Does paying big bonuses result in higher performance?

The issue of bonuses is quite a divisive issue (divisive in the sense that most people think they have got way out of hand, while a small minority think they are needed to attract the best people). George Osborne placed himself in the latter camp when he flew to Brussels recently to argue against imposing a cap on bankers bonuses of 200% of their annual salary. But is there any evidence that paying high bonuses results in those incentivised by them achieving higher levels of performance?

Now most people who have taken any sort of course in economics will have had it drummed into them pretty early on that people (referred to as consumers) always act rationally and seek to maximise their utility. Often economists use models to help them predict what will happen in certain situations that are based, in part on these assumptions. But there is a branch of economics known as behavioural economics which does not just accept these assumptions as facts, and actually try to set up scientific experiments (a novel idea I know) to see how people actually behave in certain situations.

A recent series of blog posts on Robert Nielsen’s site led me to a book by behavioural economist Dan Ariely called “The Upside of Irrationality“. His earlier work establishes the evidence that people are not in fact rational in the way many economists assume they are, and actually act irrationally in many situations. In The Upside of Irrationality (which I recommend to anyone), Ariely outlines some of his experiments into this irrationality. Chapter 1 of the book is called “Paying more for less: Why big bonuses don’t always work”, and its conclusions are very interesting.

Ariely and his team set up an experiment where volunteers would be asked to perform a series of tasks requiring varying levels of skill in return for payments based on performance (examples of tasks included remembering and repeating a sequence of flashing lights and throwing balls at a target). Each task had thresholds for performance. There was a good standard and a very good standard which would results in a bonus if achieved, but if participants failed to achieve the good standard, they would receive nothing.

Participants rolled a dice to determine the size of the bonuses they would be playing for – either a maximum of an equivalent of a days pay, two weeks pay or five months pay (the experiments were done in India where wages are very low).

So what were the results? Did those playing for the highest bonuses perform the best as we might expect? After all their incentives to do well were the greatest. Actually no. What Ariely’s researchers found was that although there was not much difference in performance between those playing for the low and medium-sized bonuses, those playing for the largest bonuses performed considerably worse. Such was the pressure they were under, they choked when they needed to perform. Note though, that the people in this group actually received the most money, but the “bang for the buck” was much lower than for those receiving lesser incentives.

Another interesting element to the research was that initially, they wanted to give the participants the money up front and then take it back if they failed to reach the required levels. Arguably, this reflects the reality of banker’s bonuses in that they have come to expect these large payments regardless of performance. For example, RBS recently announced it was paying bonuses of  £600m despite making a loss of £5.2bn. The researchers had to abandon this early on though after those playing for the big bonuses either failed utterly, or cheated by running off with the money after failing to perform well!

What does this show then? It seems that the evidence shows that paying very large bonuses is unlikely to maximise the performance of staff, and that they can in fact worsen it significantly, particularly if they those receiving them come to expect them in all situations. What was found in subsequent experiments though was that big bonuses did result in improved performance when the tasks being performed were mechanical in nature.

Research was conducted with MIT students where they were asked to perform two tasks, two times each, once for a small bonus, and once for a large one. The first task was just clicking keys on a keyboard, the second involved solving maths problems. The results showed that in the key clicking task, students performed better when a high bonus was offered, but in the other task, where some brain-power was required, as above, the higher bonus had a negative impact on performance. As Ariely writes:

“The conclusion was clear: paying people high bonuses can result in high performance when it comes to simple mechanical tasks, but the opposite can happen when you ask them to use their brains – which is usually what companies try to do when they pay executives very high bonuses. If senior vice-presidents were paid to lay bricks, motivating them through high bonuses would make sense. But people who receive bonus-based incentives for thinking about mergers and acquisitions or coming up with complicated financial instruments could be far less effective than we tend to think – and there may even be negative consequences to really large bonuses.”

The results then seem clear, those currently receiving large bonuses would probably perform better if their bonuses were much lower, while those currently receiving no bonuses (low-skilled workers) would perform much better if the were. The sky will not fall in if bonuses within the EU are restricted, and shareholders of these big companies would do well to appraise themselves of Ariely’s research before approving large payouts for company employees.

I’ll end with this quote Ariely cites in his book from US Congressman Barney Frank, who in a speech to in 2004 to an audience of bankers said:

“At the level of pay that those of you who run banks get, why the hell do you need bonuses to do the right thing? Do we really have to bribe you to do your jobs? I don’t get it. Think what you are telling the average worker – that you, who are the most important people in the system and at the top, your salary isn’t enough, you need to be given an extra incentive to do your jobs right”

Hear, hear.

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