WHEN PAYING FOR PERFORMANCE WORKS, AND WHEN IT DOESN’T
“But surely,” you might think, “there is a place where pay for measured performance is appropriate, and that is in the realm of business.” Businesses, after all, exist to make money, and people work in them to make money for themselves. It makes sense, it seems, for business managers to try to elicit their employees’ greatest effort by tying their remuneration as closely as possible to their measurable contribution to making profits for the firm.
There are indeed circumstances when pay for measured performance fulfills that promise: when the work to be done is repetitive, uncreative, and involves the production or sale of standardized commodities or services; when there is little possibility of exercising choice over what one does; when there is little intrinsic satisfaction in it; when performance is based almost exclusively on individual effort, rather than that of a team; and when aiding, encouraging, and mentoring others is not an important part of the job. For sales forces,1 or for routinized, individualized, highly focused jobs involving standardized outputs and without broader responsibilities, rewarding measured performance may well pay off. In short, as one sociologist has put it, “Extrinsic rewards become an important determinant of job satisfaction only among workers for whom intrinsic rewards are relatively unavailable.”2 These are the sort of tasks for which Taylorism (see chapter 3) was designed. There are many such jobs in any society, including a modern, technologically advanced one. But in our time, as the technologies of robotics and artificial intelligence advance, such jobs are becoming fewer and far between.3
But the salient fact is that most private-sector jobs do not match these criteria. And to the extent that they do not, direct payment for measured performance will be inappropriate and perhaps counterproductive.
People do want to be rewarded for their performance, both in terms of recognition and remuneration. But there is a difference between promotions (and raises) based on a range of qualities, and direct remuneration based on measured quantities of output. For most workers, contributions to their company include many activities that are intangible but no less real: coming up with new ideas and better ways to do things, exchanging ideas and resources with colleagues, engaging in teamwork, mentoring subordinates, relating to suppliers or customers, and more. It’s appropriate to reward such activities through promotions and bonuses—even if it is more difficult to document and requires a greater degree of judgment by those who decide on the rewards. Nor is the problem assigning numbers to performance. There is nothing wrong with rating people on a scale. The problems arise when the scale is too one-dimensional, measuring only a few outputs that are most easily measured because they can be standardized.
Indeed, the academic evidence on pay for the measured performance of CEOs and other personnel is sufficiently troubling that some scholars of organizational behavior have suggested that it should simply be eliminated. And some companies are acting accordingly. Dan Cable and Freek Vermeulen of the London Business School recall many of the problems we have explored: the depressive effect of performance pay on creativity; the propensity to cook the books; the inevitable imperfections of the measurement instruments; the difficulty of defining long-term performance; and the tendency for extrinsic motivation to crowd out intrinsic motivation. They’ve concluded that it might be more advantageous to abolish pay-for-performance for top managers, and replace it with a higher fixed salary. They even suggest, rather heretically, that you might not want people motivated primarily by extrinsic motivation at the head of your company: yet the more compensation is variable and linked to measured performance, the more likely that that will be precisely the sort of people you will get.4 And at least one of Britain’s best-known investors, Neil Woodford of Woodford Investment Management, a company with £14.3 billion under management, has eliminated bonuses for the company’s executives in favor of higher fixed pay, arguing that there is little correlation between bonus and performance.5
Forced ranking, in which managers are instructed to evaluate their employees compared to fellow employees, is another manifestation of metric fixation. It seems “hard” and “objective,” but often turns out to be counterproductive. A 2006 survey of more than two hundred human resource professionals from large companies found that “even though over half of the companies used forced ranking, the respondents reported that this approach resulted in lower productivity, inequity, skepticism, decreased employee engagement, reduced collaboration, damage to morale, and mistrust in leadership.”6
Increasing numbers of technology companies, conscious of the demotivating effect of performance rankings on the majority of their staff, are moving away from performance bonuses. They are replacing them with higher base salaries combined with shares or share options, to give employees a tangible interest in the long-term flourishing of the company (while paying special rewards to particularly high performers).7
Yet other companies are dropping annual ratings in favor of “crowdsourced” continuous performance data, by which supervisors, colleagues, and internal customers provide ongoing online feedback about employee performance. That may be substituting the frying pan for the fire, as employees constantly game for compliments, while resenting the omnipresent surveillance of their activities8—a dystopian possibility captured in Dave Eggers 2014 novel The Circle. Yet as improvements in information technology make it easier to monitor one or another index of worker performance, it will become ever more tempting to link pay to performance, whether in the form of piece rates, bonuses, or commissions9—in spite of evidence of the hazards of measuring too narrowly, and of discouraging teamwork and innovation.
A great deal of corporate dysfunction comes from pay-for-performance schemes that are narrowly tailored to measure a single outcome. Problems occur both at the top and at the bottom of the corporate ladder.
For a dramatic instance among top executives, take the case of the pharmaceutical manufacturer Mylan. Though not among the largest of American pharmaceutical firms (11th by revenue and 16th by market capitalization), it had the second-highest level of executive compensation: over the course of five years ending in December 2015, its top three managers were paid over $70,000,000 each. Over that period, its stock price rose 155 percent. In 2014 its board of directors developed a compensation scheme for the company’s top executives according to which they would be handsomely rewarded if the company’s profits grew by 16 percent each year—far beyond reasonable expectations for a company that dealt largely in generic drugs, generally considered a “mature market” where high rates of competition make for modest profits.
Mylan’s largest profit center was the EpiPen, a penlike device that easily injects epinephrine (adrenalin) into the skin to counteract severe allergic shock. Because each injection lasts for only a brief time, and because children at risk of allergic shock require a pen at home and at school, many families with a member at risk need to stock several pens at once. Since the medicine loses its potency after 12 to 18 months, the pens need to be replaced frequently. Mylan did not create the EpiPen: it was developed by another company that brought it to market in 1987. Mylan bought the rights in 2007; but since there was no effective competitor in the market, it had a near monopoly on epinephrine injectors.
In 2011, Mylan promoted one of its top executives, Heather Bresch, to the position of Chief Executive Officer, effective January 2012. From 2009 to 2013, the company upped the list price of a two-pen pack from $100 to $263; then in May 2014 (just as the new incentive system for its top executives kicked in), it doubled the price to $461, before hiking it again in May 2015, to $608.10
By the summer of 2016, Mylan’s price gouging on this essential device—used not only by many adults but also (thanks to a marketing campaign by Mylan) by thousands of school-age children—led to a public outcry and a congressional hearing. Several senators asked the Department of Justice to investigate the company’s billing practices.
How did Mylan investors fare from the company’s drive to incentivize its executives to raise profits? When Bresch took charge as CEO, the stock price stood at $22. In June 2015 it reached a high of $73. But the public outcry against the company and the resulting congressional hearings and Justice Department investigations led the price to drop to $36 in October 2016. The top executives’ single-minded focus on hitting outsized profit metrics had led to a collapse of the company’s reputation.
At the very time that Mylan’s pay-for-performance scheme for top executives was bringing down the pharmaceutical company, another major corporation was being laid low by its own version of pay-for-performance. The company in question aimed not at the top of the organizational ladder but at the bottom; its incentives were not the carrots of monetary rewards but the sticks of forced termination for those who did not measure up to its performance goals.
Here’s what happened. Wells Fargo, a major American bank, was functioning in a difficult economic environment. The Federal Reserve Board had lowered the rate of interest almost to the vanishing point, making it more difficult for banks to generate profits from the loans they extended. In an attempt to increase its profits, in 2011 the company encouraged “cross-selling”: it set quotas for its employees to sign up customers who were interested in one of its products (say, a deposit account) for additional services, such as overdraft coverage or credit cards, which were more lucrative for the bank. Failure to reach the quota meant working additional hours without pay and the threat of termination. (Perhaps their inspiration was the Alex Baldwin character in the film Glengarry Glen Ross, a boss who instructs his sales force on the rules of their sales tournament: “First prize is a Cadillac El Dorado…. Second prize is a set of steak knives. Third prize is you’re fired. Get the picture?”) But the quotas were set too high, given the limited number of customers who entered the bank on a daily basis. To reach their enrollment quotas, thousands of Wells Fargo bankers resorted to low-level fraud, creating PIN numbers to enroll customers in online accounts or debit cards, for example—without informing the customer. That was not the intention of the Wells Fargo management: they wanted their employees to get customers to open legitimate accounts. As it uncovered evidence of malfeasance, Wells Fargo fired some 5,300 employees for their actions. But the spate of fraud was a predictable response to the performance quotas that the company’s managers had set for their employees.
After news of the massive fraud broke in September 2016, Wells Fargo was fined $100,000,000 by the federal Consumer Financial Protection Bureau, $50,000,000 by the Los Angeles City Attorney, and $35,000,000 by the Office of the Controller of the Currency. The damage to the firm was not only monetary but also reputational. The value of Wells Fargo stock fell from about $50 in late August to $43 by the end of September. Once again, reward and punishment for measured performance backfired.11
The cases of Mylan and Wells Fargo are recent examples of an older and common pattern, by which policies of payment for measured performance lead employees to engage in actions that create long-run damage to a firm’s reputation.12
Is this a problem of human nature or of the propagation of the credo of paying for measured performance? To put it another way: is the notion of narrowly self-interested agents a fact of life, or is it exacerbated by a managerial ideology that uses extrinsic rewards based upon simple models of human behavior that then become self-fulfilling prophecies? Sometimes, the way in which managers and employees are addressed by their company actually influences the way they think, so that they come to act in the narrowly self-interested way posited by the most reductive versions of principal-agent theory, with deceit and guile.13 In fact, it may create a situation in which the managers and employees most knowledgeable about the workings of the performance indicators are best positioned to manipulate those indicators for their own benefit, and most likely to do so.14 Take, for example, the cases of Dennis Kozlowski, the CEO of Tyco; Bernard Ebbers, CEO of WorldCom; John Rigas, CEO of Adelphia: all went to prison in the early 2000s for enriching themselves by using their detailed knowledge of their firms’ transactions to manipulate the performance measures through which they were compensated.15
The reaction to these scandals led to the passage of the Sarbanes-Oxley Act of 2002, which sought to strengthen corporate accountability, in part by holding the members of the board of directors of public corporations legally liable for the accuracy of financial statements. While complying with the act has added substantial costs to the corporations, it may have strengthened public confidence in the validity of their financial reports—and so provides evidence of the advantages of transparency. But the increased legal accountability of each member of the board of directors has also imposed costs of a sort not measureable by economists. As a consultant to the boards of directors of Fortune 500 corporations (who for obvious reasons must remain nameless) told me, since the passage of Sarbanes-Oxley, board members are so focused on assuring the accuracy of the company’s financial reports that they have little time and inclination to deliberate upon the primary tasks of a board of directors, namely thinking strategically about the long-range future of the company! Thus only what gets measured—and potentially penalized—gets done.
THE FINANCIAL CRISIS
The financial crisis of 2008 had many causes, and some of them flowed from the attempt to substitute standardized metrics for judgment based on local knowledge, exacerbated by the effects of pay-for-performance schemes.16
As companies, including financial companies, grew larger and more diverse in their holdings, new layers of management were needed to supervise and coordinate their disparate units. From the point of view of top management, the diversity of operations meant that executives were managing assets with which they had little familiarity. That led to a search for standardized measures of performance across large and disparate organizations. Its implicit premises were these: that information which is numerically measurable is the only sort of knowledge necessary; that numerical data can substitute for other forms of inquiry; and that numerical acumen (premised upon probabilistic formulas rather than empirical research) can substitute for practical knowledge about the underlying assets.
Contributing to the financial crisis was the increasing role of financial managers who were skilled at the analysis and manipulation of metric data but did not have “concrete” knowledge or experience of the things being made or traded. As Niall Ferguson has put it, “those whom the gods want to destroy they first teach math.”
Here, in stylized form, is what happened in the lead-up to the crisis of 2008. Traditionally, banks (or individual investors) had offered mortgages to people with whom they had direct contact. They were thus in a position to exercise judgment about who was credit-worthy and who was not. And they had an incentive to exercise that judgment: since the bank (or investor) continued to hold the mortgage, their stream of future income depended on the reliability of the mortgagee.
That began to change around the year 2000, and by 2008 that system had largely been replaced by a new one. Changes in the capital regulations of banks made the origination and holding of traditional mortgages less lucrative than holding securities comprising thousands of mortgages.17 Now the mortgages were originated not by the bank but by a mortgage brokerage firm, which made its money from the number of mortgages it processed but had no financial interest in the long-term viability of the mortgages. Mortgage originators, such as Countrywide, provided loans to people buying houses, then packaged these loans into bundles of one thousand, and sold them to a bank, such as Lehman Brothers. Since they had no long-term interest in the viability of the mortgage loans they issued, mortgage originators increasingly offered “low-doc” or “no-doc” loans, meaning that borrowers were asked to provide almost no proof that they would actually be able to repay the loans. But the bank did not hold onto them either. It created a “mortgage backed security,” an interest-bearing bond, secured by the loans, and sold these to investors. With advice from the ratings agencies (such as Moody’s), financial engineers mixed good-quality mortgages, from borrowers likely to pay, with more dubious ones, so as to squeeze the most profit out of these mortgage-backed securities,18 which they carved into “tranches” bearing different degrees of risk in return for varying rates of interest. Behind all of this was a belief in the financial sector that such diversification was a substitute for due diligence on each asset. The idea was that if one bundled enough assets together, one didn’t have to know much about the assets, or make judgments about their viability.
New, mathematically complex financial instruments were created, such as credit default swaps, which were intended to insure against the risk of sudden changes in the value of mortgage-backed securities. This was supposed to use mathematical sophistication to diminish risk, but instead led to an inability of any but a few analysts to get a clear sense of what was happening. And the creation of arcane financial instruments made effective supervision virtually impossible, both by superiors in the firm and by outside regulators.
Add to this witches’ brew of dubious metrics, served up as a replacement for judgment, the fact that the remuneration of top employees at banks such as Lehman Brothers was based on pay for measured performance in the form of bonuses. Thus metrics provided the means, and pay-for-performance supplied the motivation, for undue risk-taking under conditions of opacity.19 Then, as mortgagees proved unable to make their mortgage payments, the simultaneous drop in value of mortgage-backed securities led to huge, unanticipated losses to those financial firms that had insured the securities through credit default swaps. The result was a near meltdown of the financial system.
SHORT-TERMISM
Another way in which dubious indicators of measured performance have distorted the economy is through short-termism.
Perhaps the most consequential change in the business world in recent decades has been the financialization of the economy, above all in the United States.20 As late as the 1980s, finance was an essential but limited element of the American economy. Trade in equities (the stock market) was made up of individual investors, large and small, putting their own money into stocks of companies they believed to have good long-term prospects. Investment capital was available from the major Wall Street investment banks (and their foreign counterparts), which were private partnerships in which the partners’ own money was on the line. All this began to change as larger pools of capital (from pension funds, university endowments, and foreign investors) became available for investment and came to be deployed by professional money managers rather than the owners of the capital themselves. The result was a new financial system, characterized as “money manager capitalism” by the maverick economist Hyman Minsky, or “agency capitalism” by Alfred Rappaport, a business school professor.21
Spurred in part by these new opportunities, the traditional Wall Street investment banks transformed themselves into publicly traded corporations—that is to say, they too began to invest not just with their own funds but also with other peoples’ money—and tied the bonuses of their partners and employees to annual profits. All this created a highly competitive financial system dominated by investment managers working with large pools of capital, paid for their supposed ability to outperform their peers. The structure of incentives in this environment leads fund managers to try to maximize short-term returns, and they in turn pressure the executives of the corporations whose stock they own to show gains every quarter.22
The shrunken time horizon creates a temptation to boost immediate profits at the expense of longer-term investments, whether in research and development or in improving the skills of the company’s workforce. The emphasis placed upon quarterly earnings (which are supposed to provide transparency) and “quarterly earnings guidance”—projections by management about the firm’s profitability in the coming three months—intensifies short-termism, since stock prices often rise and fall in keeping with this metric. And since the failure to reach this predicted target by the end of the next quarter may also lead to declines in stock prices, there is an inescapable temptation to game the figures so that measured performance matches the projections. It creates tremendous incentives for corporate executives to devote their creative energies to schemes that demonstrate productivity or profit by massaging the data, or by underinvesting in maintenance and human capital formation (ongoing education of employees) to boost quarterly earnings or their equivalents. The propensity for underinvestment in long-term growth is sufficiently dire that in early 2016, the CEO of the largest investment firm in the world, Larry Fink of BlackRock, wrote an open letter in which he warned, “Today’s culture of quarterly earnings hysteria is totally contrary to the long-term approach that we need.”23
Gaming the metrics often takes the form of diverting resources away from their best long-term uses to achieve measured short-term goals. Take the company that, hoping to be bought out at a multiple of earnings, tries to boost its profit by laying off necessary workers. Or the CEO who smooths out corporate earnings by postponing needed investments in an effort to meet analysts’ expectations for the quarter. Or the money-managers who buy shares of well-performing stocks and sell shares of underperforming stocks in time for listing in quarterly reports, disguising the fact that they bought the high-performing stocks at high prices and that their poorly-performing stocks may have turned around had they held onto them—known in the trade as “window dressing.”24
A focus on measurable performance indicators can lead managers to neglect tasks for which no clear measures of performance are available, as the organizational scholars Nelson Repenning and Rebecca Henderson have recently noted.25 Unable to count intangible assets such as reputation, employee satisfaction, motivation, loyalty, trust, and cooperation, those enamored of performance metrics squeeze assets in the short term at the expense of long-term consequences. For all these reasons, reliance upon measurable metrics is conducive to short-termism, a besetting malady of contemporary American corporations.
OTHER DYSFUNCTIONS
When rewards such as pay, bonuses, and promotions are tied to meeting budget targets, there is yet another danger: distorting the information system of the organization. Managers and employees learn to lie, to massage, embellish, or disguise the numbers that are used to calculate their pay. But since these are the very numbers that executives use to coordinate the activities of the organization and decide on the allocation of future resources, the productivity and efficiency of the organization is damaged as resources are misallocated.26
The attempt to substitute precise measurement for informed judgment also limits innovation, which necessarily entails guesswork and risk. As business school professors Gary Pisano and Willy Shih have argued,
Most companies are wedded to highly analytical methods for evaluating investment opportunities. Still, it remains enormously hard to assess long-term R&D programs with quantitative techniques…. Usually, the data, or even reasonable estimates, are simply not available. Nonetheless, all too often these tools become the ultimate arbiter of what gets funded and what does not. So short-term projects with more predictable outcomes beat out the long-term investments needed to replenish technical and operating capabilities.27
Performance metrics as a measure of accountability help to allocate blame when things go badly, but do little to encourage success,28 especially when success requires imagination, innovation, and risk. Indeed, as the economist Frank Knight noted almost a century ago, entrepreneurship entails “immeasurable uncertainty,” which is not susceptible to metric calculation.29
Thus, even in business and finance, metric fixation takes its toll. Businesses must be judged by more than one indicator of performance. Profit surely matters. But so, in the long run, does reputation, market share, customer satisfaction, and employee morale, which makes it possible to adapt and to find solutions to the new problems that will inevitably arise in the marketplace. In an economic world characterized by unpredictable change, there is a need for ongoing innovation, small and large, that is not readily reducible to a single performance target. Performance indicators can certainly aid, but not replace, the key functions of management: thinking ahead, judging, and deciding.30