Here’s how we break the cycle of outrageous drug-price increases

Jim Bourg | Reuters

As we enter the last few weeks of the 2016 election cycle, the pharmaceutical 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 most recent chapter in the long-running debate has begun to reveal to the public the obscure roles that pharmacy-benefit managers, insurers, hospitals and others play in the economics of delivering health care. 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.

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.

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

For example, Allergan 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.

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

Small biopharmaceutical companies now represent nearly 70 percent of the pharmaceutical industry's pipeline, according to research from the Biotechnology Innovation Organization (BIO). 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 earnings, 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 research-and-development 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 earnings per share (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 health care. 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 health care. 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 multi-year 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.

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.

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

This commentary originally appeared on 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. Follow him on Twitter @jmaxlevin.

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