Incentives and bonus systems: Can we PLEASE get rid of them?
The days of the complicated systems of variable compensation are over
by Niels Pflaeging
Once upon a time, there was a bank that had many, many employees. It was an ambitious bank, and one that held itself in high regard. The bank thought of itself as beautiful and very, very smart, thus deserving more success than any other bank in the realm. This bank overheard the story of a stupid donkey and its rider who dangled a carrot in front of the donkey. The donkey would follow the eternally unattainable vegetable – very much to the delight of the rider.
Thus the bank conceived the following ruse: Not only would its employees receive a decent salary, it would also additionally motivate them to improve company performance – just like the donkey rider in the story! So one day, the bank started offering its people incentives. Some kind of turnip. And since the bank knew a lot about money and not much about nutrition and vegetables, it used money, instead of carrots. It started calling its turnips “bonuses.” And lo and behold – something duly happened.
At this point I think I can cut the story short – it’s all over town already, anyways: bonuses and incentive systems do not actually work with human beings – regardless of how smart and sophisticated their designs are. Incentives neither improve individual performance (if there is such a thing) nor company results. Never. Ever. Why? Well, incentive systems have as much in common with performance as intelligence tests have to do with intelligence. That is, nothing at all. Intelligence tests do not measure intelligence, but the ability to solve tests; bonuses do not cause better-performing employees or better company performance, but employees who find ways to get their bonuses. Nothing more. Nothing less. To call bonus systems “pay for performance” or “meritocratic”, therefore, is utterly absurd.
"Intelligence tests do not measure intelligence, but the ability to solve tests; bonuses do not cause better performing employees, but that employees find ways to get their bonus."
The problem is not that employees are dumb, because exactly the opposite is true. In the 1990s, Harvard professor Michael Jensen illustrated how incentive pay really works: by coupling compensation to goals you introduce “breaks” into the total compensation (see illustration). These breaks prompt incentivized individuals to exploit the system for their individual advantage, to the detriment of the whole system. This happens in every situation possible. In other words: Through incentive systems, people are incentivized to game the system, and to eventually break the system.
The compensation systems we are discussing are not harmless at all. Without the “aggressive,” “motivational” pay and bonus culture, the financial crisis of 2008 would never have reached the dimensions it eventually had. Presumably, the crisis would never even have happened: incentives turn incentivized people into donkeys. They put blinders on them and rendered their behaviors apparently insane. Incentives implicitly tell managers and employees: “Reach your goal and you are fine! Do not worry if customers are happy, if you add value to the company, or if laws are broken. Just make the numbers we are giving you.”
Incentives and bonuses are compensation practices from a dark past.
They belong on the garbage heap of history.
The banking industry may indeed be extreme in its use of incentive systems. But it is by no means an exception
The financial service sector is obviously permeated by the bonus and incentive culture like no other. Here, the variable parts of total salaries are – with some exceptions – high or very high. And the ample use of variable pay has been well established within banks for decades. As a consequence, many bank executives, personnel managers as well as controllers and members of bank's supervisory boards find it hard to imagine how pay systems in their industry might work differently. This does not reduce the urgency to step away from these remuneration practices, however. Quite the opposite: the shortcomings of the financial industry, such as low quality of advice to clients, compliance and ethical violations, or extreme volatility of results and company valuations, are insurmountable without abandoning its current compensation culture.
Swiss bank UBS provides a striking example of how irredeemably broken incentive systems are. Repeatedly, and always with great fanfare, UBS has turned its incentive systems upside-down – most recently in 2012/2013. Yet those efforts always amounted to near-nothing: in the end, they just optimized the wrong thing. Despite assurances to the contrary, fixed targets, performance incentives, stock option programs, and elaborate “allocations” have stayed in place at UBS. It is clear that the near-endless chain of scandals at this bank and others will never stop this way! Bonuses predictably produce internal rat races – which you cannot end by just tweaking incentive systems. You must get rid of incentives once and for all.
But what does an alternative to incentives and to bonuses linked into individual, fixed targets, look like? Incentive-less pay systems, first of all, are much simpler and more cost-effective than the systems currently in place at UBS and so many other firms. The simplest solution of all: Pay people fixed salaries exclusively. To do that, just turn the formerly “variable” part of the salary into the fixed base salary. Total personnel cost will not increase through that change, or “flip.” It just officially fixes what previously was supposed to be variable. Another option for designing incentive-less variable pay is to give people a share of team (not: individual!) results or profit, e.g. in the shape of profit sharing or company shares or team result sharing. Always avoid stock options, though: They always create an incentive for manipulation and misrepresentation.
The enlightenment has not yet reached most of our companies and corporations
In my views, the problem with manager and employee pay in the finance industry and beyond is not so much one of absolute compensation, or total salaries. Banker's salaries today are often excessive and at times brazen, for sure. Overly high salaries are a problem the banks themselves and their owners most suffer from. Incentive systems, on the other hand, pose a threat to our societies at large. Such pay systems condition people to turn a blind eye, to abuse society, to make the numbers at all costs: “Fulfill your quota. Come hell or high water, even if it breaks the company.” This is fatal, consider how financial services have become an indispensable part of our economies. Societies as a whole require reliable and responsible financial services to function.
Managers are not greedy per sé.
They are made greedy by typical performance management systems.
As long as there are compensation systems tied to revenue, individual targets, plans and forecasts, distrust in the financial industry is justified and will never go away. My point is: People who work in organizations, including managers and bankers, are not overly greedy. But they are made overly greedy by today's performance management systems. Through so-called “Performance Management Systems,” people are systematically rewarded to be selfish, greedy, non-collaborative and distrustful. Incentives and bonuses are remuneration practices from the past. They belong on the garbage heap of history. The CEOs, the chairmen, the supervisory boards, and shareholders of this world must step up and make the move away from incentive systems happen.
In the long run, every company has exactly the people it deserves. Do your managers, employees, or colleagues behave like donkeys?
This essay is part of the book Essays on Beta, Vol. 1 by Niels Pflaeging.
Can we? Yes. Abolish them. Now!