High profile financial scandals in today's business world pop up in the media regularly. Often at the root of such scandals are incentive compensation systems that went awry. The problem might be with the program's initial design or a loophole that participants discover and take advantage of. Even if a poorly designed incentive program doesn't run afoul of the law, it may cost its sponsors a bundle without delivering desired results. Or, it might really jump the tracks, as one foreign city government found out.

The phrase "perverse incentives" is used to describe an incentive that has unintended — and generally expensive — consequences. An illuminating example is the case of the municipal government of Hanoi when that city was combating a surge in its rat population. The city decided to pay its citizens a bounty for each rat they killed and turned in. The upshot: Hanoi residents found it much easier to breed rats than capture them in the wild and collected their awards with no net impact on the city's rat population. Now that's an expensive failure!

Common Hazards

Let's hope you don't have a rat problem. Every incentive to perform, it's said, is an incentive to cheat. Some people see the offer of an incentive as a challenge to find a way to get it without doing the work. Cheating isn't inevitable, however. Perhaps the most typical incentive pay problem occurs when an employee's bonus potential is too high relative to fixed compensation.

Many self-directed salespeople thrive on having a large part of their pay based on the revenue they generate. Yet most also crave financial stability and predictability. With fixed financial obligations like home mortgages, car loans and student debt to worry about, this is easy to understand.

So, depending on the performance metrics, an ambitious employee whose compensation primarily is based on commissions or bonuses could be motivated to game the system. Alternatively, an honest but lower-performing employee might fail to earn much and become frustrated, disengaged or unproductive.

Another common hazard of incentive compensation: The pressure-cooker atmosphere that leads to high employee turnover. This can happen when the incentive compensation potential of front-line managers is substantial and linked directly to the performance of employees they supervise. Such managers can be driven to go overboard in pressuring their subordinates to perform, causing many employees to quit. When that happens, department productivity suffers.

Focusing on the Achievable

In these scenarios, the aggressiveness of the goals is as critical as compensation that's at risk if the goals aren't met. If meeting the goals doesn't require heroic effort the hazards are reduced, of course. Deciding what's achievable can involve some subjective assessment initially, but history can become your guide over time if you're willing to adjust your expectations.

If it becomes apparent that you have overestimated what's actually achievable due to changing circumstances beyond employees' control, it can be highly de-motivational to them to know their extra efforts will not be rewarded. If so, your incentive plan may not only fail but backfire. The last thing you want is for employees to conclude that their extra efforts won't be rewarded. So, although you don't want to make it a habit, sometimes you need to modify the targets you've set, mid-course.

One way to avoid aiming too high or too low is to use a multi-tiered plan. Consider establishing a bonus formula that allows all employees to qualify for something if they meet a minimum performance threshold. For example, you might require that they achieve at least 25% — or even 50% — of the performance target before they earn a pro-rata bonus.

What about those perverse incentives mentioned earlier? Here's an example of how a well-intentioned incentive program that lacks proportion can fail. Not long ago, a large bank gave branch managers high targets for new account openings. Employees believed, with good reason, that if they didn't meet their quotas they'd lose their jobs.

Sales soared. However, it was later discovered that many of these sales were generated by managers opening accounts for customers without their knowledge or consent. The unintended consequence: a massive public relations fiasco for the bank, along with financial penalties and legal costs that far exceeded any revenue increases.

Intrinsic Motivation Matters

Aside from the obvious problems associated with an overly aggressive incentive program is the fact that such a plan pushes employees to perform because of extrinsic — rather than intrinsic — motivators. In other words, employees are driven by the prospect of a cash reward more than by the desire to surpass their own personal best or out of pride in a job well done.

Of course, there's nothing wrong with financial incentives as long as they don't override your company's values. Superlative employee performance ultimately breeds success for the entire organization. However, academic research suggests that intrinsic motivation is associated with greater creativity than extrinsic motivation.

Finally, whatever the incentive structure within your compensation plan, there's no substitute for careful monitoring of how employees respond to those incentives. Work continually to find a happy medium between too-modest and too-ambitious an incentive formula.

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