The Pay-for-Performance Paradox

September 13th, 2017

In the early 1900s, the city of Hanoi, Vietnam, had a problem. A newly built sewage system provided an ideal breeding ground for rats, dramatically multiplying the rodent population. To get the issue under control, the city began paying residents for every rat they killed. It was an early version of what’s known today as paying for performance.

The system seemed to work, as residents began delivering a growing number of rat tails to city hall each week. But a few months into the program, a city official stumbled upon something unexpected—a rat farm. Instead of hunting rats in the city, people started breeding and then killing rodents on the outskirts of town in order to collect the bounties. Far from fixing Hanoi’s rat problem, the pay-for-performance scheme had exacerbated it.

Economists refer to this as the cobra effect, after a similar experiment to rid Delhi, India, of venomous snakes spurred a nearly identical sequence of events. The cobra effect is just as relevant today as it was over a century ago because it illustrates the paradox underlying pay-for-performance plans in the banking industry and throughout corporate America. While boards of directors tend to prefer a compensation system that rewards and encourages executives and employees to improve their performance, a poorly designed plan can just as easily yield the opposite result.

History offers numerous examples of incentive schemes that seemingly offered strategic, thoughtful and even elegant fixes but produced a variety of unintended outcomes,” says Michael Vann, professor of history at Sacramento State University and author of the forthcoming book, The Great Hanoi Rat Hunt, which will be published by Oxford University Press in early 2018. “The worst of these were perverse incentives, policies that actually increased the behavior that they were designed to decrease or eliminate.”

The pay-for-performance paradox has gained significance in recent years, as banks tie an increasing share of executive pay to variable compensation. This trend is most mature at large banks. At JPMorgan Chase & Co., the biggest bank in the country with $2.6 trillion in assets, chairman and CEO Jamie Dimon earns only 5 percent of his compensation from a fixed salary. An additional 18 percent comes in the form of an annual cash bonus. The rest comes in the form of stock that’s awarded only if the bank meets short- and long-term performance targets laid out by the board of directors of the New York City-based bank.

The trend has caught on at smaller banks as well. In 2013, just under three-quarters of CEO pay at the median publicly traded bank with less than $5 billion in assets consisted of a fixed salary, with the rest coming from a mix of discretionary and performance-based bonuses, according to data provided by ISS Corporate Solutions. By 2016, the mix was nearly half and half. Over this same stretch, moreover, the ratio of small banks that provide long-term incentives subject to forfeiture if performance targets aren’t met increased from roughly 1.5 percent up to 28 percent.

The say-on-pay rules enacted by the Securities and Exchange Commission in 2011 are a commonly cited catalyst for the growing preference in favor of performance-based pay. The rules give investors in publicly traded companies the right to vote on executive remuneration. It’s an advisory vote, and therefore not binding on a bank’s board of directors, but the ability to cast proxy ballots has narrowed the focus of institutional investors around the issue.

In order to represent their clients and satisfy their fiduciary duties, institutional investors feel the need to make informed and thoughtful votes on this,” says Kern McPherson, senior director of North American research at shareholder advisory firm Glass Lewis. “Institutional investors definitely want to see a substantial share of executive pay packages tied to performance.”

It’s not just investors who support paying for performance, say compensation consultants; it’s also popular among executives and employees who want to share in the fruits of their labors. This is why one of the main considerations that comes into play when designing an incentive-based compensation system is retention. “Two overarching questions when measuring the effectiveness of a pay-for-performance system are whether it incentivizes the right performance and whether it provides the right retention value, in addition to being aligned with the stockholder experience at the company,” says Natalia Weaver, vice president at ISS Corporate Solutions.

Yet, while this remains the conventional view, there are people both within the banking industry and outside of it who take issue with the underlying premise of paying for performance. “I have no idea why I was offered a contract with a bonus in it because I promise you I will not work any harder or any less hard in any year, in any day because someone is going to pay me more or less,” said Deutsche Bank CEO John Cryan in 2015. “I’ve never been able to understand the way additional excess riches drive people to behave differently.”

A growing body of research suggests that detractors like Cryan may be onto something. In a survey published last year by the global advisory firm Willis Towers Watson, only half of employers who responded said that short-term incentives are effective at driving higher levels of individual performance. More pointedly, a 2014 study of 1,500 large companies conducted by researchers at the University of Utah, Purdue and Cambridge found a negative correlation between CEO pay and subsequent stock performance. “The more CEOs are paid, the worse the firm does over the next three years, as far as stock performance and even accounting performance,” one of the authors told Forbes.

There’s also research suggesting that performance-based compensation, while thought to be effective at increasing the output of front-line employees who perform routine tasks, may be counterproductive for managers and executives, who face a more nuanced set of responsibilities.

“One important reason why performance-based pay for senior executives, such as CEOs, is likely to do more harm than good is because their performance is all but impossible to measure—even in the long-run,” says Freek Vermeulen of the London Business School. “And pretty much any measure that you then develop to link someone’s pay to is going to end up distorting behavior, rather than steering it in the direction that you want it to go.”

This is why it’s important to keep the cobra effect in mind when designing a pay-for-performance system. “Any incentive plan will motivate performance. The question is: Have you thought of all the right ways to do so such that you don’t unintentionally motivate the wrong behavior,” says Susan O’Donnell, a partner at Meridian Compensation Partners.

Experts in the field of executive compensation offer a number of recommendations to combat the unintended consequences of performance-based compensation plans. First, use a basket of performance metrics that reflect multiple objectives rather than just one. Second, avoid setting targets that are unreasonably high or low. High targets will reduce cost but breed contempt among the plan’s beneficiaries, while low targets won’t provide the desired incentive to drive improvement. Finally, insert clawback or vesting mechanisms to balance a bank’s interest in long-term solvency against its desire for short-term profit maximization.

There’s little reason to believe that the trend toward paying for performance will abate anytime soon at banks or, for that matter, companies in other industries. But as a growing body of research shows, it’s not a panacea that guarantees improved results.

John Maxfield is a writer and contributor to Bank Director.