Are Big Bonuses Counterproductive?

Does exceptional pay encourage exceptional effort?:

What’s the Value of a Big Bonus?, by Dan Ariely, Commentary, NY Times: By withholding bonuses from their top executives, Goldman Sachs and UBS may soften negative reaction from Congress and the public... But will they also suffer because their executives, lacking the motivation that big bonuses are thought to provide, will not do their jobs well? ...[D]oesn’t the promise of a big bonus push people to work to the best of their ability?

To look at this question, three colleagues and I conducted an experiment. We presented 87 participants with an array of tasks that demanded attention, memory, concentration and creativity. ... We promised them payment if they performed the tasks exceptionally well. About a third of the subjects were told they’d be given a small bonus, another third were promised a medium-level bonus, and the last third could earn a high bonus.

We did this study in India, where the cost of living is relatively low so that we could pay people amounts that were substantial to them but still within our research budget. ...

What would you expect the results to be? When we posed this question to a group of business students, they said they expected performance to improve with the amount of the reward. But this was not what we found. The people offered medium bonuses performed no better, or worse, than those offered low bonuses. But what was most interesting was that the group offered the biggest bonus did worse than the other two groups across all the tasks.

We replicated these results in a study at the Massachusetts Institute of Technology... We found that as long as the task involved only mechanical skill, bonuses worked as would be expected... But when we included a task that required even rudimentary cognitive skill, the outcome was the same as in the India study: the offer of a higher bonus led to poorer performance.

If our tests mimic the real world, then higher bonuses may not only cost employers more but also discourage executives from working to the best of their ability. ... For most bankers, a multimillion-dollar compensation package could easily be counterproductive. ...

Comments

[ndd]

You mean the psychological concept of satiation works in economics as well, contrary to generally taught neoclassical orthodoxy? Whocudanode?

[Valter]

to ndd: no, it cannot be about satiation since the subjects were satiated before (I think we can agree on this, can't we?) and they would not get the bonus unless they performed well enough.

The opposite could be true, namely that the high-bonus subjects got so excited at the prospect of winning a lot of money that it interfered with their cognitive ability. Like a CEO spending all his mental energy on "How to spend it" instead of "How to earn it", I suppose.

[reason]

Valter,
I have a slight variant on that - the problem is not the anticipation of the big bonus, it is the fear of not getting it. Just like a job applicant, stress can be a big problem.

[reason]

Of course this is not really the argument for large CEO salaries. The argument is that good CEO's are in short supply and the high salaries are quasi-rent required in order to obtain their services. The logical answer to that is that rents should be taxed HARD!

[crack]

UBS has done more than just lower their bonuses this year, they've changed their bonus methodology. It looks sort of promising.

http://curiouscapitalist.blogs.time.com/2008/11/17/the-race-to-the-bottom-of-the-bonus-pool/

[robertdfeinman]

Every major firm is doing badly at present. This would seem to indicate that external business conditions are more important that the personality, motivation or skill of their CEO's and other top managers.

This is also true across nations. In places like Japan and Germany, the pay schemes of CEO's are such that they get less compensation and are not as dependent upon stock options either. Nevertheless these firms are also lagging, so there is nothing about the US system that inherently produces better (or worse) CEO's.

The simple fact is that in the US the top jobs are doled out as part of incestuous relationships between firms which trade executives, hire each other to be on the boards of directors and employ the same executive compensation consultants to determine pay packages.

Since the stockholders no longer have any influence on how their firms are run there are no counter forces to prevent excesses. Just as in any other market, collusion and limiting new entrants produces artificial price rises and inefficiencies.

The focus on a handful of CEO's at financial firms will do nothing to fix this situation. Even public institutions like universities (include state-owned) are now paying high six figures to presidents and leaders of hospitals and other charitable organizations.

Since we don't believe in state control of compensation packages there needs to be some other mechanism to rein in this compensation arms race.

One way would be to require corporations to submit compensation to the stockholders. In addition the votes should be counted in a such a way that insiders don't control the outcome as they do now. Right now money votes, not people.

For non-profits, changes to the IRS regulations could force them to become more responsive. The majority of such institutions have self-perpetuating boards where the existing members recruit replacements and there is no other control. Some non-profits like the ACLU run competitive campaigns for their board with each contributor getting one vote. This is a step in the right direction, but the actual CEO is still picked by the board.

As with all distortions of power it is the lack of good governance controls that is the root cause of the imbalances.

[ndd]

Is there anyone here who seriously thinks that mega-corporate executives seize up with stress and underperform because of the thought that they might get $$$$Millions in bonuses?

HAHAHAHAHAHAHAHAHAHA

How many think said corporate executve might mail it in because the bonus is "in the bag" and s/he is already richer than Croesus?

That, my friends, is satiation.

[bp]

is this like the specialized ants that are no more productive than the generalized ants, or the time-and-motion studies of the past that backfired when they figured out that employee morale had a lot to do with productivity?

how about the claim that CEOs must be paid high amounts which are not tied to performance because it would deter incentives to take the necessary optimal level of risk, from which the flat-fee basis of renumeration shields them from the consequences of tolerated poor choices in order to achieve the good ones - otherwise they'd just plod along with low-risk, low-return outcomes

... brought to you by the anti-socialists who believe pay not tied to performance is socialism ...

versus claims that the skills necessary to make good high-risk choices really are that scarce and the high pay reflects that competitive salary necessary to lure said talent due to a "shortage" of the same

high pay is obviously in part, an implicit insurance policy designed to lower the opportunity cost of carrying out certain duties like laying off employees, outsourcing, undercutting pension and healthcare plans and manipulating the political process - not to speak of committing crime in the financial industry

the "shortage" argument is bogus because the shortage is artifical, created internally via entry barriers to bar an oversupply of highly qualified entrants who could easily perform the same duties but may not due to different incentives rather than different skills

the reason for an inverse relationship between pay and performance is more apparent in the real world than in an experiment based on "an array of tasks that demanded attention, memory, concentration and creativity"

these cognitive factors tend to be fixed with individual personal traits and don't vary well for most purposes ... instead, they're applied toward different outcomes according to different incentives at different levels of income, like the 500 or so individuals who actually understand how derivatives work ... a sort of grossly overpaid, mind-numbing task that could be achieved by others in some ways with similar cognitive skills for much less pay (current retroactive investigations will bear this out as green-eyeshade underlings heretofore confined to shunned internal audits are unleashed to evaluate the carnage)

it's not so much that peformance declines as pay increases ... those 500 derivators could have been good jugglers or speed stackers of plastic cups as well as tack sharp diagnosers of medical symptoms or whatever ... it's as much about pay not to perform as it is about pay for performance

as to why the experiment produced the same inverse results, obviously the participants paid the most were overwhelmed morally with the guilt of being paid more than they were worth and unlike a conventional executive, became rattled and disoriented in carrying out the same tasks cooly implemented by their lower paid cohorts

[OhNoNotAgain]

"How many think said corporate executve might mail it in because the bonus is "in the bag" and s/he is already richer than Croesus?"

I'm with ndd on this one. CEOs seem to make a name for themselves with one company, and then proceed to milk this one good performance for all its worth with all sorts of guaranteed pay packages over the next 4 or 5 years. God help those next companies that see these CEOs coming in and out like they're going through a revolving door, each one changing the direction of the company as it flails around and quickly sinks into the abyss.

says...

So, the people who determine salaries and bonuses give themselves huge salaries and bonuses, and that does not motivate them to do "better". And big bonuses do not help people when remembering strings of characters or reacting to a spot when staring at a computer monitor. This is an argument? There is a conclusion here? Thats funny.

[Bruce Wilder]

"The argument is that good CEO's are in short supply and the high salaries are quasi-rent required in order to obtain their services."

I don't think that's a "quasi-rent"; I think that's just "rent". But, yeah, this is the Hollywoodization argument -- that the best executives are rare stars, competing for a few seats on the corporate machine, with a very, very high marginal productivity.

It is not necessarily a bad argument, just one that leaves aside all the psychological and social considerations, not to even mention risk incentives. Is it money that sorts out Steve Jobs from Archie McCardell?

Or, does the big money create the kind of social tournaments amid a den of thieves, which pretty much ensure that the worst of worst compete and "win"? As another commenter put it, the central issue is corporate governance. And, the big bucks tend to overwhelm all other considerations. The big bonus tied to corporate financial performance is as much an incentive to rig the books, as it is to actually perform. Or, it is an incentive to form a political faction, which will play musical chairs, to get its members a taste of riches.

[kharris]

I am pleased to see wage differentials being exploited to solve a real problem - how to do experimental economics involving rewards of a meaningful size. What will they think of next?

[Arne (not anne)]

I did not see a link to answer this question. As a subject presented with the description of the bonuses and the requirement to do exceptional work, does the subject have the necessary information to guess whether he can achieve exceptional performance? If the bonus is higher, does that not imply that the performance to get it should be greater? If it is moderately high, then he may assume he just needs to perform above average, and we all know that we are above average. :-) If the the bonus is exceptionally high, then the subject may assume he must be in the top 1 or 2 percent to achieve the bonus. If he does not think he can make it into the top performers, then there is a disincentive to try.

CEOs of top companies may actually respond differntly to this test. They are alredy self-selected to be people who are more likely to assume that they can perform exceptionally well. They would not be likely to give up without trying.

[Jack]

Not surprising. Now economists will have to find another way to defend the licenses to steal given to CEOs. They're an innovative group, so it shouldn't be too hard for them.

[Valter]

to ndd:

you are missing the point of the experiment: the experimental subjects in India and MIT were NOT satiated with money before the experiment (there was a typo in my previous comment; sorry), hence satiation cannot be an explanation of the experimental results.

As for the CEOs, we do not know whether the results would be replicable with CEO compensation levels and if so, whether the underlying psychological mechanism would be the same. In fact, I doubt it would - hence my half-joking reference on CEOs wasting their time on "How to spend it" (a Financial Times magazine) instead of working.

That reminds me: back to work!

[S Brennan]

To the Pooh Poohers above,

The experiment lends credence to real world observations. CEO's in other countries are kicking US CEO's ass in just about every area of endeavor [see balance of trade], save embezzlement and yet foreign CEO's are paid considerably less. Thus the experiment reflects reality.

Which as Jack Says...

[Is] "Not surprising. Now economists will have to find another way to defend the licenses to steal given to CEOs. They're an innovative group, so it shouldn't be too hard for them."

[TigerPaw]

Trying to figure out how CEO pay is related to performance isn't going to get too far because in most cases pay/performance have very little to do with each other. What's really going on in many instances is the CEO thinking to himself "how much can I pay myself without people screaming to the point I'll get tossed out". Doing an analysis on that will yield very different answers, and I'd wager far more accurate ones.

[don]

I think the incentives for damage in the design of corporate bonuses, especially in the financial sector, are not well represented by the experiment the authors perform. They don't ask the right questions. The problem is, the reward structure gave incentives to mislead about performance (remember the dot-com bust?) and to take too much risk, because the risk-reward distribution is truncated at the bottom (by the 'tyranny of zero'). So, the above experiment is largely irrelevant to the important questions about executive pay.
S. Brennan - right.

[ndd]

Valter, I agree with your statement about the experimental subjects themselves.

But note the penultimate paragraph:
If our tests mimic the real world, then higher bonuses may not only cost employers more but also discourage executives from working to the best of their ability. ... For most bankers, a multimillion-dollar compensation package could easily be counterproductive. ...
which prompts my statement about satiation.

[Arne (not anne)]

Having found a link to the study
http://nash.princeton.edu/seminars/BEHAVIORALECO/
BEHAVIORAL%20ECO/BE%20Fall%202005/Ariely.pdf
, I am more impressed by the study, but less impressed by trying to extend it to CEO pay.

In the 2005 writeup, they discuss why the participants choke under pressure.

says...

"Thus the experiment reflects reality"

Really? A CEO receiving a smaller bonus will perform better? Really? A hard-working competent CEO will perform worse due to being overpaid? Really? Foreign CEOs perform better because they are paid less? Really? We can agree that the surprising results of the experiments are pleasantly provocative, but really, do they reflect reality? Really?

[btg]

why wasn't there another group in the study - people who were told that there would be no reward beyond the slight gratitude of the people conducting the experiment... i would probably guess that the people getting no reward at all would have done just as well as the ones getting a reward.

but apart from pay, those high paid execs also get the thrill of wielding power and prestige of being the head of a huge company... and the sense of mastery and accomplishment from success itself. the great leaders in business - like bill gates and warren buffet - often end up giving away much of the money they have made, and others, like ross perot, often had fairly modest lifestyles...

maybe the right way was where the heads of companies were almost exclusively people who had worked their way up to the top after spending their entire careers in the same company - like in japan, or the 1950s type "organizational man".

says...

Carl Icahn has some interesting takes on this issue. He is heading up a "good" cause, a crusade against corporate excesses . It would be worth it to check out his website and gain some extra insight on the issue. He has many colorful arguments against the current determination of executive compensation. He suggests attacking the heart of the problem, not chasing after the ex-CEOs of now defunct companies, by addressing deficiencies in the current corporate governance system.

http://www.icahnreport.com/

[Real Person from the Real World]

Why is it that commodity flunkies are penalized when we admit to the hiring HR gatekeeper while looking for a job, that we are looking for better compensation? Rather we are expected to *sell ourselves* on the basis that the job in question is our *passion". OTH, it's commonly assumed that corporate big shots will only perform well if they get greased with extra money, in addition to a fat salary. For the vast majority of us, you aren't supposed to be taking a job for more money, or even for money at all, but just for the "passion" of doing it! (Thank you Joe Campbell, for making life tougher for working stiffs.) I am sure Steve Spielberg enjoys what he does, but he is also well compensated for it, as are CEOs and Investment Honchos. It is a lot easier to have passion for a any job, when it is well paid, but when a big bonus is expected year after year like an entitlement in addition to generous regular pay, it hardly seems like it would ever come to mind in daily work or perhaps as someone suggested above, cause pressure to perform and choke performance.

What was originally probably done was in finance - if the firm did well, excess profit could be distributed among workers, but it seems that bonuses came to be seem as an employment entitlement far beyond financial firms, and that year after year, no matter how a firm did, even if it lost money, bonuses were paid. This whole incentive thing is just a perverse product of the "greed is good" mentality.

[nathan]

bonus comp may add stress and diminish cooperation ...

also, to the extent employers discriminate in unfair ways or in ways not good for shareholders and debt holders (managers get bonuses backwards, just like they got lending risk wrong), it may magnify the deterioration of the employer's situation in the long run for the short-term benefit of bonused managers.

[Real Person from the Real World]

The rats always flee a sinking ship, but make sure they have a nice boat to flee in.