2016-02-25 11:03:41
Dan CableFreek Vermeulen
February 23, 2016
For chief executives and other senior leaders, it is not unusual for 60-80% of
their pay to be tied to performance whether performance is measured by
quarterly earnings, stock prices, or something else. And yet from a review of
the research on incentives and motivation, it is wholly unclear why such a
large proportion of these executives compensation packages would need to be
variable. First, the nature of their work is unsuited to performance-based pay.
As the incoming Chief Executive of Deutsche Bank, John Cryan, recently said in
an interview: I have no idea why I was offered a contract with a bonus in it
because I promise you I will not work any harder or any less hard in any year,
in any day because someone is going to pay me more or less.
But moreover, as we will show, performance-based pay can actually have
dangerous outcomes for companies that implement it.
Following the global economic crisis of 2008, large bonuses and stock options
have been held responsible for overly risky behavior and short-term strategies.
This has led to arguments that executive compensation needs to be organized
differently so that the variable component motivates the right behaviors.
Particularly in business schools, various Finance and Accounting professors
have argued for including more long-term incentives, and for replacing variable
pay packages that largely consist of stock options with a mix of bonds and
stocks.
As professors of Organizational Behavior and Strategic Management, we take a
different and perhaps more radical stance. We argue in favor of abolishing
pay-for-performance for top managers altogether. We propose that, instead, most
firms should pay their top executives a fixed salary.
Note: We are not arguing that top managers such as CEOs should be paid less.
That may very well be the case too, but that s not the focus of our analysis.
Here, we are merely arguing that, regardless of the size of a top manager s pay
package, it should be a fixed salary, rather than a variable amount of money
dependent on performance criteria. In fact, we believe this to be true not only
for CEOs and other people in the C-suite, but for senior executives in general.
Although there may be reasons executives would prefer to be paid as they are
today for example, variable stock-based pay in the United States is taxed at
a lower rate than are salaries from our review of the literature, we see no
compelling evidence that such arrangements actually benefit the companies
making the payouts.
This argument is based on five related, data-backed insights from research:
contingent pay only works for routine tasks; for creative tasks, a results
focus is ineffective at best, and can in some circumstances actually impede
performance; extrinsic motivation crowds out intrinsic motivation; contingent
pay too often results in fraud; and measuring performance is notoriously
fraught.
1. Contingent pay only works for routine tasks. Companies should abolish
contingent pay for their top executives because theirs is the least appropriate
job for it. Decades of strong evidence make it clear that large
performance-related incentives work for routine tasks, but are detrimental when
the tasks is not standard and requires creativity.
Research by Duke professor Dan Ariely and his colleagues, for example, has
shown that variable pay can substantially enhance people s performance on
routine tasks; the higher the reward, the more productive people who were
working on routine jobs became. However, for people working on creative tasks
where innovative, non-standard solutions are needed results showed that a
large percentage of variable pay hurt performance. For the latter group, even
when individuals could earn an additional month s salary for performing well,
variable pay reduced their ability to fulfill their task.
Similarly, research by Ruth Kanfer and Philip Ackerman of the Georgia Institute
of Technology showed that challenging Air Force enlisted personnel to land a
certain number of airplanes did not increase their effectiveness when learning
was necessary in fact, they performed worse at the task. On routine tasks
where learning is not necessary, highlighting performance goals works great.
Of course, the task of a top manager is not a routine one. Most top managers
need to be innovative and creative, open to learning about change, and
developing new solutions for non-routine problems. They need to carefully
balance various needs and uncertain outcomes in a volatile environment. This is
the type of job that is particularly unsuited to substantial variable pay.
2. Fixating on performance can weaken it. The goal of most executive incentive
plans is to focus leaders on hitting goals and achieving outcomes. After all,
that s why it s often called performance-based pay. But as researchers have
found, if you want great performance, performance is the wrong goal to fixate
on.
Several studies have shown that when employees frame their goals around
learning (i.e., developing a particular competence; acquiring a new set of
skills; mastering a new situation) it improves their performance compared with
employees who frame their work around performance outcomes (i.e., hitting
results targets; proving competence; seeking favorable judgments from others).
For example, in a study of salespeople conducted during a product promotion,
researchers found that salespeople with a learning mindset significantly
outperformed salespeople with a performance-oriented mindset. Recent research
by one of us (Cable) and his colleagues showed that consultants creativity
innovation improved when they focused on learning rather than results, and also
were more likely to help their colleagues perform.
In fact, various studies over the last 20 years for instance by Kanfer and
Ackerman again, as well as Kanfer and Edwin Locke have shown that, in work
situations where learning is important, performance or outcome goals can have a
deleterious effect on performance.
Learning goals are more effective at improving performance precisely because
they do the opposite of most executive incentives: they draw attention away
from the end result and focus instead on the discovery of novel strategies and
processes to attain the desired results. Therefore, focusing top managers
attention on the end result by tying rewards to performance goals is
counterproductive: it prevents people from learning and developing something
new.
3. Intrinsic motivation crowds out extrinsic motivation. When people feel
intrinsically motivated, they do things because they inherently want to, for
their own satisfaction and sense of achievement. When people are extrinsically
motivated, they do things because they will receive bigger rewards. The goal of
contingent pay is to increase extrinsic motivation but intrinsic motivation
is fundamental to creativity and innovation.
And when financial incentives are applied to increase senior leaders extrinsic
motivation, intrinsic motivation diminishes. A meta-analysis of 128 independent
studies conclusively confirmed this effect. Although all studies have
methodological shortcomings, the consistency of the results across so many
studies, samples, and methodologies is noteworthy. As noted by the authors,
expected tangible rewards made contingent upon doing, completing, or excelling
at an interesting activity undermine intrinsic motivation for that activity.
Because intrinsic task motivation is fundamental to creativity and innovation,
highly variable incentives deplete top managers of the intrinsic motivation
they so much need to perform optimally.
4. Contingent pay leads to cooking the books. When a large proportion of a
person s pay is based on variable financial incentives, those people are more
likely to cheat. In academic terms, we would put it this way: extrinsic
motivation causes people to distort the truth regarding goal attainment.
When people are largely motivated by the financial rewards for hitting results,
it becomes attractive to game the metrics and make it seem as though a payout
is due. For example, different studies have shown that paying CEOs based on
stock options significantly increases the likelihood of earnings manipulations,
shareholder lawsuits, and product safety problems. When people s remuneration
depends strongly on a financial measure, they are going to maximize their
performance on that measure; no matter how.
And not surprisingly, research by Maurice Schweitzer and colleagues has
revealed the relationship between goal setting and unethical behavior is
particularly strong when people fell just short of reaching their goals a
common outcome of the oh-so-popular stretch goals.
Thus, cooked books, false sales reports, and illegal means to performance
emerge when financial incentives cause leaders to care more about looking good
in terms of results than actually doing well in terms of creating value.
5. All measurement systems are flawed. Incentive plans demand that some metric
be used as the trigger for a payout. The problem is that whatever package you
construct bonds, stocks, or bonuses whatever performance criteria you
decide on will be imperfect. For a complex job such as senior management, it is
simply not possible to precisely measure someone s actual performance, given
that it consists of many different stakeholders interests, tangible and tacit
resources, and short- and long-term effects. Even with HR executives clamoring
for enhanced people analytics (and technology companies bending over
backwards to deliver them) any measure you choose is going to be an inadequate
representation of how you would like your CEO to behave.
The problem is that once you link someone s financial rewards to a particular
measure or set of measures, it is going to affect that person s behavior in
terms of what they do, and don t do. As Steven Kerr wrote in his classic
article On the folly of rewarding A, while hoping for B, most organisms seek
information concerning what activities are rewarded, and then seek to do (or at
least pretend to do) those things, often to the virtual exclusion of activities
not rewarded. If you reward quarterly profits, for example, you should not be
surprised if CEOs cut back inappropriately on long-term investments such as
research and development and advertising when they need it to boost their
numbers and hit their bonus target.
This last point you probably already knew. Most boards (or whoever determines
senior executives compensation schemes) realize they have a limited view of
the people who work for them. Even when performance seems easy to measure,
because it is unambiguous and objective, there is usually a catch, and the
measure will still turn out to be flawed. For example, in IVF (fertility)
clinics, the measure of success seems unambiguous and objective: the percentage
of pregnancies that result from treatment is a clear and objective performance
goal. Yet, research by Mihaela Stan and one of us (Vermeulen) showed that even
in this situation, focusing on that metric distorted health-care providers
behavior to the detriment of clinics long-term performance. Clinic managers
ended up excluding difficult patients from the treatment (such as women with
complex medical conditions) to boost their clinics success rates. And over the
long-term, these decisions deprived their providers of valuable opportunities
for learning which made them worse off in the long run.
Hence, whatever measure you use, you are going to end up with an imperfect
quantification of what ideally you would like your top executives to do. And,
inevitably, it will end up distorting their behavior.
What about competing for talent?
Perhaps you think you have to offer a large percentage of variable pay to help
your firm attract top executives. Even if that is true, think about who will be
attracted to such a package: the very people most in need of a financial
incentive to work hard and perform well. Are you sure those are the people you
should want to attract in the first place?
We suspect not. Intrinsically motivated people do the best they can, and making
a very large percentage of your pay dependent on some result can only ruin
that. As Theresa Amabile has noted, There is abundant evidence that people
will be most creative when they are primarily intrinsically motivated, rather
than extrinsically motivated by expected evaluation, surveillance, competition
with peers, dictates from superiors, or the promise of rewards.
To return to new Deutsche Bank CEO John Cryan, he also said: I don t empathize
with anyone who says they turn up to work and work harder because they can be
paid more. I ve never been able to understand the way additional excess riches
drive people to behave differently.
We only half agree: Abundant evidence shows that people including top
managers will in fact start to behave differently if you make a large
proportion of their remuneration dependent on some measure of performance. But
it will not be in a way you want them to behave.
Dan Cable is professor of organizational behavior at London Business School.
Freek Vermeulen is an Associate Professor of Strategy and Entrepreneurship at
the London Business School. He is the author of the book Business Exposed: The
Naked Truth about What Really Goes on in the World of Business. Follow him on
Twitter @Freek_Vermeulen.