Photographer: Victor J. Blue /Bloomberg

Heresy! Stop Paying CEOs Performance Bonuses, Harvard Business Review Says

Companies would benefit if executives got straight salaries, two professors argue.

For Harvard Business Review to advise companies to stop paying executives based on performance is like your local church telling parishioners to stop dropping money in the collection basket. Yet there it is, in an article published on the magazine's website Feb. 23: "Performance-based pay can actually have dangerous outcomes for companies that implement it."

Lest there be any mistake, the article goes on to say, "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."

Salaries account for only 4 percent of compensation for top execs, according to the Bloomberg Pay Index, which ranks the 200 highest-paid executives using the most recent data available as of a company's fiscal year-end.

I spoke on Feb. 25 with Freek Vermeulen, who co-wrote the article with Dan Cable. Both are professors at London Business School. The argument has "hit some sort of a nerve," he said. Many other authors have recommended changes in performance-based pay, such as making more of it contingent on a company's long-term performance. But by rejecting the whole idea of performance-based pay, "some say that we're throwing out the baby with the bathwater," Vermeulen said. He remains unmoved, he said: "I haven't been convinced by any arguments we've heard."

The theory of performance-based pay goes back to a landmark 1976 paper in the Journal of Financial Economics by Michael Jensen and William Meckling called "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure." It's based on an idea that seems so obvious to economists that it couldn't possibly be wrong: People respond to financial incentives, so if you give them more money when they do the right things for their companies, better results will follow.

But does the real world work that way? John Cryan, the new, British-born co-chief executive of Deutsche Bank AG, has his doubts. Last November in a speech at an industry conference, Cryan said he’s skeptical that paying more necessarily motivates his employees:

“I sit on trading floors and wonder what drives people,” he said. “I don’t fully empathize with anyone who says they turn up to work and work harder because they can be paid a little bit more, but that may be a personal view. I’ve never been able to understand the way additional excess riches drive people to behave differently.”

Of his own pay, he said: “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.”

Cable and Vermeulen cite five problems with performance-based pay:

  • "Contingent pay only works for routine tasks." Sure, people will stack bricks faster for a bonus. But research shows that it's less successful if the job involves learning and creativity.
  • "Fixating on performance can weaken it." Executives perform worse when they have certain explicit goals to hit. They do better when they are free to work on "developing a particular competence; acquiring a new set of skills; mastering a new situation."
  • "Extrinsic motivation crowds out intrinsic motivation." This is what Cryan was talking about. The really good CEOs—Steve Jobs, for example—aren't working for the money. They love what they do. Paying for performance can actually weaken their bond with their work.
  • "Contingent pay too often results in fraud." This one's kind of obvious. Set a goal and people will find a way to hit it, even if that involves cooking the books.
  • "Measuring performance is notoriously fraught." By now most boards of directors know that rewarding executives strictly on quarterly earnings is a mistake. But the problem is bigger than that: "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."

Cable and Vermeulen are swimming against the tide, according to Swaminathan Kalpathy, a finance professor at Texas Christian University's Neeley School of Business. According to a 2015 working paper by Kalpathy and three other authors, in 1998 some 21 percent of companies they studied gave executives awards that they could cash in if the company reached certain milestones. By 2012, the last year covered by the study, the ratio had jumped to 68 percent.

Kalpathy said he agrees with several of Cable and Vermeulen's points, but is nevertheless in the baby/bathwater camp: To say performance-based pay is irretrievably bad "seems like a pretty blanket statement." The idea that executives respond to incentives, he said, "is kind of the cornerstone of agency theory."

Cable and Vermeulen don't deny that bonuses and the like affect executive behavior. "But," they conclude in their article, "it will not be in a way you want them to behave." Their paper doesn't get into the level of CEO pay, just the composition. How high salaries ought to be is the logical next question for research, Vermeulen told me.

"We're going to have to address that," he says.