The biggest problem with CEO bonuses isn’t the obscene pay

It’s the incentives themselves that cause the problems.
It’s the incentives themselves that cause the problems.
Image: AP Photo/Procuraduria General de la Republica
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All employers want workers who care deeply about their performance and go the extra mile for their team, regardless of whether they’ll be rewarded with something extra for it. So why don’t corporate boards feel the same way when they hire CEOs?

Business leaders should be intrinsically motivated to care about their results, and variable, performance-based pay ends up substituting that motivation—poorly—with external incentives, London Business School professors Dan Cable and Freek Vermeulen argue in an article published in the Harvard Business Review.

Research shows internal motivation—doing something for the sense of satisfaction and accomplishment—is critical to creativity and innovation, and it’s undermined by tangible rewards. Incentives work best when trying to coax more out of  employees doing mundane or routine tasks; for creative work, they can have the opposite effect.

Cable and Vermeulen are pushing back against the conventional wisdom, built up over decades, that CEOs should be rewarded when their companies flourish—for example, through stock options, which are meant to align the incentives of executives with that of shareholders. It’s a logic based on the concept of “homo economicus,” that humans are rational actors, only pursuing their own financial self-interest.

Years of behavioral economics, however, show that people are more complicated than that, and financial motivations can get in the way of other goals. The authors of the HBR piece cite recent studies showing that when salespeople focus on learning-oriented outcomes, such as mastering a new skill, they perform better than those aiming for revenue targets. Creativity also increases.

There are other problems with tying so much CEO pay to performance incentives. It increases the temptation to fudge the numbers, and any metric a company uses—be it share price, earnings or margins—usually can’t accurately capture one executive’s contribution.

Cable and Vermuelen’s argument isn’t that CEOs ought to be paid less, but that they should be paid on a flat rate. They write:

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.

They cite the views of Deutsche Bank’s new co-CEO, John Cryan, who has said he’s mystified by the idea of performance pay.

“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,” Cryan said at a conference in Frankfurt last November, according to Bloomberg.

Cryan is backing up his words: In January Deutsche Bank said it was scrapping bonuses for its executive board and cutting incentive pay across the company.