It is not unusual for 60 to 80 per cent of chief executives and other senior leaders’ pay to be tied to performance – whether performance is measured by quarterly earnings, stock prices or otherwise.
And yet, from a review of research on incentives and motivation, it is wholly unclear why this is the case.
If you have someone who will only do a good job based on a large bonus, you should really consider someone else.
As John Cryan, the chief executive of Deutsche Bank, recently said: “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.”
Research points to five problems with performance-based pay.
1. Contingent pay only works for routine tasks
Research by Dan Ariely, the Duke University professor, and his colleagues showed that variable pay can enhance people’s performance on routine tasks – for example, for a factory worker. But where innovative, non-standard solutions are needed, results showed that variable pay hurt performance.
2. Fixating on performance can weaken it
Performance-based pay is named so because incentive plans encourage leaders to hit specific goals. But as researchers have found, if you want high performance, performance is the wrong goal to fixate on.
Recent research by one of this article’s authors, Dan Cable, and colleagues showed that consultants’ creativity improved when they focused on learning rather than results, and they also were more likely to help their colleagues perform.
3. Extrinsic motivation crowds out intrinsic motivation
A meta-analysis of 128 independent studies confirmed that when financial incentives are applied to increase senior leaders’ extrinsic motivation, intrinsic motivation diminishes.
4. Contingent pay leads to cooking the books
When a large proportion of a person’s pay is based on variable financial incentives, they are more likely to cheat.
Research conducted in America has revealed the relationship between goal-setting and unethical behaviour is particularly strong when people fall just short of reaching their goals. Our colleague Daniel Effron, assistant professor of organisational behaviour at the London Business School, found that cheating occurs at the last chance to do so – “The cheat-at-the-end-effect”.
5. All measurement systems are flawed
Incentive plans demand that metrics are used as the trigger for a payout. Whatever measure you use, you will undoubtedly end up with an imperfect quantification of what you would like your executives to do.
Research by Mihaela Stan and Freek Vermeulen, the other co-author of this piece, showed that in fertility clinics, the measure of success seems unambiguous and objective. After focusing on distorted metrics, healthcare providers’ behaviour negatively affected clinics’ long-term performance.
High bonuses can lead to unethical behaviour, even cheating, and high pay rewards strip out the desire to do the job for the love of it, replacing passion with remuneration. Our solution might seem radical, but it’s based on evidence.
We argue in favour of abolishing pay-for-performance for top managers. We propose that most companies should pay their top executives a fixed salary.
Even if only 30 per cent of pay is flexible, there is a high probability that the incentive will distort the executive’s behaviour and that the metrics to activate the bonus will be wrong.
If you think that suggesting senior executives’ pay be fixed is “throwing out the baby with the bathwater”, that is an understandable response. But consider this: to tie pay to long-term performance, we need to understand two crucial points. First: can you define long term? Second: can you define performance? Put them together to create “long-term performance” and what do you get? Ambiguity.
Why do we do the things we do? What is it that drives our behaviours? Extrinsic motivation occurs when we are motivated by a desire to gain a reward or avoid an adverse outcome. Extrinsic motivation decreases creativity and innovation.
Intrinsic motivation involves engaging in behaviour because it is personally rewarding: the desire to participate in an activity for its own sake. Good chief executives really don’t need extrinsic motivation. And pay-for-performance destroys that all-important intrinsic motivation, which is vital to creativity and innovation.
Evidence shows that people will start to behave differently if you make a large portion of their pay dependent on a measure of performance. But it will not be in a way you want them to behave. Fixing executive pay is a radical solution. And there are arguments for either sides of the debate. But in this case, we say fix it.
Dan Cable is a professor of organisational behaviour, and Freek Vermeulen an associate professor of strategy and entrepreneurship, at London Business School
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