ensure there is little reward for price increases in the absence of a change in unit volume sales or increased product benefit.

Additionally, we need to reward long-term investment in pipeline and innovation while reducing and balancing the incentives to buy back stock. Similarly, we need to reward those who reduce their costs without cannibalizing innovation, and bring value to patients, doctors and our economy.

The innovator world has changed, and if we don't proactively change along with it, we will be forced to do so. As we tackle the complex problem of drug pricing, among the many things we need to change is how we are incented.

We need to show patients, shareholders and other stakeholders that we will take action. And we need to challenge others who participate in delivering healthcare -- including generic companies, payers, PBMs and healthcare systems -- to do the same.

Dr. Jeremy Levin has more than 25 years of experience in the global pharmaceuticals industry, leading companies and people to develop and commercialize medicines that address compelling medical needs worldwide. He is currently chairman and CEO of Ovid Therapeutics Inc., which is developing drugs for Orphan diseases of the brain.

Companies and Institutions Mentioned

Allergan plc (NYSE:AGN), Dublin, Ireland

Ovid Therapeutics Inc., New York, N.Y.