For months now, seemingly bloated CEO salaries have been a hotly debated topic in every major business publication. It isn't just that executives were being paid hundreds of times what the average worker earned. The problem was that executives seemed to be getting remunerated that much for doing a mediocre job. And now, the bonus debacle at AIG has also cast a harsh light on executive bonuses for the same reasons. Executives are supposed to be given outsize pay for outsize performance, and that pay was supposed to ensure a performance boost. Why did this apparently logical concept let us down?
Interestingly enough, science might be able to shine a light on that. Several 2008 studies performed by MIT Sloan School of Management behavioral economist Dan Ariely found that, for tasks requiring any sort of cognitive skill, creativity, or mechanical knowhow, big bonuses actually resulted in worse performance. Yes, you read that right. Rather than acting as motivators for mental accomplishments, big bonuses were stressors. The subjects wanted to do better and earn those outsized rewards, but because they were so worried about getting that bonus, their concentration was off and they did a poorer job. The only scenario where big bonuses for high performance made good motivators were for tasks that required repetitive, mechanical skills.
Ariely also tested the effects of public scrutiny on job performance by having study participants complete puzzles and other cognitive tasks in front of others. As it turns out, public scrutiny was just as big of a stressor as a huge bonus. The subjects really wanted to do well. They were focused on doing a great job, but the stress of being scrutinized by onlookers threw them off.
Combined, these studies show that when the current compensation models of executives were made, we didn't take human psychology into account. Rather than creating an environment where great performance drives great results, companies produced a combination of extreme competitive scrutiny and the stress of huge bonuses. This is especially true on Wall Street, where the bonus accounts for much of the salary. To put it bluntly, companies have unwittingly set up many of their executives for failure. This may explain the why a Corporate Executive Board survey found that more than 40% of newly promoted executives underperform and turnover in the C-suite is so high.
Paying for Poor Performance
But experiments are one thing. Is there any historical evidence that something to the same effect actually happens, and does it show how this would play out at a time of crisis? Actually, yes, there is, and yes, it does. Some 73 years ago, Harvard University's John C. Baker, an assistant dean and instructor in finance at Harvard Business School, found that during the Great Depression, companies that paid their CEOs the highest percentage of their total earnings during both the boom years tended to perform the worst. And considering what we've covered above, this makes perfect sense. Now we know big bonuses for cognitive tasks and public scrutiny contribute to another powerful stressor: a painful economic crisis.
Clearly, it's hard to justify keeping the status quo for executive compensation structures when science tells us we're actually doing almost everything we can to blunt performance and put too much stress on our executives. Yes, stress is supposed to be part of their jobs, but there are biological limits to which we can stress people and expect them to perform. Maybe rather than issuing big bonuses at the end of the year and putting executives in the spotlight, we should try something else.
The best idea I've heard would spread out executive bonuses throughout the year, awarding the execs for meeting certain goals that will get the company where it ought to be at the end of the year. It's also consistent with the findings of the studies we've covered. When bonuses are smaller, they're not as big of a distraction, and they allow executives to focus on the work at hand rather than the eventual payoff.
In addition, boards may want to reconsider the size of executive pay packages. For any investment there's a point of diminishing returns, and it seems that certain companies have gone past it, guided by ideas that seem to make perfect sense but are actually handicapping performance. I think that a future study should pin down that critical ratio of executive pay to company earnings and serve as a sliding scale by which compensation boards can make their decisions.
Perhaps introducing a little science into the boardroom would be a good thing for companies and the economy at large.