In praise of across-the-board bonuses

By Felix Salmon
August 18, 2013
Quentin Fottrell has a great headline today: "25% of firms give bonuses for incompetence".

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Quentin Fottrell has a great headline today: “25% of firms give bonuses for incompetence”. Which is shocking — but not in the way that Fottrell intends. Because it’s not really incompetence which is being rewarded here. Instead, it’s simply employees getting a bonus when their employer does well enough to be able to afford to give out such a thing.

Obviously, if you give out a bonus to all your employees, then you’re going to be giving a bonus to your lowest-performing employees. But that’s probably as it should be, since trying to measure individual performance is a mug’s game, and the performance review is something which deserves to die. Performance-related pay is a nasty, invidious thing, and I’m very glad that an increasing number of companies are doing away with it.

The problem is that people like Fottrell tend to think that bonuses, by their nature, must be performance-related, and that if you’re not going to be paying out bigger bonuses to your best performers, then that defeats the purpose of having a bonus system in the first place. And he’s completely wrong about that. The reason is that bonuses are a great way of tackling the serious problem of sticky wages — a problem which causes a significant amount of unemployment in the economy. It shouldn’t be 25% of firms giving out what Fottrell calls “bonuses for incompetence”: it should be 100%. If that were the case, the unemployment rate would be significantly lower than it is today.

It’s basic economics that sticky wages cause unemployment. In any economy, there will be some firms which become less competitive over time; in order to restore their competitiveness, they will need to cut their wages. If they can’t do that, they will simply go bust. But cutting nominal wages is very hard. The result is that firms go bust unneccessarily, and their employees get laid off unneccessarily. On top of that, thanks to wage stickiness, there are many firms paying above-market wages to their employees — that is, wages which are above what an equally-qualified person would require to do the same job. That too causes unemployment: if a firm would like to be able to hire 20 people at $15 per hour but instead can hire only 15 people at $20 per hour, that reduces the firm’s overall productivity and also means five fewer jobs in total.

When economists talk about the necessity of implementing “structural reforms” in an economy, one of the key reforms they generally have in mind is making it easier for companies to hire, to fire, and to reduce wages for workers when times are tough — those reforms are generally understood to be helpful in reducing unemployment, and countries where doing such things is difficult do indeed, as a rule, have higher unemployment rates than countries where doing such things is easier.

Structural reforms don’t need to be handed down from above, by legislatures — in fact, they’re often more effective if they’re not. And if you want a structural reform which makes wages less sticky, especially when inflation is very low and you can’t count on inflation to do your dirty work for you, then the first place you should look is bonuses.

Think of three people. Anna, who was being paid a salary of $60,000, is told that this year she will be paid only $57,000 — she’s being given a $3,000 pay cut. She gets very angry. Betty, in the country next door, was also being paid a salary of $60,000, and gets no pay rise, despite the fact that there’s 5% inflation. She’s not happy, but she’s not as angry as Anna. Finally there’s Carly, who is being paid a salary of $50,000, and who got a $10,000 bonus last year; this year, she’s told, she’ll get a $7,000 bonus. She’s pretty happy.

All three women, of course, end up with effectively the same amount of money both last year and this year. But because of social norms, Carly accepts her 5% pay cut with much more equanimity than Betty, who in turn is significantly happier than Anna. An economy with more Carlys and fewer Annas is going to have less sticky wages — and, as a result, lower unemployment.

There’s something quite fair about paying your employees a decent base wage and then giving them a bonus on top which is dependent on how well your company does over the course of the year. It helps align incentives; it also means that when the company makes lots of money, its employees share in the good fortune to a greater degree than they would otherwise. Conversely, it gives the company a certain amount of flexibility to cut annual payroll costs when things get tough. None of this has anything to do with performance reviews; it’s just a way to make a large part of a company’s expenses a bit more efficient.

Bonuses even make it that much easier to hand out pay rises: if Anna asks for a pay rise she won’t like the answer, but if Carly asks for a pay rise, it might be possible to work something out. And of course pay rises in general are cheaper when they’re being applied to a lower base salary.

Finally, bonuses help to encourage saving. Employees tend to spend whatever is in their regular paychecks; if you get a lump-sum windfall, on the other hand, you’re more likely to save it. Bonuses are bad for people living paycheck-to-paycheck, but hourly workers don’t tend to get bonuses anyway. So let’s hope they catch on. Maybe one day, the minimum size of the company-wide bonus would be a direct function of the size of the bonus given to the CEO. But I’m not going to hold my breath on that one.

Comments
13 comments so far

What a bizarre piece – making all sorts of macro-economic arguments irrelevent to running a business, while repeating the “performance reviews deserve to die” mantra. So incompetent people should never be fired? There should be no economic accountability for behavoir or performance? What planet are you from?

Posted by BryanWillman | Report as abusive

From the point of view of a company, what really can kill a company is major screw-ups. So you want an incentive system that prevents that. The most effective incentive system that I’ve heard of to prevent major screw-ups is what’s used by the military, where punishment for mistakes often goes to the whole team, even when it’s clear who’s to blame for it. This creates some really intense peer pressure to avoid screw-ups, and people watch each other on that. From that point of view, the best bonus system would be one that works like this: If the company had a bad year, nobody gets a bonus. Even if it’s only one department that caused the problem. If the company had a good year, bonuses can be related to individual performance.

Posted by Doly | Report as abusive

Your point about the ease of hiring and firing being directly proportional to unemployment rates in different countries is a good one, and born out by evidence. Just look at the German example for instance. Ten years ago German employment rules and unemployment rates were very similar to those in France; Germany restructured and made it easier to hire and fire people and now the economy is booming, and German unemployment is getting on for half that in France.

In my experience there are very generally two types of people; those for whom bonus size is a motivatory factor in their work, and those for whom it – and it’s associated annual appraisal – is not, even anti-motivational. Typical examples here would be salesmen (who live for the excitement earning a commission or bonus brings them) and accountants (for whom filling in all the hours of the week with output seems more rewarding).

Over time though, people do tend to expect the bonus, and then any reward-focussed motivatory influence is lost, whereas the less effective punitive effect increases with habituation when bonuses are cut. The most insidious ingredient in the bonus culture though is the part it plays in magnifying intra-company politics; bonuses end up being paid not so much for having done a good job as for having brown-nosed enough with your manager to be given a bigger bonus than a co-worker with less interpersonal skill, irrespective of work ethic or individual productivity.

Looking further, bonuses based simply on share price can be viewed as contrary to long term company success as the short-termism this leads to often precludes expensive investments that would pay out over the long term more than the short term, share price boosting cuts in expenditure save.

As with many things, so long as there is human diversity, a “one size fits all” strategy may not suit everyone or be the most effective policy. Perhaps lumping the personal and company performance together into one single bonus could be replaced with a more finessed approach of giving two bonuses per year – one for overall corporate performance, and one for individual performance to be given six months away from the other. But this individual bonus should not be automatic, and perhaps could be offered as an opt-in/opt out scheme. This would present employees with the option of taking an enhanced salary to replace an individual bonus system, or choosing the performance related bonus system that could theoretically pay out higher than the enhanced salary – or zero! The idea here would be to offer something for both the risk seekers and the risk averse within an organisation. By catering for both main personality types (the individual and the team worker) bonuses might become useful again.

Addendum: multi-million bonuses for CEOs are surely bad for business though; allowing someone to retire comfortably after just three years in the job as CEO is not IMO conducive to long term thinking for non-business starters; instead it seems more geared to “milking” the company, the employees, the customers and the economy.

Posted by FifthDecade | Report as abusive

Of course, the risk is that good people will jump ship.

To the rival that pays a higher base salary.

To the rival that gives bigger bonuses to better performers rather than smaller bonuses to all – including the morons.

To the rival that doesn’t withhold one guy’s bonus because of a failure elsewhere.

To the rival that rewards the individual for exceptional performance in their role, irrespective of the broader performance of the company.

The question is: even if such individuals are mostly deluded or arrogant, do you really want to risk losing a small number of really good (difficult to replace) people and acquiring a reputation for under-valuing such people in the market?

Posted by Staberinde | Report as abusive

If there’s any doubt the bonus system as is just isn’t working properly, just look at this report about a study of bonuses for managers that showed that men’s bonuses are, on average, about twice as big as those for women – and the men’s salaries are already 25% higher on average.
http://www.bbc.co.uk/news/business-23761 607

Posted by FifthDecade | Report as abusive

This is a good, sensible article. A pleasure to read.

Posted by JamesGoddard | Report as abusive

One thing worth pointing out here in the context of economies like the UK where housing is a larger cost and home ownership is high; it is the base salary, not including the bonus, that is used to calculate salary multipliers. So reducing base salaries would cause a contraction in home ownership.

The other thing is that people get used to consistent bonuses; witness the outcry by traders when their assured bonuses were axed.

Posted by PhilH | Report as abusive

What Felix calls “across the board bonuses” are more commonly (and correctly) referred to as “profit sharing payments.” They make sense as a component of compensation, but they are compatible with also offering bonuses based on individual performance.

As for “trying to measure individual performance is a mug’s game”, I can’t believe that Felix truly thinks that. Is he really saying that he’s never found some colleagues – whether supervisors, peers, or subordinates – to be clearly better at their jobs than others? How does he think that people should be promoted or terminated? Drawing names out of a hat?

And, if some people are better performers than others, then it makes sense to reward those good performers disproportionately, for all the reasons of retention (and motivation) that Staberinde. I’ll certainly agree that evaluating individual performance is tough, but I don’t see that as a reason to throw one’s arms in the air and not even try.

I’ll also point out that it’s easy to criticize any particular system of compensation, because they are invariably imperfect, but the onus falls on someone to suggest a better one. As an example – paying salespeople commission solely on their own sales is easy to criticize when they won’t help each other and act like competitors rather than people working for the same company. Until that is, you therefore decide to pay salespeople commission based on group sales, and then have high performers leave because they don’t like sharing equally with their colleague who surfs the ‘net all day. Even Felix’s proposal here isn’t really a system of compensation, because someone, somehow, still has to decide if Carly stays in her job (or gets promoted, or gets fired) and whether she’s paid $50k plus a $7k bonus or $60k plus a $10k bonus.

On the plus side, I hope that Felix’s stated enthusiasm for the benefits of wage flexibility means that he’s realized the flaws in his arguments for a $15 per hour minimum wage.

Posted by realist50 | Report as abusive

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