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Fallout: The Financial Crisis

Why big bonuses are counterproductive

Marketplace Staff Apr 6, 2009
Fallout: The Financial Crisis

Why big bonuses are counterproductive

Marketplace Staff Apr 6, 2009


Kai Ryssdal: Controversial performance bonuses aren’t reserved for companies that have taken government bailouts. Today New York Attorney General Andrew Cuomo sued a hedge-fund manager who funneled more than $2 billion of his client’s money to Bernie Madoff. For his superior performance the fund manager, Ezra Merkin by name, received fees and bonuses totalling $470 million. Interestingly enough, there is some research out there that shows the bigger the bonus, the worse the performance. Behavioral economist Dan Ariely is with us to explain. Dan, good to talk to you again.

DAN ARIELY: Same here.

Ryssdal: What do we know about money and how hard we work for it?

ARIELY: Suprisingly little. A lot of money is being spent on compensation, but we actually know very little about it. So together with some friends we decided to check it out. And we started by checking out the most trivial assumption: the idea that the more money that is on the line, people would perform better. We wanted to give people either a small bonus, a medium bonus or a large bonus. Now my research budget is not that big, and I wanted the big bonus to be very big, like a six-month salary. So we went to India and guess what happened? Across many tasks, the more money that was on the line, the worse people did.

Ryssdal: Say that again. More money, lower performance?

ARIELY: That’s right. When we gave them a huge bonus, performance went down.

Ryssdal: Why?

ARIELY: So it turns out that money is a two-edged sword. It’s a motivator, but it’s also a stresser. And beyond a certain point the stress can overwhelm the performance. So imagine, for example, I said, “If you perform well in the next 10 minutes there’s $50,000 in there for you.” How well will you perform?

Ryssdal: Right, probably not too well, actually, right?

ARIELY: Yeah. And it turns out this also not only happens with humans, it also happens with rats. So a long time ago there were some rats that were given the task to learn a maze, and if they learned well they could either get, alleviate, avoid, either a small shock, a medium electrical shock or a huge electrical shock. And unsuprisingly, they did better for the medium shock than on the small shock. They were more motivated, and they actually learned faster. But when the big shock was in the question, was in the balance, they actually performed worse. They were so consumed, so terrified from this large shock, they were not able to think about anything else. And that’s the same thing that happens to us with money.

Ryssdal: So we just get stressed. When we see all that money on the line, we just get stressed, and our performance goes down.

ARIELY: That’s right. And this is not the worst of it. We did one more thing in the beginning of the experiment in India. We tried to get people very stressed, the most stressed we could with this amount of money we had. So for some people we gave them the money upfront, and we said, “Look, this is your money. If you don’t perform well, we’ll take the money back from you.” Now with one subject he was shaking the whole time, he couldn’t do anything, he was so stressed. Then we went with another guy, who was not as shaky. But he, when he didn’t make the money, he ran away with all our money in the end, we couldn’t catch him he was so fast.

Ryssdal: He just left.

ARIELY: He just left. So we stopped doing it this way. But I think this is actually a good analogy for many people about how they think about their bonuses. They expect them; they anticipate them. And because of that they even have a more devastating effect on their performance.

Ryssdal: Well, is there a way, then, for managers to think about this, and say well, maybe I should give them some percentage of a bonus, or is there a better way to compensate to maximize performance?

ARIELY: There’s all kinds of ways to get the benefit of bonuses without getting the stress connected to them. For example, how about if we gave the bonus quarterly, rather than yearly. Or how about it was the average of the last five years, rather than just the last performance.

Ryssdal: And yet, these guys on Wall Street, just because that sort of seems to be the bonus question of the day, they’re getting millions of dollars for losing everybody billions.

ARIELY: I actually went to one of these big investment firms, and I presented these results. And I said, “Guys, why don’t we revise how you think about bonuses?”

Ryssdal: How did that go over? I’m sure that was a great reception you got, right?

ARIELY: They basically said, “Well, this could happen for other people, but not for us. We’re professionals; we know what we’re doing. We don’t get stressed by these millions of dollars of bonuses. It doesn’t really affect us.” And then I asked them what happens — this was before the financial meltdown — what do you talk about in October, November and December? They said, “Nothing but the bonuses.” Now, you know, will this happen to everybody? I don’t think so. And I don’t want to imply that bonuses are always bad. We just need to think about how we take this into account when
we design compensations.

Ryssdal: Dan Ariely teaches behavioral economics at Duke University. His book on what we’ve been talking about is called “Predictably Irrational.” Dan, thanks a lot.

ARIELY: My pleasure.

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