Why Performance Pay Is a Bad Incentive for Good Behavior

Pay for performance seemed like a great idea at first. Actually tie compensation to whether or not the person in question achieved mutually agreed-upon (or imposed) goals; what a concept! And then reality took over. 

Reality being the very human desire to please those with whom you work, whether they be on the assembly line or in the board room. Which often results in resets when circumstances 'beyond anyone's control' render the original formula 'unfair.'

And then there is the issue of simple math, as in the application of game theory to the achievement of pay-related objectives by fiendishly clever and highly motivated lab rats, er, employees. Or, to put it another way, depends what you mean by 'performance.' JL
 
John McDermott reports in the Financial Times:

The biggest predictor of whether a manager received a bonus this year was not the money they brought in, but whether they received a bonus last year.
"A third of failing UK managers still receive bonus’ "

Financial Times, June 4

How hard can it be to pay people what they deserve?Very hard, actually, as shown by the survey of 72,000 employees in 372 companies carried out by the Chartered Management Institute, an accreditation body. The adoption of “performance-related pay” over the past few decades has been a giant experiment in behavioural psychology.

It’s presumably been an expensive experiment, too.
I imagine so, especially when the biggest predictor of whether a manager received a bonus this year was not the money they brought in, but whether they received a bonus last year.
What does that tell us?
It shows the power of what has happened before in framing future decisions.
I don’t quite understand

Take the work of Richard Thaler, a behavioural economist at the University of Chicago. Rational theories of economics would suggest that if we were to win early on at a night in the casino, we would treat this money no differently to any other in our pocket. Thaler, however, showed that we see such winnings as the house’s money rather than our own, and are therefore likely to keep on making large bets.

What do casinos have to do with employee bonuses?
In both cases, how we react is set by reference points. And when it comes to bonuses, there are two that matter. The first is how much we are paid compared to the colleagues around us.
And the second?

The second is the gap between what happens and what we expected to happen, which in turn is often based on last year’s results, says Alexander Pepper, a professor of management at the London School of Economics.

That doesn’t mean employers should lazily use past pay to decide bonuses.

No, but they do seem to understand the idea of loss aversion, made famous by Daniel Kahneman and Amos Tversky. The two psychologists showed that the fear of losses looms larger than the prospect of equally sized gains.

Companies are worried about upsetting their staff.
Yes.
This doesn’t seem like a well-functioning market.

It isn’t the one predicted by classical or Keynesian economics, but it may make sense. In his book Why Wages Don’t Fall During a Recession (1999), Truman F Bewley explained the title through interviews with more than 300 trade unionists, employers and unemployment counsellors. The Yale economist concluded that companies were worried about morale; they did not want to cut pay, demotivate employees and risk falling productivity.

And the same thinking is going on when it comes to annual bonuses?
Another reason is because some companies have to pay bonuses, according to their pay deals, and I expect some of the awards reflect simple inertia, but, yes.
There must be a better way of motivating staff.
One way would be to surprise employees.
Boo!

Or they could use the power of expectations in a subtler way. In a 2014 paper, researchers from Harvard Business School used the freelance website Upwork to give three sets of similar workers the same task, only varying the hourly pay: $3, $4 or $3 before unexpectedly raising it to $4. The $3 and $4 groups worked equally hard, but the “3+1” group worked harder.

So what?
Expectations matter. So do gifts. Pepper says that small “recognition awards” can motivate employees way beyond what would be expected by the gifts’ value.
Hmmm. I think I’d rather have a £5m bonus than free tickets to the O2, thank you.
Fair enough, but that may not be the wise choice from your company’s viewpoint.
Why’s that?

In 2005, research led by behavioural economist Dan Ariely found that for simple tasks such as data entry, higher incentives meant higher productivity. But for more complicated, cognitive tasks, he discovered that above a certain level, “high stakes” led to “big mistakes”.

They choked, basically.

Basically. This pattern — known as Yerkes-Dodson law — can also be seen in sport. A 2001 report into Australian basketball players found that their successful free-throw percentages were lower in games than in training.

So if companies shouldn’t offer rewards for failure, or big rewards for success, what should they do?

One answer is suggested by a 2012 study led by Roland Fryer, a Harvard economist, in which teachers are paid in advance for improving pupils’ grades. But if they then fail to do so, they hand the money back. Pupils taught by this group did significantly better than those taught by teachers under a normal pay deal.

So what is the lesson?
Don’t avoid loss aversion.