Stop Paying Executives for Performance

Dan Cable (top left) is professor of organizational behavior at London Business School.
Freek Vermeulen (top right) is an Associate Professor of Strategy and Entrepreneurship at the London Business School. He is the author of the book Business Exposed: The Naked Truth about What Really Goes on in the World of Business.

For chief executives and other senior leaders, it is not unusual for 60-80% of their pay to be tied to performance – whether performance is measured by quarterly earnings, stock prices, or something else. And yet from a review of the research on incentives and motivation, it is wholly unclear why such a large proportion of these executives’ compensation packages would need to be variable. First, the nature of their work is unsuited to performance-based pay. As the incoming Chief Executive of Deutsche Bank, John Cryan, recently said in an interview: “I have no idea why I was offered a contract with a bonus in it because I promise you I will not work any harder or any less hard in any year, in any day because someone is going to pay me more or less.”

But moreover, as we will show, performance-based pay can actually have dangerous outcomes for companies that implement it.

Following the global economic crisis of 2008, large bonuses and stock options have been held responsible for overly risky behavior and short-term strategies. This has led to arguments that executive compensation needs to be organized differently so that the variable component motivates the right behaviors. Particularly in business schools, various Finance and Accounting professors have argued for including more long-term incentives, and for replacing variable pay packages that largely consist of stock options with a mix of bonds and stocks.

As professors of Organizational Behavior and Strategic Management, we take a different – and perhaps more radical – stance. We argue in favor of abolishing pay-for-performance for top managers altogether. We propose that, instead, most firms should pay their top executives a fixed salary.

Note: We are not arguing that top managers such as CEOs should be paid less. That may very well be the case too, but that’s not the focus of our analysis. Here, we are merely arguing that, regardless of the size of a top manager’s pay package, it should be a fixed salary, rather than a variable amount of money dependent on performance criteria. In fact, we believe this to be true not only for CEOs and other people in the C-suite, but for senior executives in general. Although there may be reasons executives would prefer to be paid as they are today – for example, variable stock-based pay in the United States is taxed at a lower rate than are salaries – from our review of the literature, we see no compelling evidence that such arrangements actually benefit the companies making the payouts.

This argument is based on five related, data-backed insights from research: contingent pay only works for routine tasks; for creative tasks, a results focus is ineffective at best, and can in some circumstances actually impede performance; extrinsic motivation crowds out intrinsic motivation; contingent pay too often results in fraud; and measuring performance is notoriously fraught.

1. Contingent pay only works for routine tasks. Companies should abolish contingent pay for their top executives because theirs is the least appropriate job for it. Decades of strong evidence make it clear that large performance-related incentives work for routine tasks, but are detrimental when the tasks is not standard and requires creativity.

Research by Duke professor Dan Ariely and his colleagues, for example, has shown that variable pay can substantially enhance people’s performance on routine tasks; the higher the reward, the more productive people who were working on routine jobs became. However, for people working on creative tasks — where innovative, non-standard solutions are needed – results showed that a large percentage of variable pay hurt performance. For the latter group, even when individuals could earn an additional month’s salary for performing well, variable pay reduced their ability to fulfill their task.

Similarly, research by Ruth Kanfer and Philip Ackerman of the Georgia Institute of Technology showed that challenging Air Force enlisted personnel to land a certain number of airplanes did not increase their effectiveness when learning was necessary – in fact, they performed worse at the task. On routine tasks where learning is not necessary, highlighting performance goals works great.

Of course, the task of a top manager is not a routine one. Most top managers need to be innovative and creative, open to learning about change, and developing new solutions for non-routine problems. They need to carefully balance various needs and uncertain outcomes in a volatile environment. This is the type of job that is particularly unsuited to substantial variable pay.

2. Fixating on performance can weaken it. The goal of most executive incentive plans is to focus leaders on hitting goals and achieving outcomes. After all, that’s why it’s often called “performance-based pay.” But as researchers have found, if you want great performance, performance is the wrong goal to fixate on.

Several studies have shown that when employees frame their goals around learning (i.e., developing a particular competence; acquiring a new set of skills; mastering a new situation) it improves their performance compared with employees who frame their work around performance outcomes (i.e., hitting results targets; proving competence; seeking favorable judgments from others). For example, in a study of salespeople conducted during a product promotion, researchers found that salespeople with a learning mindset significantly outperformed salespeople with a performance-oriented mindset. Recent research by one of us (Cable) and his colleagues showed that consultants’ creativity innovation improved when they focused on learning rather than results, and also were more likely to help their colleagues perform.

In fact, various studies over the last 20 years – for instance by Kanfer and Ackermanagain, as well as Kanfer and Edwin Locke – have shown that, in work situations where learning is important, performance or outcome goals can have a deleterious effect on performance.

Learning goals are more effective at improving performance precisely because they do the opposite of most executive incentives: they draw attention away from the end result and focus instead on the discovery of novel strategies and processes to attain the desired results. Therefore, focusing top managers’ attention on the end result – by tying rewards to performance goals – is counterproductive: it prevents people from learning and developing something new.

3. Intrinsic motivation crowds out extrinsic motivation. When people feel intrinsically motivated, they do things because they inherently want to, for their own satisfaction and sense of achievement. When people are extrinsically motivated, they do things because they will receive bigger rewards. The goal of contingent pay is to increase extrinsic motivation – but intrinsic motivation is fundamental to creativity and innovation.

And when financial incentives are applied to increase senior leaders’ extrinsic motivation, intrinsic motivation diminishes. A meta-analysis of 128 independent studies conclusively confirmed this effect. Although all studies have methodological shortcomings, the consistency of the results across so many studies, samples, and methodologies is noteworthy. As noted by the authors, “expected tangible rewards made contingent upon doing, completing, or excelling at an interesting activity undermine intrinsic motivation for that activity.” Because intrinsic task motivation is fundamental to creativity and innovation, highly variable incentives deplete top managers of the intrinsic motivation they so much need to perform optimally.

4. Contingent pay leads to cooking the books. When a large proportion of a person’s pay is based on variable financial incentives, those people are more likely to cheat. In academic terms, we would put it this way: extrinsic motivation causes people to distort the truth regarding goal attainment.

When people are largely motivated by the financial rewards for hitting results, it becomes attractive to game the metrics and make it seem as though a payout is due. For example, different studies have shown that paying CEOs based on stock options significantly increases the likelihood of earnings manipulations, shareholder lawsuits, and product safety problems. When people’s remuneration depends strongly on a financial measure, they are going to maximize their performance on that measure; no matter how.

And not surprisingly, research by Maurice Schweitzer and colleagues has revealed the relationship between goal setting and unethical behavior is particularly strong when people fell just short of reaching their goals – a common outcome of the oh-so-popular “stretch goals.”

Thus, cooked books, false sales reports, and illegal means to performance emergewhen financial incentives cause leaders to care more about looking good in terms of results than actually doing well in terms of creating value.

5. All measurement systems are flawed. Incentive plans demand that some metric be used as the trigger for a payout. The problem is that whatever package you construct – bonds, stocks, or bonuses – whatever performance criteria you decide on will be imperfect. For a complex job such as senior management, it is simply not possible to precisely measure someone’s “actual” performance, given that it consists of many different stakeholders’ interests, tangible and tacit resources, and short- and long-term effects. Even with HR executives clamoring for enhanced “people analytics” (and technology companies bending over backwards to deliver them) any measure you choose is going to be an inadequate representation of how you would like your CEO to behave.

The problem is that once you link someone’s financial rewards to a particular measure or set of measures, it is going to affect that person’s behavior – in terms of what they do, and don’t do. As Steven Kerr wrote in his classic article “On the folly of rewarding A, while hoping for B,” “most organisms seek information concerning what activities are rewarded, and then seek to do (or at least pretend to do) those things, often to the virtual exclusion of activities not rewarded.” If you reward quarterly profits, for example, you should not be surprised if CEOs cut back inappropriately on long-term investments such as research and development and advertising when they need it to boost their numbers and hit their bonus target.

This last point you probably already knew. Most boards (or whoever determines senior executives’ compensation schemes) realize they have a limited view of the people who work for them. Even when performance seems easy to measure, because it is unambiguous and objective, there is usually a catch, and the measure will still turn out to be flawed. For example, in IVF (fertility) clinics, the measure of success seems unambiguous and objective: the percentage of pregnancies that result from treatment is a clear and objective performance goal. Yet, research by Mihaela Stan and one of us (Vermeulen) showed that even in this situation, focusing on that metric distorted health-care providers’ behavior to the detriment of clinics’ long-term performance. Clinic managers ended up excluding difficult patients from the treatment (such as women with complex medical conditions) to boost their clinics’ success rates. And over the long-term, these decisions deprived their providers of valuable opportunities for learning – which made them worse off in the long run.

Hence, whatever measure you use, you are going to end up with an imperfect quantification of what ideally you would like your top executives to do. And, inevitably, it will end up distorting their behavior.

What about competing for talent?

Perhaps you think you have to offer a large percentage of variable pay to help your firm attract top executives. Even if that is true, think about who will be attracted to such a package: the very people most in need of a financial incentive to work hard and perform well. Are you sure those are the people you should want to attract in the first place?

We suspect not. Intrinsically motivated people do the best they can, and making a very large percentage of your pay dependent on some result can only ruin that. As Theresa Amabile has noted, “There is abundant evidence that people will be most creative when they are primarily intrinsically motivated, rather than extrinsically motivated by expected evaluation, surveillance, competition with peers, dictates from superiors, or the promise of rewards.”

To return to new Deutsche Bank CEO John Cryan, he also said: “I don’t empathize with anyone who says they turn up to work and work harder because they can be paid more. I’ve never been able to understand the way additional excess riches drive people to behave differently.”

We only half agree: Abundant evidence shows that people – including top managers – will in fact start to behave differently if you make a large proportion of their remuneration dependent on some measure of performance. But it will not be in a way you want them to behave.

This article appeared in Harvard Business Review

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