Thursday, June 10, 2010

Rethinking the Relationship between Pay and Performance

As I read Dan Ariely's new book, I was particularly intrigued by his research findings regarding the effects of bonus compensation on human performance. Ariely conducted an interesting experiment in India along with several colleagues. They created a a variety of games and tasks for subjects to complete, and they created three conditions (low, medium, high bonus). They chose India so that the bonuses would be small in absolute dollar terms, but very high in terms of their worth to an average Indian citizen. The highest bonus level actually constituted approximately five months’ pay for the subjects in the experiment.

What were the results? You might expect performance to rise with bonus level. After all, that fundamental belief underlies compensation schemes in most companies. However, Ariely and his co-authors found that performance was lowest in the highest bonus condition. The same results held in the United States. What happened? Some combination of stress, fear of losing the money, and other psychological pressures, such as over-attention to the bonus as opposed to the task itself, seemed to cause participants in the highest bonus condition to actually perform poorly on the games and other tasks in the experiment. One can certainly relate to this finding. Consider how many business executives may find themselves obsessing over their compensation toward the end of the year, and perhaps becoming distracted from the actual work that they must accomplish.

By the way, these results hold when the tasks involve some level of cognitive skill. If the tasks are purely mechanical in nature, then higher bonuses yield higher performance. That finding indeed suggests that stress may play a factor in diminishing performance on tasks that require thinking and reasoning (such as many business tasks).

9 comments:

Dr William J McKibbin said...

Dan Ariely's new book, "The Upside of Irrationality" can be purchased at:

http://amzn.to/cF5bL9

Thank you for the opportunity to comment...

professor cz said...

Eliminate the bonus system. Mintzberg (2009) calls the culture of bonuses on Wall Street and public corporations a form of legalized corruption and largely responsible for the financial meltdown of 2008. According to Olive (2009) “… excessive CEO pay is the cancer eating away at sound corporate management. Excessive pay for top management distorts decision making. It encourages reckless and short-term behavior that damages the enterprise and undermines the wider economy. He goes on “Mostly this cursed phenomenon takes the form of CEOs betting the company for a quick windfall, hence the crisis in global finance that brought us to the brink of a second Great Depression.” As we observe with the bonus system and compensation in general we can conclude that most executives operate with the belief that they are special and how they are paid should have little relationship to reality. Consequently they have their special compensation systems structured by “compensation consultants” who guarantee a handsome bonus no matter what the company does. In addition these bonus systems only reward short term goals and forces greedy CEO’s to terminate employees, outsource, offshore and reduce R&D and long range objectives to fatten the bottom line for the big short term bonus. While there is wide spread belief among academic researchers and business writers that CEO compensation should be aligned to corporate performance the chief complaint is that current compensation practices tend to reward short term profitability. Consequently we find that current compensation practice results in short term bottom line results where CEO’s push their employees to take short-term risks with little regard for the long-term effects. This view became particularly visible during the crisis of 2008 and led to a movement by business writers, politicians and others to suggest that CEO compensation should be changed to consist of restricted stock and other forms of long-term compensation designed avoid rewarding short-term performance. According to Cooper, Gulen and Rau (2009) this proposed system of compensation implies a positive relationship between long-term incentive pay and future firm performance. They disagree and they have demonstrated that there is not only no positive relationship but in fact there is an inverse or negative relationship between CEO compensation and long term shareholder wealth. In fact they discovered the higher the CEO long term compensation the lower the shareholder returns. We now have significant evidence to suggest that overpaying executives will decrease shareholder wealth. Why? The answer is simple excessive pay is a disincentive to do well but it is an incentive to “take the money and run.”

Gary Duell, ChFC, MBA said...

Current executive compensation systems, approved by the overlapping board on which they serve, turn CEOs from "parents" (for whom the health and happiness of their charges are reward enough)into vampires.
I've seen no convincing evidence that $15,000,000 is any more motivating than $7,500,000.

Bajwa said...

nice article, i enjoyed reading it. it re-instates that incentives are not the only thing required to improve the performance.
i think, its the time to bring in spirituality into managemenet especially in HR.
Thanks

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No Gods Required said...

You should check out Alfie Kohn, on the subject of parenting and competition.

No Gods Required said...
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