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Dan Ariely asks, What is the right amount to pay bankers?

Posted by: Emily McManus

Dan Ariely’s new book, The Upside of Irrationality, debuts tomorrow — he sends us this teaser, based on research that’s described in much more detail in Chapter 1 of the new book:

Recently there has been a public outcry against astronomical executive salaries. The basic public sentiment is that it seems unfair that people make so much money for mismanaging our money, especially when it is so difficult to see how bankers’ talents and abilities justify their compensation. Naturally, it’s particularly offensive when executives receive high bonuses after disastrous performances, or, worse, when the bonuses come from taxpayers’ money courtesy of government bailouts.

Not surprisingly, bankers have fought back, claiming that the high salaries are required to attract the best and brightest to crucial, high-stress, high-skill positions, and that the most talented and valuable bankers would go elsewhere if salaries were capped. It is your basic free market argument: if they can’t recruit and retain the best minds in business, these minds will simply go elsewhere, leaving us with less qualified people in charge of the economy—and that, in the end, would send us all down the tube.

Rather than seeing this as an ideological debate between self-serving bankers on one side and morally outraged taxpayers on the other, it is more useful to ask what we really know about the relationships between very large bonuses and job performance.

To look at the question of how bonuses affect performance, Uri Gneezy, George Loewenstein, Nina Mazar, and I conducted a few experiments. In one, we gave participants an array of tasks that demanded attention, memory, concentration, and creativity. We asked them, for instance, to fit pieces of a metal puzzle into a plastic frame, to play a memory game that required reproducing a string of numbers, to throw tennis balls at a target, and a few other such tasks. We promised payments of different amounts (either low, medium, or very high bonuses) if they performed any of these tasks exceptionally well. About a third of the subjects were told they’d be given a small bonus (relative to their normal wages), another third were promised a medium-sized bonus, and the last group could earn a very high bonus.

By the way, and before you ask where you can sign up for this experiment, I should tell you that we did the study in India, where the cost of living is relatively low. By doing it there, we could pay people amounts that were substantial to them but still within our research budget. The low bonus was 50 cents, equivalent to what participants could receive for a day’s work in rural India. The medium bonus was $5, or about two weeks’ pay, and the very high bonus was $50, roughly five months’ pay.

What do you think the results were? Would our participants follow the expected reward pattern with the group offered the smallest bonus performing worst, those offered the medium bonus performing better, and those offered the very high bonus performing best? When we posed this question to a group of business students, naturally they expected performance to improve with the amount of the reward. In the business world this assumption is practically a natural law, and the logic that gets executives to command very high pay. But our experiment results revealed the opposite. As it turned out, the group offered the highest bonus did worse than the other two groups in every single task! And the people offered medium bonuses performed no better or worse than those offered low bonuses.

We replicated these results in a study at MIT, where undergraduate students were offered a chance to earn a very high bonus ($600) or a lower one ($60) by performing two four-minute tasks: one that called for some cognitive skill (adding numbers) and another that required only mechanical skill (tapping a keypad as fast as possible). We found that as long as the task involved only mechanical skill, bonuses worked as we usually expect: the higher the pay, the better the performance. But when the task required even rudimentary cognitive skill (as we might suppose in- vesting and banking do), the outcome was the same as in the Indian study: a potential higher bonus led to poorer performance.

Our results led us to conclude that financial rewards are often a two-edged sword. They motivate people to work well, but when these financial rewards get very large they can be- come counterproductive and actually hurt performance. If our tests mimic the real world, then higher bonuses may not only cost employers more, but also hinder executives in working to the best of their abilities.

When I presented these results to a group of banking executives, they assured me that their own work and that of their employees would not follow the pattern we found in our experiments. (I suggested that with a suitable research bud- get and their participation, we could examine their assertion, but they were not interested.) I strongly suspect that they were too quick to discount our results. I’d be willing to bet that for the vast majority of bankers, if not for all of them, a multimillion-dollar compensation package could easily be counterproductive because of the stress involved in attaining it, because of the fear of not getting it, and because it takes their minds off the job and focuses their attention on the large bonus.

I don’t want to argue that in all situations, regardless of job type or the characteristics of the person, it will be more productive to pay less. But I do want to suggest that compensation is a complex issue involving complex economic incentives, stress, and other aspects of human psychology that we often don’t understand and don’t take into account. Perhaps the naively simple theory that more money equals better performance is not as practical as we thought, at least not all the time. If more money led to better performance, wouldn’t we expect that those who got tens of millions in compensation would be optimal performers? Maybe even perfect? The fact that those with very high salaries and bonuses failed so miserably in the financial fiasco of 2008 should add to the evidence against a direct link between higher rewards and better performances.

The bottom line is that much like in other areas of our lives, we are not perfect, we are not rational, and there are multiple hidden forces that shape our abilities and decisions. We can continue to assume that we are perfect, but this will only set ourselves up for more fantastic failures. If instead we were to realize where we fall short, where we fail, and try to do something about it, our future could indeed be brighter -– and not just in the domain of banking and salaries.

A few related TEDTalks:

1) This one talks about the research I describe in this blog post: Dan Pink >>

2) This one relates to the ways in which regulations can choke motivation: Philip K. Howard >>

3) This one is related to another chapter in the new book (happiness and adaptation): Dan Gilbert >>

– Dan Ariely

Comments (19)

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  • Philip Hyland commented on Jul 30 2011

    It seems that this study is flawed from inception. The motivation of ‘top performing’ bankers
    is hardly massive bonuses but rather status. If a banker considers himself one of the best
    he wants confirmation and acknowledgement of this from his community and this comes
    in the form of a compensation measure. He does not expect his actual bottom line results
    to correlate with the size of his compensation package nor would he expect his actual bottom
    line to be greater if you doubled his rewards since he is trying to maximize the bottom line
    at all times. It appears this whole experiment has a dubious premise and the context of the
    study is far removed from rural India or students at MIT.
    Anyway many peer reviewed studies have concluded that no banker or portfolio manager can
    consistently beat the market. A more productive investigation might be to examine the effects
    on markets of massive short term profits in motivating practioners to rig the game. It is clear
    that fraud, manipulation, conflict of interest, insider trading, abound throughout tne marketplace and at present we seem to be powerless to do much about it.

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  • Swapnil Jain commented on Jul 6 2010

    I would appreciate if more information on the research conducted is provided. Answers to some questions like – Did all the participants have the same level of cognitive ability and skills to perform the job, Were the participants aware about this differential bonus payments system etc could change the interpretation of the results of the study.

  • john smith commented on Jun 3 2010

    “our future could indeed be brighter”

    This sounds promising but when you give someone too much money and power there’s always going to be greed which prevents this brighter future…

    We need to pay people who do great work or are willing to do great work higher salary, but there needs to be a cutoff point I think to prevent what is happening at the moment, as mentioned in the post.

    pharmacy technician salary

  • Barnabee M commented on Jun 2 2010

    A further point: motivation. If you ask someone to perform a task for 10 minutes, or an hour (your post does not say how long but I will assume it was not weeks, months or years) then they will likely do an OK job.

    If you ask them to sustain a diligent, time consuming, highly cognitive set of tasks for months or years, where at any point they have the option of neglecting the work to some extent, the results may be different. In banking this is true, one can neglect to call contacts, check certain figures or run models or risk calculations – to a certain extent. This is generally imperceptible to the bank but those who are most diligent generally perform better. This is one thing that bonuses help to ensure.

    I have seen it myself among investment bankers after news of limits on or loss of a bonus – they openly state that they feel no incentive, they stop doing the extras that help win business and produce profit and they are not motivated to perform.

  • Eyal Erez commented on Jun 1 2010

    The study is interesting, but it does not test what the bankers are claim. Which is that big bonuses _attract_ talent, who would otherwise go elsewhere.

    I also found the fact that the bankers did not want to pursue this study further amusing. I guess the type of incompetency that this study might reveal is preventing the study from being held in the first place.

  • Alex Chaffee commented on Jun 1 2010

    Nice analysis, but as other commenters have noticed, It’s a little off the point, because bankers’ “bonuses” by and large are not tied to performance; they’re just an accounting trick to deliver a (huge) percentage of salary in a big chunk.

    The title question of “What is the right amount to pay bankers?” is not addressed by these studies.

  • Joé A commented on Jun 1 2010

    The Perfect definition of a biased Research/Conclusions:

    1-Helooo!: This research absolutely do NOT apply to bankers because Bankers ARE driven by Money$ , that’s why they do that job! On the contrary bankers’ wage is IS the perfect example when the Null hypothesis “The higher the bonus the higher the performance” could not be rejected.

    2-”I should tell you that we did the study in India”: What about cultural differences and so on…… See More

    3-Maslow’s pyramid is the real answer!

    I will stop here, people have completely lost their critical sense and believe everything they see as long as it’s entertaining (cartoons…)= Indoctrination
    There is a big diference between how the world Should work and how the world really works so I would suggest everybody to stop the intellectual masturbation and dreaming and go back to work for real.

    Smart AND Hungry people are the absolute performers period. That’s why so called developed countries are doomed , it’s because they became lazy…

  • Jason Dodge commented on Jun 1 2010

    a TED talk I saw a while ago meshes really well with the video Han Jun Zeng posted
    http://www.ted.com/talks/simon_sinek_how_great_leaders_inspire_action.html

  • Robert Reck commented on Jun 1 2010

    This study is great as far as it goes, but it would not be good science to infer that it has any application to executive pay in the banking business, or any other business.

    In my humble but considered opinion, this study shows that some people can not handle pressure. People that can handle performance pressure and do well are valuable in performing arts, sports, and business. For such people, the added pressure of great economic reward is just part of the equation.

    The executive compensation issue seems more to revolve around the linkage (or lack of linkage) of pay with performance. Enron is a good example. Enron regularly hired “talented” graduates for top dollars, yet their continued rewards in the company had little relationship to the profitability of the company. (Please check Gladwell’s essay about this in “What the Dog Saw”..) The issue is not whether super-competent executives deserve high salaries, but how this competence is evaluated.

  • Peter Krizan commented on Jun 1 2010

    You missed 2 points worth taking look at:

    1. The “brightest minds” pay lots of money to acquire top education, thus they can accept only jobs with remuneration on a respective level enabling them to pay back the costs of education and start-up their lives and families. If they don’t come from rich families owning their own businesses, they have basically 2 options: consulting and investment banking. Within the course of time their salaries obviosly grow. You can’t attract and keep Harvard absolvents without paying them a lot, regardless of what they would do.

    2. The best payed people are not those working hard, but those having the proper contacts (industry, government, media), playing golf and maintaining their powerful network of clients and partners.

    BIG SALARY IS BASED ON POSITION AND INFLUENCE WITHIN A NETWORK (COMPANY, SOCIETY)!

    Huge network of influential decisionmakers is what you acquire on top universities and what makes you valuable. You ignored this crucial criterion.

    • Melissa Boyack commented on Jun 1 2010

      I totally agree with your second point—one which also may point to sources of corruption—but your first falls short. High salaries help pay debts, sure, but above a certain amount there is no longer any relevance.

      • Peter Krizan commented on Jun 1 2010

        I agree that the first argument is weak, however the second one points rather to the “business than usual” than to sources of corruption. Take a simple example, regardless of industry: would you pay less to a salesman who does not know any influential decisionmakers or a lot to an established salesman with lots of contacts on the market? It’s definitely not about (social) corruption or bribery, just about the action radius of a company on the market.

        The same applies for further specialist positions bringing big revenues or high-level management positions with huge action radius and responsibilities not only on the market but within a company as well.

        Bankiers work on the crossroads of economy and it is obvious that they have the biggest action radius and influence, thus get paid over average. However, exactly because of this fact they should not be allowed to do whatever they think is profitable – the activities with systematic risk must be regulated, not the salaries.

        • zachary folwick commented on Jun 1 2010

          Good points Peter, you are right I would pay a salesman with tons of contacts… maybe that’s the problem… the money managers are salesmen instead of … money managers.

          Would you rather hand your money to a salesman, or to somebody who’s job it is to manage money? Even with my tiny little savings, my money manager describes herself as a saleswoman. That would be sad if her definition of “saleswoman” wasn’t “service provider”.

      • Peter Krizan commented on Jun 1 2010

        @zachary: I can’t “Reply” on your comment directly.

        The problem is not the intangible product (cash management, credit provider) where you know for what you pay, but the measurement of results of a separate activity: asset management. This is actually a casino – nobody on the market without insider information can predict market movement in a short term (behavioural & irrational) and it is not true that the stocks are profitable in a long term (see related studies, Nikkei etc.), so even “value-oriented” approach does not provide any guarantees.

        Because of this, most asset managers are measured only by relative benchmark instead of absolute performance: If your (active/passive) asset manager burns 10% of your money when market falls 15%, you pay him for destroying value and maybe he gets even an industry prize for beating the benchmark.

        Therefore the “casino players” should be separated from traditional banking and payed only based on their absolute performance, see Volcker rule

  • Fabian Graebner commented on Jun 1 2010

    great post :)

  • eddie choo commented on May 31 2010

    I wonder how many policymakers would examine the fullest implication of such studies, and other related studies. To seriously implement policies along such lines – to limit the wages of those in the banking professions and other high executive professions would generate a political firestorm. But that’s where courage is needed, no?