Saturday, February 12, 2011

Are big bonuses counter-productive?

The usual argument against high remuneration of senior executives is that it is often undeserved. I have some sympathy for that view. It is particularly difficult to understand how a person who is given a promotion to the top job can actually be worth substantially more than a competitor who narrowly missed being given that job. The person who is given the promotion will not necessarily add anything more to the profits of the firm than would the person who missed out. In many cases the prestige of the top position would be adequate compensation for the added responsibilities involved.

Nevertheless, it is possible to view the recipients of such unmerited rewards as the lucky beneficiaries of a system that generally produces good results for shareholders. Tournament theory recognizes that high remuneration for senior executives can be in the interests of shareholders for much the same reason as high prize money for winners of tennis and golf tournaments is in the interests of the spectators. The prize money is there to attract the top players and to encourage them to perform well during the tournament. Providing part of the remuneration in the form of a bonus helps to ensure that the interests of the chief executive are aligned with those of shareholders.
The Upside of Irrationality: The Unexpected Benefits of Defying Logic at Work and at Home
In his recent book, ‘The Upside of Irrationality’, Dan Ariely suggests, however, that big bonuses can actually be counter-productive. He argues that very high bonuses ‘can create stress because they cause people to overfocus on the compensation, while reducing their performance’ (p. 47). The general idea is that people (and other animals) tend to choke when exposed to very high incentives and social pressure.

I suppose readers would be most familiar with examples of choking from professional sport. Greg Norman’s habit of choking at the end of major golf tournaments is legendary. Rather than being remembered for the tournaments he won, he is more often remembered for not winning tournaments that he led until the last round. (Interestingly, this has not prevented the Great White Shark from becoming a successful businessman.) Several books have been written about choking and how to deal with it. Henry Scuoteguazza has recently reviewed three of them here.

The experiment that Dan Ariely reports that seems to me to be most relevant to payment of big bonuses involved payment of different levels of rewards to people participating in various cognitive games. The bonus rates ranged from equivalent to about one days pay to about five months pay. (To make the experiment affordable it was conducted in rural India.) The participants who stood to earn the most had the lowest level of performance – they choked under pressure.

How relevant are such experimental results to the world of business? Ariely tells us that when he presented his findings to a group of bankers they maintained that they were super-special individuals who work better under stress. I suspect the bankers were probably about half-right about themselves. Their work environment would have tended to favour people who are able to cope well with the stresses associated with high-powered incentives. At the same time, in my view events of recent years suggest that many bankers are affected by a herd mentality – too willing to follow their colleagues into risky territory and then to join the stampede when danger becomes obvious.

Coming back to tournament theory, the critical issue is not whether the incentive provided by the bonus system actually causes the chief executive to work more diligently and effectively, but the effect it has on the profits of the whole firm. Even though chief executives, like sports professionals, may sometimes have difficulty in coping with the pressures associated with huge rewards, a bonus system providing such rewards could still be in the interests of shareholders. Then again, ... !

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