Wean Us from Incentive Myths
The furor over the compensation paid to AIG executives (and for that matter, the bonuses distributed a few months ago at Merrill Lynch) provides President Obama with a teachable moment--an opportunity to move the conversation from the specifics concerning almost incomprehensible decisions to a broader and more important discussion about incentive misalignment and how it occurs.
With respect to the specific instances in question, the government can not, as a matter of practicality, given its limited resources and more important priorities, and should not get itself into the business of passing judgment on executive pay packages. Although the anger is understandable, the proposed remedies are problematic and possibly illegal.
But at the same time, problems with incentives abound. And the problems represented by these two, highly publicized incidents are, in fact, quite common and are daily occurrences in both public and private sector organizations. If we are going to build more effective organizations, a task necessary for making our economy more productive and competitive, we need to both recognize and begin to do something about these ubiquitous incentive issues.
The problem is twofold. First of all, as my colleague Chip Heath pointed out in an article on the extrinsic incentives bias, we overuse and overvalue financial incentives as the solution to every organizational problem. Data show that we believe others are motivated by financial incentives even though we know such incentives are not that important to use--leading to the overuse of financial rewards. Second, most reward systems are much too blunt for the complex, multidimensional aspects of performance in the real world.
So when the city of Albuquerque, New Mexico, faced excessive overtime from crews picking up trash, it put in a reward system so garbage truck crews would receive eight hours of pay regardless of how long it took them to complete their route. The result: speeding and more accidents, missed pick ups, and driving the trucks overweight to avoid having to go to the dump as often. In financial services, companies rewarded people for making loans and packaging securities without taking into account whether the loans would actually be paid back or the securities would wind up being toxic.
It is not that the people designing the incentive systems weren't smart. It's that either you make incentives so complicated that they are no longer comprehensible and lose their motivational power or else you make them so simple that you risk encouraging behavior that isn't quite what you actually want.
Smart organizations recognize the weaknesses of financial incentives and therefore build organizational cultures that provide social rather than monetary guidance and control of behavior. There is in all of this a lesson to be learned about how to manage more effectively and an opportunity to wean ourselves from inaccurate precepts about human behavior and the sources of organizational effectiveness. Such education is a difficult task for any leader, particularly in times such as these. But the lessons are important and the president should not let this opportunity pass to engage in a broader discussion of how to build more effective organizations of all types.
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