adding science to executive pay

Paradoxically, huge bonuses at relatively long intervals set us up for failure.





After the recent AIG scandal, executive pay once again became a sore topic for many companies. How much should they pay their CEOs? Are they paying too much? What about the prearranged severance packages and what do they mean to investors? But as they debate away, they may be missing something very important. The underlying premise behind today’s executive compensation with giant, year-end bonuses could be setting senior management up for failure rather than motivating them to perform better at work.

In my recent column for BusinessWeek, I examined studies by behavioral economist Dan Ariely which put the time honored idea of bigger pay motivating better performance to the test with a seemingly counterintuitive result. For any task that requires creativity and problem solving, the lure of a huge bonus keeps throwing people off and impeding their performance. It seems that after a certain figure, the bonuses are so outsized and the anticipation of the massive reward is so great, the stress starts messing with the brain and takes away our focus from the work we’ll have to do to get the money. If you’re solving puzzles or taking tests in a study group, it’s not a big deal. If you’re managing a company with 60,000 employees and untold billions in capital, a gargantuan annual bonus can steer you into disaster territory. Snap judgments are made, risks aren’t properly evaluated, missteps happen and next thing you know, the company’s stock is down 20% and analysts are advising anyone who’s listening to sell.

But wait a second, aren’t C-level execs supposed to be able to live up to the pressure? Yes, but their brains are working against them. The evolution of the human mind hasn’t caught up with the rigors of today’s corporate life and its limitations are what’s behind the problems we have with our attention spans when a bag of money is waved in front of our noses. Ariely also found that the same problems appear when public scrutiny becomes a big factor. The more we keep looking over people’s shoulders, the more mistakes they make. This doesn’t mean we can’t go around criticizing bad bosses and CEOs who bet the farm and lost. However, putting execs up to the microscope and publicly evaluating their every move is going to raise their stress levels through the roof and get them to make more mistakes. It’s just how their (and our brains for that matter) are wired.

So how do you reward a CEO for a job well done? A potential solution is to set up milestones at the end of every quarter, each one building up to where the company wants to be at the end of the year and if the quarterly goals are met, pay a smaller bonus at the end of the quarter. This doesn’t have to be a pay cut, it’s just paying the annual bonus in quarterly installments and the smaller sums with shorter time horizons should help executives focus on getting to their end goal one step at a time and doing it right. The same research which shows that the promise of immense rewards at the end of the tunnel throws off performance, also found that a moderate bonus both improves performance and keeps workers on task. So if you’re on a compensation committee of a company’s board of directors, remember that just like everything else in life, a little moderation does wonders.

All right, now we know a potentially better way to structure an executive’s pay but what about a total dollar amount? How much is too much? When does a CEO get too comfortable and starts losing incentive? Well, a study from the Great Depression by a then-Harvard finance instructor hints at an idea of an optimal ratio of revenue to executive pay. In his research, companies that paid the highest percentage of revenues to their CEOs performed worse and recovered slower than companies with more moderate compensation schemes. If someone were to do a reverse study and find a good range of pay to earnings ratio, we could establish a sliding scale that will help compensation committees in making their final decisions.