Despite job losses and pay cuts related to the global financial crisis, executives in certain sectors, such as banking, still are earning astronomical salaries. This highlights the difficulty of designing fair and effective variable-remuneration systems.
Even so, Professor Josep Rosanas of the Instituto de Estudios Superiores de la Empresa at the University of Navarra in Spain defends the benefits of such forms of compensation, provided that the total compensation is not too high.
Linking pay to performance often is criticized for making money the overriding motivator. Companies justify the high salaries of their top executives by arguing that such compensation improves economic performance, though the evidence for this is sketchy. Even when a company boosts profits, it is difficult to determine the extent to which this was due to a given executive’s singular efforts.
Besides, no matter how good the performance of senior executives, profitable business performance must be due at least partly to the collaboration of others, though it’s virtually impossible to measure or quantify the contribution of each and every person. Equally difficult is being able to measure or quantify job complexity.
Moreover, employees who receive variable compensation according to a certain management metric, such as more money for more loans granted, are more likely to act in ways that may be beneficial to them but detrimental to the company. That was the case of mortgage brokers authorizing more than was advisable during the U.S. subprime mortgage crisis. The results were bad for the companies, which found themselves saddled with unviable loans, but the brokers profited from the loan volume and therefore acted rationally. The economist Adam Smith recognized this tension as long ago as the 18th century, noting the conflicting set of interests at play between owners and workers.
Granted, then, any incentive system will be flawed. Rather than scrapping variable-compensation systems altogether, though, Rosanas believes that they should be redesigned.
First, he writes, it is important to distinguish between variable compensation and incentives, which are not the same. Incentives are payments aimed at enticing executives to do the bidding of company shareholders or owners, which can dangerous by creating a conflicting set of priorities. Variable compensation, on the other hand, can be understood as giving recognition for a job well done. Conceived this way, variable compensation, instead of being a blunt instrument, becomes a “duty of justice,” Rosanas says, so long as it is not too great in comparison with the employee’s basic pay.
In using the term “weak incentives,” Rosanas is referring to an idea proposed by the Stanford economist John Roberts: Reward employees with a modest additional amount for achieving some measurable results, but not so much as to spur them to engage in maximizing behavior, which is when the perverse effects start to creep in.
Rosanas highlights two main reasons to incorporate weak incentives into compensation systems.
First, weak incentives serve to counterbalance the negative effects of implicit incentives. For example, a fixed salary easily can be taken for granted, because people get paid the same regardless of the results, sometimes leading them to put in less effort as time passes. Under these circumstances, offering a little something extra can go a long way to keep them engaged and motivated to achieve some measurable goal.
Second, everyone welcomes a certain degree of recognition for a job well done. Words of appreciation are important, but coupling them with money makes them even more credible, especially because it recognizes that there was a cost involved for those making the effort.
