“Why Pay for Performance Should Get the Sack”

Yves here. Before reacting reflexively to the thesis of the article, consider this corroborating view from the former chairman of Goldman, John Whitehead, back in 2007:

“I’m appalled at the salaries,” the retired co-chairman of the securities industry’s most profitable firm said in an interview this week. At Goldman, which paid Chairman and Chief Executive Officer Lloyd Blankfein $54 million last year, compensation levels are “shocking,” Whitehead said. “They’re the leaders in this outrageous increase.”

Whitehead went even further, recommending the unthinkable, that Goldman cut pay:

Whitehead, who left the firm in 1984 and now chairs its charitable foundation, said Goldman should be courageous enough to curb bonuses, even if the effort to return a sense of restraint to Wall Street costs it some valued employees. No securities firm can match the pay available in a good year at the top hedge funds.

“I would take the chance of losing a lot of them and let them see what happens when the hedge fund bubble, as I see it, ends,” Whitehead, 85, said….

By Bruno S. Frey, Professor of Economics at the University of Zurich and Margit Osterloh, Professor (em.) for Business Administration and Management of Technology and Innovation, University of Zürich; and Professor, Warwick Business School. Cross posted from VoxEU

As the bonus culture in the financial sector once again comes under attack, this column rubbishes the typical defence that banks need to pay top dollar to attract the best talent.

Scientific literature has extensively dealt with variable pay-for-performance. Despite the fact that serious problems linked to this approach have thus become obvious, many authors continue to support compensation according to predetermined performance criteria because they are committed to the traditional concept of the ’homo oeconomicus’.
Overall, there has been a marked change of opinion in academia (see for instance Bryson and Freeman 2008 on this site). The idea that people are solely self-interested and materially orientated has been thrown overboard by leading scholars. Empirical research, in particular experimental research, has shown that under suitable conditions human beings care for the wellbeing of other persons. Above all, they are not solely interested in material gains (see eg Frey and Osterloh 2002). Recognition by co-workers is greatly important. Many workers are intrinsically motivated, ie they perform work for its own sake because it is found challenging and worth undertaking. This applies not only to qualified employees but also to persons fulfilling simple tasks. They often are proud of their work and performance.

There are four major arguments against variable pay-for-performance:

In a modern economy, it is practically impossible to determine tasks that are to be fulfilled in the future precisely enough so that variable pay-for-performance can be applied. In a society continually faced with new challenges, superiors oftentimes find it impossible to fix ex ante what an employee will have to do in the future.

It would be naïve to assume that the persons subjected to variable pay-for-performance would accept the respective criteria in a passive way and fulfil their work accordingly. Rather, they spend much energy and time trying to manipulate these criteria in their favour. This is facilitated by the fact that employees often know the specific features of their work better than their superiors. The wage explosions observable in many sectors of the economy can at least partly be attributed to such manipulations, eg when managers are able to contract easily achievable performance goals.

Variable pay-for-performance results in employees restricting their work to those areas covered by the performance criteria. In the literature, this is known as the ’multiple tasking’ problem. This may induce employees to spend considerable time and energy during their work trying to find a better-paid job with another firm. They therefore neglect their tasks insofar as they are not contractually fixed by the performance criteria.

Variable pay-for-performance tends to crowd out intrinsic work motivation and therewith the joy of fulfilling a particular task. However, such motivation is of great importance in a modern economy because it supports innovation and helps to fulfil tasks going beyond the ordinary.

Many observers acknowledge these problems connected with variable pay-for-performance and even emphasise them. They nevertheless cling to this form of compensation because they do not see any alternative. However, there are well-proven and effective ways to induce the members of an organisation to perform in a desired manner. The three most important ways are the following:

First, the employees have to be carefully selected. Above all, employers must check whether the job seekers are interested in the work to be performed or solely in the money that will come along with it. In all too many sectors of the economy this task seems to have been neglected. In the financial sector, for example, many persons have been chosen whose only goal is to get as high a salary as possible. They therefore exhibit no loyalty to the firm and immediately accept any job that offers higher compensation. As a result, the fluctuation among employees has increased strongly. Efficiency has been reduced because the tasks have to be taken over by ever new persons who lack the experience necessary.

Secondly, employees have to be paid a fixed compensation corresponding to their performance. They must be given the signal that they are paid a good wage but that they are expected to work accordingly. Thus, a market wage has to be paid in order to be able to win and keep employees. The compensation can after some time be adjusted on the basis of a comprehensive evaluation of their work. This procedure avoids the multiple tasking problem. At the end of the year, one can also distribute part of the profit to employees according to their contribution to overall performance rather than according to ex ante criteria.

Thirdly, awards can be used to enhance employees’ work motivation. Awards such as “Employee of the Month” support social recognition among the members of the firm. They should therefore be presented in a festive ceremony, emphasising what type of performance is important to the firm. Research on awards in a call centre of a credit-card company suggests that the motivation of the persons getting the award is enhanced. The performance of the employees not getting an award is not reduced. Rather, they make an effort to get the award in the future (Neckermann et al 2008). Employees working in a team are usually proud that (at least) one of its members has received an award.

Variable pay-for-performance is an attractive concept to compensate employees only at first sight. It turns out to be a mistake when analysed more thoroughly. As argued here, there are more favourable alternatives available.

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    1. Yves Smith Post author

      You’ll notice they approve of bonuses based on:

      1. Company wide profits and

      2. Individual performance

      That was how it worked in the old partnership days. The line in Goldman was “Better to do a C job in an A year than an A job in a C year.”

      And on a cash basis, partners made less than senior vice presidents for quite a few years. Another line was that Goldman partners lived poor and died rich.

    2. Fraud Guy

      At the top level: Ability to avoid prosecution?

      At all the retail locations I go to, the general feeling is acceptance (à la Kubler-Ross), but they have jobs (most are on 2nd/3rd/nth career).

      1. bmeisen

        That shouldn’t be a reason for pursuing a career in the financial sector. It performs an important function, we can surely all agree. And I don’t believe it requires genius to keep the accounts in order.

        Helping companies and individuals make payments, protect their savings, and make investments, and doing so without going ponzi or surrendering to moral hazard – it seems the brilliant dudes running the show these days can’t do that.

        1. Fraud Guy

          It is dangerous for those who handle the money to determine how much they should get paid for their services. It may tend to lead to a little advantageous hubris on their part (see Dimon in Yves’ later post).

  1. vlade

    The “pay” is not about the money, it is about status and as an easy way how to compare one against his/her peers (and feel better than the peons toiling 9-5). So, to an extent, the banks already use indirect incentives….

    Lowering of the pay would then lower both not only the financial side (and some people followed their own advice and are leveraged up to their eyeballs themselves, so it would hurt), but the pride too – and that just wouldn’t do.

    That’s why you need an external tie-breaker, as in some outside regulation. Personally, as I stated before, I believe all pay over and above small multiple of the average (in ltd companies) should be in unlimited-loss-bearing shares of the company. If Fuld’s shares were ULB, he would be goner.

  2. anon

    What’s really needed are:

    Limits to managerial salaries based on a set multiple of the salary paid to the lowest-paid worker in the firm,

    A living maximum and minimum wage. That’s right, a limit to how much can be earned, and

    Punitive taxes on accumulated capital.

    The true left wing parties in Europe, such as Die Linke in Germany and the Front de Gauche in France, propose these reforms, among others. They’re part of what a real electoral alternative might look like.

  3. Linus Huber

    I have no problems for a banker to earn 10 mio in a year. BUT, as this represents an income of an entrepreneur who lives with downside risks, the banker must be made accountable on a personal level, meaning to be ready to also loose 10 mio in a year.

    Once this rule would be applied, you would soon find out who are real risk takers and who are simply looters.

    1. anon

      Your vision does not indicate why taking risks has a social and ecological value at all, much less a social and ecological value that is proportional to the proposed monetary or capital “rewards.”

      Remember, it’s been shown that “Hospital Cleaners Are Worth More Than Bankers (and Quelle Surprise, Bankers Destroy Value!)”:

      I put rewards in quotes above on the basis of the argument that elevated compensation does not produce greater happiness. For example, see:

      And, for more commentary on the idea of a maximum wage:

  4. Innocent Bystander

    There are other major pitfalls with performance pay, which were very obvious when this system was first introduced. W Edwards Deming pointed all this out decades ago, but we need to keep rediscovering it apparently.

    1. It is totally destructive of teamwork. This is particularly the case when there is some sort of quota for performance pay, often called “bell curving”. My bonus is your not-bonus. So if I can reduce your productivity, I will benefit! Not what the company needs.

    2. It encourages short-term thinking. Anything that does not deliver results in the bonus time-frame is assigned zero value. Ever wondered why companies are destroying their competitive advantage by outsourcing all their skills to China and India? “In the long run we’ll all have gotten our bonuses and moved on” (apologies to Keynes).

    3. Encourages taking bad bets with asymmetric payoffs where there is usually a win, but occasionally (or later on) a huge loss. If there is a huge loss, OK you may miss one year’s bonus but you can you move on and fight another day. If there is a profit, you collect a nice bonus. There are even risk management consultants who can make it easy for you. Given a risk structure, they will advise you how to “stuff the risk into the tails” where it probably won’t hurt you this year.

    4. Accurate reporting is destroyed, because people only want information that will help their bonus to come to light. Because most companies typically use one reporting system that is used to measure people’s performances as well as to run things, the vital information needed to run the company is corrupted.

    I remember vividly when individual performance bonuses were introduced. There was a rapid and serious impact in all of these areas.

  5. Ek Snarko

    Very good posts all. Thought provoking. But ya’all are missing something I believe is central.Despite all this free market/enterprise flak, the reality is that people want to be insulated FROM the market as far as it may impact them. Risk and lowest bidder for the rest. Fortune through OPM and “exceptionalism” for themselves. We all wish to drive the King’s Highway to our goals without interference. Madness and globalization have pretty much squelched this.

    Another thing: Where are these guys gonna go? That is what my bosses have asked me over the years and applied it to far others. Perhpas some ofthese positions should be globalized.In reality the mba is representative of widely dispersed knowledge, and is worth far far less than people with existing connections. If you accept that finace is finance and math is math and econ is econ, why not hire any of the millions of Indians, Chinese Philippinos or Brazilians who could do them cheaper?

    No, its like internet companies using me as ad input;If you are making money off my life or money where is MY cut?

  6. Cahal

    Good article, but surprised that they didn’t hit the low hanging fruit: large incentives can backfire. In experiments, subjects were given varying degrees of reward for performing tasks. The ones that did best were the middle of the road level, whilst large rewards caused peole to lose their nerve.

    1. bluntobj

      One item that I take exception with:

      “They therefore exhibit no loyalty to the firm and immediately accept any job that offers higher compensation. As a result, the fluctuation among employees has increased strongly. Efficiency has been reduced because the tasks have to be taken over by ever new persons who lack the experience necessary.”

      Loyalty? After decades of downsizing and RIFs for the purposes of “enhancing shareholder value” employees are still expected by managerial consultants to demonstrate loyalty and not have a care about their own financial reward? (Note: I agree with the premise that wall street workers are paid too much)

      Banks are reaping what they have sown in the housing market. They have also modeled exactly the kind of behavior they find in their employees now: zero loyalty, make the most in the fastest time possible, and screw ethics and principles for a quarterly boost that brings a higher bonus.

      A fix for the situation will not be found in twiddling the pay amounts. Loyalty, care, responsibility, and ethics went out the window when when employees became “headcount” to be manipulated to smooth earnings. Reverse this attitude first. Otherwise, nothing changes.

  7. Aquifer

    I hope folks will keep this in mind in deciding whether to jump on the bandwagon of PFP as a way to produce “efficient” cost control in healthcare.

    Two obvious problems arise:
    1) the parameters chosen in any particular area may be the wrong ones for any particular patient
    2) a physician will be incentivized to “cherry pick” – avoid those patients who, for any one of a number of reasons unrelated to the actual quality of care, may not do well

    Both considerations are incentives in the wrong direction as far as the best interests of real people, the patients, or “customers” as they are referred to these days ….

  8. Ian Ollmann

    “The idea that people are solely self-interested and materially orientated has been thrown overboard by leading scholars.”

    This is somewhat hard to reconcile with the BBC trader of doom video we saw today in this site. Perhaps the notion that would be Goldman employees actually are solely self-interested and materially oriented is not so far off the mark!

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