Monday, August 14, 2017

The Dark Side of Incentive Pay?

The Financial Times recently published a thoughtful commentary by Jonathan Ford arguing that performance pay in the financial sector has been bad for financial market consumers. He extolls the virtues of the post-war, pre-liberalization banking system where a particularly industrious bank manager might get rewarded with a letter of commendation from the bank president. Ford notes that there were flaws.
The system was not perfect: it could entrench snooty managers and make credit hard to come by.

In contrast to these halcyon days, today's financial managers face constant competitive pressure and are constantly rewarded for increasing profits. We hope that profits are generated by delivering ever increasing value to customers. But, especially during the financial crisis, there were many examples of bankers fleecing customers. He notes that the bad acts are a result of bad incentives and suggests a remedy for these bad acts.
But there is of course a simpler way to avoid offering bad incentives. That is simply to pay employees a salary based on what the job is worth.

On net, was the move to market liberalization, and incentive pay as a consequence, worth it?

I will note that, over the past four decades, the financial sector has seen nearly as much innovation as the IT sector. Spreads between interest rates to borrowers and savers and in stock market transactions have shrunk dramatically. More consumers have access to more financial instruments than ever before in part because more financial instruments are available at cheaper rates than ever before. Ask your grandparents if they diversified their retirement fund into international equity funds when they were your age and you will probably get a blank stare. This innovation is also a result of market liberalization. Would de-liberalization and a reduction in banker incentive pay also put a halt to further financial market innovation?

1 comment:

  1. Incentive pay, especially in the financial sector, is a relatively new phenomenon. Pay for performance started appearing in the 1980s in the financial sector and is now commonplace in most companies across all sectors and industries for executives as well as rank and file employees.

    Does incentive plans/pay for performance really work? Common belief is that if the incentive plan isn’t working, the problem is that the incentives need to be adjusted or it wasn’t implemented correctly, not that pay for performance doesn’t work. Over the long term, organizations spend considerable time and money trying to fine tune the behaviorist backed theory of pay for performance.

    Over the short term, yes, there is substantial evidence supporting incentives and performance increases, but over the long-term, doubts continue to grow over the effectiveness of incentive pay.

    One of the largest reviews of pay for performance was done by Richard Guzzo and colleagues, analyzing hundreds of comparisons from 98 studies. The review resulted in no significant effect overall of incentives on performance.

    What was found is that the greatest effect on productivity and performance was training and goal setting programs within organizations, far exceeding pay for performance.

    Other reasons on why incentive pay fails:
    • Pay is not a motivator - W.Edward Deming’s finding that pay ranks 5th or 6th of concerns of managers and subordinates.
    • Rewards ultimately punish - Herzberg’s findings that coercion and fear destroy motivation and create defiance and defensiveness.
    • Rewards rupture relationships – rewards and incentive pay reduce possibilities of cooperation and relationships are often the casualties of the scramble for rewards
    • Rewards ignore reasons – relying on incentives for performance improvement does not address underlying problems and meaningful change
    • Rewards discourage risk taking – employees do precisely as they are asked to do to achieve the reward and creativity is stifled and discouraged
    • Rewards undermine interest – in the long run, no artificial incentive can match the strength of intrinsic motivation, focus on intrinsic motivation and performance and productivity will improve