Finding the Right Performance Incentives to Motivate Employees
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Strategy Economics Oct 10, 2016

Find­ing the Right Per­for­mance Incen­tives to Moti­vate Employees

Some incen­tive schemes encour­age hard work — oth­ers reward those who game the system.

Using the right reward system can incentivize car dealership employees and lead to stronger work performance.

Yevgenia Nayberg

Say you are an exec­u­tive of a com­pa­ny des­per­ate to meet mar­ket expec­ta­tions. If you meet them, your stock options hit their strike price — but it looks like the firm’s per­for­mance is going to come up short. You could make a last-ditch effort to enter a new mar­ket, but it’s risky. Under oth­er cir­cum­stances, you would nev­er con­sid­er it. Do you go for it anyway?

Or con­sid­er that you are a port­fo­lio man­ag­er who receives gen­er­ous bonus­es for strong per­for­mance, but pays noth­ing out of pock­et for gen­er­at­ing loss­es. Do you opt to sell mort­gage-backed secu­ri­ties or cred­it default swaps, which have an extreme­ly high prob­a­bil­i­ty of turn­ing out favor­ably — but a small prob­a­bil­i­ty of blow­ing up the firm?

In both of these cas­es, you just might. After all, if the gam­ble fails, you are not much worse off. Your stock options are still worth­less; your bank account bal­ance is pre­served. And if the gam­ble suc­ceeds, terrific!

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As a way to moti­vate every­one from sales­peo­ple to CEOs, orga­ni­za­tions often dis­pro­por­tion­ate­ly reward per­for­mance above a spec­i­fied threshold.

For employ­ees, the idea is that increas­ing out­put a lit­tle bit gives me a lot rel­a­tive to los­ing out­put,” says Dan Bar­ron, an assis­tant pro­fes­sor of strat­e­gy at the Kel­logg School.

But a recent study by three Kel­logg School researchers — Bar­ron, George Geor­giadis, an assis­tant pro­fes­sor of strat­e­gy, and Jeroen Swinkels, a pro­fes­sor of strat­e­gy — sug­gests that sim­ple con­tracts that reward per­for­mance pro­por­tion­ate­ly, thus doing away with a mag­i­cal thresh­old, may offer a bet­ter way of align­ing employ­ees’ incen­tives with those of the company.

And the ben­e­fits could reach beyond firms.

Those types of incen­tive struc­tures were a key dri­ver of exces­sive risk-tak­ing, which led to the finan­cial cri­sis,” says Geor­giadis. So think­ing about the incen­tive con­tracts that deter this kind of risk-tak­ing behav­ior is important.”

Moti­vat­ed to Game

The rea­son­ing behind incen­tive schemes with a thresh­old” fea­ture makes intu­itive sense: What com­pa­ny wouldn’t want to use the lure of a huge pay­off to eek out extra effort from employees?

Risk-tak­ing is an inevitable part of any prof­it-mak­ing ven­ture. What we want you as an employ­ee to do is take on smart risks.” —Dan Barron

But there is a poten­tial prob­lem: gam­ing. Employ­ees who game a con­tract are, in a sense, allowed to reap rewards while putting forth less effort than the con­tract intended.

They don’t have to work as hard to make their quo­tas. If they hap­pen to fall short, you just take on a lit­tle bit of risk,” says Bar­ron. Why would I want to exert all the hard work that it takes to actu­al­ly shift out­put up when I can instead just take a lit­tle gam­ble and I’ll prob­a­bly end up okay anyway?”

So what kind of incen­tive scheme can­not be gamed, but still moti­vates employ­ees to work hard?

To find out, the researchers built a math­e­mat­i­cal mod­el to explore how employ­ees might behave under var­i­ous con­tracts. (The research falls under con­tract the­o­ry,” the same dis­ci­pline for which the most recent Nobel Prize in eco­nom­ics was awarded.)

How can the firm ensure that, when the time comes for an employ­ee to make the deci­sion about how to behave, his incen­tives are aligned with the firm’s?” asks Georgiadis.

They found that a sim­ple or lin­ear” con­tract is gen­er­al­ly best. This means that the reward offered is direct­ly pro­por­tion­al to how an employ­ee per­forms and the risks that she takes. There is no thresh­old to game: a CEO is com­pen­sat­ed equiv­a­lent­ly for the same rise in prof­its regard­less of whether the firm bare­ly hits or bare­ly miss­es its target.

The researchers also looked at a third type of con­tract, where per­for­mance below a thresh­old is dis­pro­por­tion­ate­ly pun­ished. They found that while it does not encour­age gam­ing, it also does not ade­quate­ly reward strong per­form­ers. If an employ­ee only has to per­form ade­quate­ly to receive a reward, why would he both­er work­ing hard­er, or tak­ing even a smart risk?

Lin­ear con­tracts are opti­mal. They pro­vide the strongest pow­ered incen­tives that do not induce gam­ing,” says Barron.

Impor­tant­ly, lin­ear con­tracts nei­ther encour­age nor dis­cour­age actu­al risk-tak­ing — an inevitable part of any prof­it-mak­ing ven­ture,” says Bar­ron. What we want you as an employ­ee to do is take on smart risks.”

In oth­er words, risks that are not dri­ven by gaming.

Oth­er Applications

Lin­ear con­tracts can ward against a sec­ond kind of gam­ing as well — one that, the researchers found, is math­e­mat­i­cal­ly equiv­a­lent to risk-tak­ing: shift­ing out­put across time.

Say, for instance, you are a sales­per­son look­ing to meet your quo­ta for July. It is the last day of the month, and you are just one sale short of a huge bonus. How steep of a dis­count are you will­ing to offer the next cus­tomer through the door — if she signs the paper­work today?

It’s ulti­mate­ly the same kind of gam­ing,” says Bar­ron. Why should a sales­per­son put in the effort to sell more cars all month long when a steep dis­count on July 31st can result in the same reward? A lin­ear con­tract, which stip­u­lates the same com­mis­sion regard­less of when a car is sold, would elim­i­nate this incentive.

The researchers note that some­times these two types of gam­ing can work in tandem.

What CEOs some­times do,” says Geor­giadis, is they see they’re going to miss their earn­ings tar­gets, and then they cut main­te­nance, or R&D projects, or some invest­ments on this or that, or train­ing expens­es. By doing this, they meet the tar­gets — but they’re real­ly shift­ing out­put earn­ings across time, because they’ll have to do that main­te­nance at some point. And at the same time, they’re shift­ing risk, in the sense that if I cut main­te­nance, that means there is a high­er chance of a dis­as­ter happening.”

Con­tracts that incen­tivize gam­ing can affect more than indi­vid­ual orga­ni­za­tions; they can affect the broad­er econ­o­my. For instance, plen­ty of experts have linked the finan­cial cri­sis in 2008 to per­verse incen­tives for bankers and port­fo­lio man­agers,” says Geor­giadis. “[Their firms] were giv­ing them very strong incen­tives if they made mon­ey, and if they lost mon­ey, they didn’t have to pay any­thing out of pocket.”

On top of that,” says Geor­giadis, they would get a bonus if their per­for­mance was above a thresh­old. That kind of incen­tive scheme is exact­ly what induces sell­ing insur­ance’ — basi­cal­ly tak­ing huge left-tail risks, which is what we saw hap­pened with those cred­it default swaps and mort­gage-backed securities.”

The same kind of con­tracts that are going to deter the bad kind of risk-tak­ing from the firm’s per­spec­tive also poten­tial­ly can be used to deter the bad kind of risk-tak­ing from society’s per­spec­tive,” says Barron.

Advice for Organizations

How can com­pa­nies know whether their incen­tive schemes are like­ly to be gamed by employ­ees? There are no hard and fast rules, say the researchers.

It’s dif­fi­cult to infer from out­comes that this gam­ing is going on,” says Bar­ron. He advis­es com­pa­nies to look at the incen­tives that are offered, and put your feet into [the shoes of] your very evil broth­er. How would you game those incentives?”

As a firm, says Geor­giadis, if you are wor­ried about gam­ing, then a lin­ear con­tract is gen­er­al­ly a good idea. It’s not always a good idea, and there are caveats: our mod­el is not the world. But a lin­ear con­tract is a good idea.”

What I would like peo­ple to take away more than any­thing else is an aware­ness of the kinds of gam­ing that peo­ple can do and the kinds of incen­tive schemes that encour­age that gam­ing,” says Bar­ron. If, at the end of the day, com­pa­nies under­stand that a bonus scheme is going to encour­age gam­ing — and they offer it any­way — then fine. But don’t do it and then lat­er real­ize, oops, we intro­duced a lot of gam­ing that we weren’t expect­ing.’ At least walk into that trap with your eyes open.”

Featured Faculty

Daniel Barron

Associate Professor of Strategy

George Georgiadis

Associate Professor of Strategy

Jeroen Swinkels

Richard M. Paget Professor of Management Policy, Professor of Strategy, Chair of the Personnel Committee

About the Writer

Jessica Love is editor in chief of Kellogg Insight.

About the Research

Barron, Daniel, George Georgiadis, and Jeroen Swinkels. 2016. “Risk-Taking and Simple Contracts.” Working paper.

Read the original

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