As everyone knows, incentive compensation is a two-edged sword: Such pay can incentivize the wrong as well as right type of risk taking. That is, the prospect of a bonus may motivate employees to game the numbers instead of improving a company's actual returns. The latter is obviously a plus for a business, the former a negative to the extent it fools management into overpaying for poor performance.
Now a new study shows the risks of such compensation schemes is greater than the rewards.
The study, entitled Are You Paying Your Employees to Cheat? An Experimental Investigation, compared the level of cheating in three different compensation systems. Under a traditional bonus system, employees are rewarded if they reach a financial target, usually some measure of profit. Under a piece-rate system, employees are rewarded for each completed task, meaning more productive workers can earn more. In a tournament system, only employees with the highest productivity receive monetary compensation.
Study participants were given seven letters and asked to make as many words as possible in one minute. They underwent seven rounds of the word-scramble task, and different groups were rewarded based on one of the three compensation systems. Another participant marked their work, but individuals were responsible for reporting their final score to researchers and weren't told the results would be audited. The test ultimately allowed them to choose to report their true score or lie to receive the money.
"We were basically dangling a carrot of them," said Francis Tapon, a professor at the University of Guelph in Ontario and co-author of the study, in a prepared statement.
Result: Over half the group lied but the most cheating by a single person was under the piece-rate scheme, and, cheating in the tournament compensation (requiring performance in the top 10 percent), showed low levels of cheating similar to those of the piece-rate group.
The conclusion was clear, Tapon said: "Bonus schemes almost guarantee cheating." In fact, the study found about 250 percent more cheating with the target-based bonus. It also found that the closer people are to their target, the higher the likelihood that they will cheat to receive the bonus.
How to explain the results? Under the bonus scheme, participants often came close to the target and may have felt they worked hard and deserved to be paid for their efforts," said co-author Brian Cadsby in a prepared statement. "This feeling of entitlement acts as justification for cheating." And the temptation may be greater when it requires a "small lie."
In contrast, participants compensated under a piece-rate system, where they were compensated for each word they created, perceived no sense of unfair treatment as they might under a bonus scheme, Cadsby ventures. They also may have experienced more guilt about cheating under a piece-rate systems, he adds, because it required "bigger" lies.
"If guilt and the unhappiness it creates are greater when the lies are bigger, we would expect to see more people lying under the bonus scheme when small lies produce relatively big payoffs, compared to piece-rate schemes, where bigger lies are required for that same payoff," said Cadsby.
People are less likely to cheat under a tournament system than in a bonus system because they don't know what their competitors have achieved or how much they have cheated, and thus there is less of a guarantee of a pay-off for lying surmised Tapon. She added that they also feel more guilt about cheating colleagues, and not just an employer.
This has significant implications for companies and boards, she said. "Incentive compensation is overused by executives who don't realize what behavior they are promoting," Tapon warned, adding: "There are limits to how far you can push your troops. At some point, they will pretend to achieve these heroic targets and, instead, cheat because this is the only way for them to meet management's demands."
What's the solution? Obviously, organizations need to audit their compensation schemes to avoid cheating. Beyond that, however, Tapon says bonus schemes tied to financial targets should be rethought, at least in terms of their contribution to overall compensation.
"Perhaps a decent level of fixed compensation with some method of recognizing outstanding performers works better than a low fixed compensation with turbo charged bonuses linked to heroic targets," she concluded.