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When Financial Incentives Backfire - Ideas for Leaders
Idea #180

When Financial Incentives Backfire

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KEY CONCEPT

Companies often rely on performance-based systems to reward their ‘smartest’ or most productive employees. But financial incentives can have unintended consequences. New research suggests that the smartest workers also tend to be the most skilled at playing performance-based systems for personal gain. Leaders need to look closely at the way they structure and design incentives — and reduce the risks of employees concentrating their efforts on activities that trigger rewards.


IDEA SUMMARY

Economic theory tells us that human capital, i.e. employee ability, is positively linked to productivity and that high performers should be rewarded. Strong financial incentives for performance, however, can carry unexpected costs for companies. (The financial crisis was but the most vivid demonstration of this.)

A recent study of a private Polish retail bank suggests that some smart employees manipulate incentive systems for their own gains — threatening the profitability of organizations.

Researchers looked at the detailed, daily records of the bank over a 13-month period following the introduction of a new incentive plan. They also conducted interviews with the bank’s top executives as well as with 17 outlet managers, and carried out a survey of all outlet managers about their personal characteristics.

They found that the incentive system was ‘gamed’: smart employees diverted efforts from ‘true’ objectives to measured objectives in order to maximise personal gain. How did these employees exploit the system?

First, they predicted their sales targets, which the bank used as a yardstick for performance. Although top management had based these targets on a sophisticated, secret algorithm, as well as on demand forecasting and strategic planning, the cleverer outlet managers had enough insight into the bank’s internal processes to predict sales targets accurately. In other words, they demonstrated a particular type of skill: ‘firm-specific human capital’.

Next, these managers used their discretion over the price (interest rate) of loans in order to boost sales, thus tailoring performance to meet targets. One manager even told the researchers: “When a client walks into an outlet asking for a loan, and I need to sell, there’s no way she’s going out without one. I’ll match any competitor’s price and add something on top.”

The records confirmed significant use of discounting to meet loan sales targets among managers with high levels of ‘firm-specific’ capital. What were the financial implications for the bank?

The researchers compared the profits earned for a given loan with the benchmark of what it ‘should’ earn, based on the bank’s objectives and demand for loans. Depending on the benchmark, they found that the profit loss ranged from 2 to 12 percentage points. What’s more, the proportion of profits lost due to incentive gaming increased over time, and more rapidly where managers had superior organizational knowledge. (The smarter the employee, the faster they learned.) While it’s hard to predict hypothetical profits, these findings suggest a significant cost to the company.

So should companies fire their brightest employees? The researchers stress that gaming is a possibility not an inevitability and that it depends on many factors. Personal integrity and perceptions of fairness both affect the odds of it happening. (Not everyone will be inclined to play the system and push the boundaries — and the risks are reduced if people feel they’re treated properly.) Organizational hierarchy and the way tasks are defined will also have an impact. The most important factor, however, is probably the extent to which performance measures — and therefore incentives — can be manipulated. Incentive systems, the research confirms, need to be carefully structured and designed.


BUSINESS APPLICATION

There are certain specific steps companies can take to reduce the manipulation of incentive systems — and the associated costs with it. These include:

  • Resetting the rules and changing the system once the smartest employees have figured it out.
  • Using more subjective measures for performance or choosing to measure performance over the longer term.
  • Offering weaker financial incentives.

More generally, there are cultural measures that mitigate the risks. These include:

  • Building a sense of belonging among employees — the more closely people identify with the organization, the more likely they are to act in the collective interest.
  • Offering intrinsic as well as extrinsic rewards – for example, job satisfaction, praise and recognition, and the prospects of promotion.
  • Building trust — and a strong team culture. (The more people like the organization and the greater their perception of fairness, the more they’ll feel guilty about acting out of self-interest.)

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Institutions

Idea conceived

June 1, 2013

Idea posted

Jul 2013
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