If bonus or “incentive pay” schemes work so well for senior executives and bankers, why does everyone not get them?

The conventional answer is that a bonus scheme or incentive plan will indeed encourage the recipients to make more money for the shareholders or clients on whose behalf they act …

A classic paper on the “principal-agent problem” … by Bengt Holmstrom and Paul Milgrom pointed out that the conventional answer makes the mistake of assuming that jobs are simple and consist only of one task. In reality, agents — such as executives acting on behalf of shareholders — have multiple tasks with many dimensions. Some of these will be easier to measure than others …

The more complex the job, the more dimensions involved — as in being a corporate chief executive, say — the less justification there is for an incentive reward scheme. This is reinforced in the specific context of shareholder principals and chief executives, when the latter are responsible for the value of the assets they are managing on behalf of the company’s owners. Incentives linked to whatever can easily be measured lead agents to turn their efforts away from maintaining and enhancing the value of the asset over time …

As the economy becomes increasingly complex and intangible, monitoring and measuring seem ever harder. The simplistic case for bonus and incentive pay schemes grows ever weaker.

Indeed, the best arrangement would seem to be the opposite of the pattern we observe now. Corporate executives and senior bankers doing complex jobs involving many impossible-to-monitor activities are the last people who ought to be paid via an incentive scheme; while bonuses for fast-food workers or shop-floor employees make more sense.

Diane Coyle