The Problem with Paying Executives Based on Performance

March 29, 2016

At many large corporations, top executives earn as much as 80 percent of their salaries from performance-based bonuses. The idea is that CEOs will be more likely to do a good job if the company rewards them for success, such as increasing quarterly earnings or raising share prices. According to a new study from the London Business School, however, this widely accepted strategy might not be as effective as many companies think.

First of all, the study argues that contingent salaries simply don’t suit the nature of an executive’s job. Performance-based pay works best for employees who do routine, repetitive tasks that can quickly become dull. Setting production goals for these workers ensures that they stay focused in order to receive a greater reward. Executives, on the other hand, must constantly come up with innovative ideas and creative solutions to large problems. The research shows that bonuses can actually harm a person’s performance in these non-routine jobs. After all, there’s no certain outcome to any business decision. With performance goals in place, executives can develop an unhealthy fixation on making the right choices, causing them to do worse on the job.

What’s more, evaluating how a single executive’s performance affects the business as a whole is nearly impossible. While benchmarks like earnings reports and stock prices provide some indication, these fail to consider major factors such as the impact of shareholders’ input and the resources at the company’s disposal. Even worse, contingent pay plans sometimes provide the motivation for executives to cook the books. Several studies show that CEOs are more likely to manipulate earnings if their pay is linked with the company’s success. Despite the problems that come along with performance-based bonuses, though, executives enjoy such enormous payouts from this system that they’re unlikely to change it anytime soon.

 

Questions:

  1. Why is it so difficult to determine how a single executive affects the company as a whole?
  1. Do executives at major corporations get paid too much money?

 

 Source: Dan Cable and Freek Vermeulen, “Stop Paying Executives for Performance,” Harvard Business Review, February 23, 2016. Photo by Ken Teegardin.

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