You Manage It! 4: Ethics/Social Responsibility The Pitfalls of Merit Pay and Pay for Performance

Merit Pay? For Whom?

Three recent studies suggest that the link between pay and performance may not always show in the pay checks of women and minorities. A joint study of nearly 200 British executives by the University of Exeter in Britain and Tilburg University in the Netherlands found when men and women with similar experience achieved improved results, the women were rewarded far less. Bonuses for men rose over 250 percent at poorly performing companies that began to improve, whereas bonuses for women rose an average of merely 4 percent. An MIT study of nearly 9,000 nonmanagement information technology workers at a U.S. firm found that minorities received lower raises, even after controlling for variables such as job titles, starting pay, and education levels. Another study by the National Security Personnel System (NSPS) evaluated the Pentagon’s pay-for-performance system and concluded that “Employees in higher-level, higher-paid positions got higher performance ratings and payouts than lower-level, lower-paid employees. The report further found that, in general, being a racial minority had a negative effect on one’s rating and payout, and being black had a more negative effect than membership in other racial groups.”

Pay for Performance

The following situations emerged in very different organizational settings after incentives were introduced to reward good employees:

  • ▪ Prior to the financial crisis of 2008–2012, banks and security firms have been accused of fostering imprudent risk taking by showering employees with bonuses linked to revenues and volume of transactions. After 2008, large financial firms tried to defuse public anger and political retaliation by limiting these practices. But according to a recent Wall Street Journal report, “Bank of America Corp. and Citigroup Inc. are doling out shares that employees can sell within months—much sooner than normally allowed. Other giant banks, including Goldman Sachs Group Inc., Morgan Stanley and Royal Bank of Scotland Group PLC, let certain employees borrow money to relieve personal cash crunches. And some U.K. banks have considered raising base, or cash salaries—funds that won’t be subject to the country’s new 50% tax on bonuses.”

  • ▪ Several large banks were recently sued for housing foreclosure fraud. The lawsuits allege “common law fraud and misrepresentation as well as violations of consumer fraud statutes.” Part of the problem may be traced to the incentive system that rewarded bank employees for expediting the foreclosure paperwork. The banks have admitted problems in the paperwork, uncovering evidence of “employees not verifying documents their signature suggested they verified.”

  • ▪ Green Giant had to abandon a bonus plan intended to reward employees for thoroughly cleaning the peas harvested for its vegetable packages. Employees had begun bringing their own insect parts to the factory, dropping them in the peas, and removing them to qualify for the incentive pay.

  • ▪ Insects of a different sort were the undoing of another incentive pay plan, when a software developer found its programmers actually creating coding “bugs” in order to be rewarded for removing the glitches from their own work.

  • ▪ By late 1996, ailing Sunbeam’s well-paid new CEO Al Dunlap had fulfilled his mission to turn the company around and help its stock value soar. Then in 1998 the value of Sunbeam stock fell precipitously, from $53 a share to less than $4, and the SEC began an investigation of the company’s accounting practices. Dunlap had improved Sunbeam’s short-run performance, but he had not been able find a company willing to purchase it, leading Sunbeam’s board of directors to fire him.

Critical Thinking Questions

  1. 11-31. What is the common thread across the widely different examples of “merit pay” and “pay for performance” given in this case?

  2. 11-32. What are some of the pros and cons of linking pay to objective criteria that are important to the organization such as quality control measures, profitability, and low turnover?

  3. 11-33. What can an organization do to ensure that merit pay and other incentives are administered fairly? What kind of data would you gather to ensure that the pay-for-performance system is not biased in favor of any particular group? Explain.

  4. 11-34. How would you prevent the problems that arose at Green Giant, the software developer, and Sunbeam and still reward good performance? Explain.

  5. 11-35. Assuming you are a top executive at Green Giant or the software developer, would you punish the employees who engaged in those unethical acts, the managers who devised the incentive system, or both?

  6. 11-36. Some people believe that most employees will act ethically even though they have a chance to take advantage of an incentive system through inappropriate behaviors. Do you agree?

Team Exercise

  1. 11-37. Divide the class into groups of three to five students. One set of teams will defend the proposition that incentives can be beneficial to a firm by reinforcing desired behaviors. Another set of teams will defend the position that in most cases incentives promote a “let’s beat the game” attitude among employees that leads to poor performance.

Experiential Exercise: Team

  1. 11-38. In a midwestern state prone to frequent and severe snowstorms, the head of the Department of Transportation (DOT) has introduced a proposal to provide an incentive to snowplow operators linked to the number of miles shown on the odometer during each shift. The incentive plan, scheduled on a trial basis for the winter season of 2014–2015, is intended to motivate the snowplow operators to cover more ground and to clean the roads quicker. One student will role-play a compensation consultant to advise the DOT on the proposal; another student will role-play the position of the head of the DOT. The role-play should last 10 to 15 minutes, after which the instructor will moderate an open class discussion on the issue.

Experiential Exercise: Individual

  1. 11-39. Many have blamed the Wall Street debacle of 2008–2012, which the Wall Street Journal has referred to as the “worst crisis since 1930s,” to the inappropriate use of pay incentives for top executives of large financial giants. According to this view, these executives earned huge bonuses if profit increased, inducing them to take imprudent risks “with other people’s money” and to actively engage in speculation (particularly in the housing market). Despite tough talk about clamping down on pay abuses, many people feel that banks and security firms are finding ways to ease the toll on employees who were responsible for the crisis in the first place, except that now these institutions have access to a large infusion of money from the federal government (what some people refer to as bailout money). Research this issue and come up with a set of recommendation to reward top executives in a way that does not reinforce bad behaviors.

Sources:Based on Davidson, J. (2011). Lessons learned from pay-for-performance. www.washingtonpost.com ; Enrich, D., Munoz, S. S., and Lucchetti, A. (2010, January 28). Banks see past pay limits. Wall Street Journal, A-1; Ng, S. (2010, Jan. 19). AIG tries to defuse bonus pay showdown. Wall Street Journal, C-3; Benoit, D. (2010, Nov. 10). Investors sue J. P. Morgan. Wall Street Journal, C-2; McGregor, J. (2008, September 22). Merit pay? Not exactly. BusinessWeek, 17; Bloom, M. (1999). The art and context of the deal: A balanced view of executive incentives. Compensation and Benefits Review, 31(1), 25–31; Hilsenrath, J., Serena, N. G., and Palelta, D. (2008, September 18). Worst crisis since ’30s, with no end yet in sight. Wall Street Journal, A-1.
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