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

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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