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Why employee pay incentives could be bad for business

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In the mid-80s, an American football team – the New York Jets – had a problem; Ken O’Brien, their acclaimed quarterback, had stopped performing up to expectation. In particular, as one of the Jet’s former star quarterbacks, Joe Namath, put it, “I see him hold onto the ball more than he should”. 

The question was, why? Early in his career, Ken had a tendency to take excessive risks and as a consequence throw some untimely, costly interceptions. In an attempt to prevent this type of behaviour continuing, the contract that he’d signed with the team penalized him financially for every in-game interception that he threw. 

The incentive contract worked – Ken subsequently threw fewer interceptions, however, it came at a cost. While he no longer passed the ball when the chance of interception was great, he also stopped passing the ball when he should have in fact taken the risk, crippling his performance. According to some, this only got worse over time. 

This problem also rings true in the business world. Powerful financial incentives (such as year-end or month-end bonuses, pay-for- performance, piece-rate pay, or stock options) have obvious benefits in the workplace. 

By rewarding individual performance managers can align the interests of different organisational members and shareholders, encourage and direct efforts within the workforce, help to eliminate any unwanted behaviour, prevent staff from free-loading and so on. Indeed, the vast majority of US and Europe-based companies opt to use such compensation schemes for their employees.

However, it is these same incentives that, on the surface increase staff efficiency, can also lead to highly adverse consequences for businesses. Providing financial incentives can give rise to harmful “incentive gaming”, as staff commonly exploit such systems for their own gain. Additionally, as with Ken O’Brien’s performance on the field, these effects can become more pronounced over time, through the occurrence of adverse learning.

These effects are also further exacerbated by the ability levels of the staff they are awarded to, as though the smartest employees are typically the ones whose productivity is most increased via powerful financial incentives, they are also the ones who can cause a company the most risk by manipulating incentive schemes. 

Events such as the 2008 financial crisis or infamous stories such as the downfall of Enron, or past scandals at Tyco and WorldCom all provide vivid illustrations of the perverse effects powerful financial incentives can have on a company.

Recent research shows that the efficiency of financial incentive systems in organisations typically follows a life-cycle trajectory similar to that of, for example, products.

Early in the life-cycle stage, a given design of incentives is likely to increase the efficiency of operations – a process commonly referred to as ‘productive learning’, and is an intended consequence of any incentive system. 

However, from a certain point on, as employees become familiar with the system, they learn how to exploit its design to their own advantage and begin to do so through incentive gaming.

Consequently, the effectiveness of the system begins to decrease as staff place more focus on their own objectives rather than those of the company. Such effects are commonly present across a variety of industries ranging from manufacturing, to services and IT to name a few.

The magnitude of incentive gaming within a business can also be hugely significant. For example, in a recent study of a large European bank staff tinkered with the terms of their loan sales – pricing them below the benchmark value in order to sell more and hit their targets. As a result, staff caused profit losses amounting to more than 13 per cent over a 13-month period following the introduction of a new financial reward scheme.

Because of this, organisations are typically faced with the following dilemma: though offering powerful financial incentives is more beneficial the smarter the employee is, the dark side of this trade-off is that these more-able employees may also be the ones to best manipulate the incentive system to their advantage. Indeed, research shows that the effect is magnified by cognitive abilities of organisational members as shown below.

So, what can organisations do to better their incentives whilst ensuring that they are not trapped, or damaged by their adverse consequences?

One solution is to periodically change the design of incentives on offer to staff. This can include changes in how companies measure performance, relative importance of individual vs. team outcomes, incorporating both objective and subjective measures into staff performance evaluations and so on. Indeed, many organisations are already doing this, and alter their incentive systems every two-to-three years. By doing this, managers can reset the “adverse learning clock”, and solve some of the problems introduced by gaming behaviours.

The second solution is more delicate and involves completely rethinking the use of all financial incentives on an industry-wide level – especially in those with high human capital, in order to put an end to such problems. Though incentive gaming may be expected, and perhaps even accepted to some degree by managers, on the net however, this effect is quite often negative. Lest we forget, the rogue traders who marked the unfolding of the 2008 financial crisis were certainly amongst the most skilled and creative workers in their field.

And, as with Ken O’Brien, though motivating – or retraining your best performers with financial incentives may seem like a winning solution in the short term – the long term effects can often be more costly than you planned for.

Tomasz Obloj is a professor of strategy at HEC Paris where he teaches the core strategy course.

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