Bonuses Good. Clawbacks (Sometimes) Better. Design Checks & Balances Best of All!

"Any organization that invests more time and thought into designing performance bonuses than considering clawbacks is guilty of bad behavioral economics and even worse management."

So says MIT Sloan School Research fellow Michael Schrage in his HBR blog post Bonuses Are Good, But Clawbacks Make Them Better.  He rants about "pay-for-performance people", their over-reliance on incentive scheme design (there's that word again) and their under-reliance on clawbacks.  He calls our attention to what he sees as "a fundamental asymmetry" in the presence of bonuses and the absence of clawbacks.

Not sure I agree.

I do concur that clawbacks can be an important consideration where enormous amounts of money are on the line, and for high profile, high leverage positions and situations.  They have been, of course, featured prominently in Sarbanes-Oxley and now in the Dodd-Frank regulations, primarily as a means of mitigating excessive and inappropriate executive compensation awards.  I get concerned, however, when someone pushes hard for clawbacks for rank and file employees like software developers and salespeople, as Schrage does here.

Did the software design team get a bonus for delivering code early and under budget, only to have it be revealed a few months later that there were quality issues?  A salesperson received a large bonus for closing a deal, which then turned out to deliver little or no margin to the company?  Situations like this are typically the result of hastily crafted, poorly considered plan designs - with no checks and balances in place.

Checks and balances are imperative in variable pay design.  Any incentive plan which delivers cash for beating deadlines and budgets had better include the appropriate countervailing elements that consider things like quality -- or safety.  This is simply common sense.  Your salespeople are in a position to craft agreements that heavily influence profit margins and you are paying them based on top line revenues alone?  Sorry, but that is dumb, dumb, dumb. 

Putting employee compensation at the mercy of clawback mechanisms because you can't be bothered to design incentive plans with appropriate checks and balances?  That, my friends, is bad management.

Bonuses - when thoughtfully conceived and carefully designed - ARE good.  Clawbacks have their place, but not as your default solution for all variable pay efforts; they are a poor and potentially destructive substitute for well crafted plans.

Checks and balances in all reward efforts?  Best of all!

Ann Bares is the Founder and Editor of the Compensation Café,  Author of Compensation Force and Managing Partner of Altura Consulting Group LLC, where she provides compensation consulting services to a wide range of client organizations.  She earned her M.B.A. at Northwestern University’s Kellogg School and is a bookhound and aspiring cook in her spare time.  Follow her on Twitter at @annbares.

Image courtesy of time.com

Comments

[Paul Hebert]

Couple of thoughts relating to the examples you gave on "Did the software design team get a bonus for delivering code early and under budget, only to have it be revealed a few months later that there were quality issues? A salesperson received a large bonus for closing a deal, which then turned out to deliver little or no margin to the company?"

The key to well-crafted plans IMHO is to focus the payout on the things the person you're paying can actually control. In the software example - if the code was good but the implementation was bad should the coder suffer because the roll-out team did something wrong that wasn't part of the initial specs?

I'm particularly sensitive to the sales example in that many times I sold a project that was highly profitable only to see the margins erode over time due to incompetence on the account service team - who, by the way continued to get paid the same as I watched my commission check dwindle due to decreased profits (something I had zero control over.)

As you stated - whither we call it a clawback or a check and balance - there should be some mechanism to level the field and pay people what they earned without penalizing them for what OTHER people screwed up.

I'm sure I'm off base here but couldn't resist venting my frustration with programs that continue to focus so much on "outcomes" versus behaviors that you have these kinds of problems.

Bonuses on outcomes should probably only apply at team or division levels to remove moral hazards.

[E. James (Jim) Brennan]

The embedded link to the old "scheme" post reminded me of another MarkTwainism about "sort."

A "scheme" is simply a semantically neutral word for a "plan" in the UK, with no negative implications in Blighty; but it is characterized as a sneaky underhanded plot in the US. Wonder how Canadians view it. Depends, I suppose.

Similarly, Brits tend to "sort it out" rather than "handle it," travel on trams rather than streetcars, and ride lifts instead of elevators. Just like Sam said, we have two peoples divided by a common language.

"Clawback" may be likewise be viewed as an overt admission that the program is severely flawed or it could be a simple contingent option for plan self-correction normal for any sensible use. We have brakes on cars (autos in Brit-speech) and even that verb form of "brake" has different connotations in different cultures.

Meanwhile, I'd venture the opinion that outcomes are the products of behaviors within certain situational constraints and under specific organizational contexts. You are both right, IMHO. Something done that was worth $X six months ago might be worth a completely different $Z amount today. What you pay should depend on what you intend to reward at that time. Stuff changes, so behaviors and outcomes need to follow suit. Sometimes you must focus on one, sometimes on the other. You can develop whiplash trying to keep track of such directional changes.

[michael schrage]

if i may, the critique here is completely reasonable and not unfair...we both agree that 'checks and balances' - or, more crudely, - 'carrots and sticks' should play a part in well-designed compensation/performance incentives schemes...

...my concern - and hypothesis - is that we 'overinvest' in the design of 'incentives' and 'underinvest' in deterring and protecting ourselves from those who would 'game the system' in culturally damaging and economically destructive ways....

if gamers 'knew' that cutting more than one corner could lose them more than just, say, a job, i'd argue that would have a salutory effect...

to be sure, clawbacks should be more of a C-level and their direct reports practice but, gosh, just like stock awards, i'd suggest moving them a bit more to the middle

[Dan Walter]

Very interesting discussion here. I think that rather than "overinvesting" in design, most companies severely under-invest in it.

Generally, payouts are materially wrong for only a few reasons.

1. Cheating. No element of plan design other than an elegant clawback will help this.
2. Incorrect Metrics. (You choose revenue, but forget costs) Better work up-front can reduce this problem by ensuring companies pick metrics that best apply to their success. Clawbacks would not work and be unfair for this problem.
3. Incorrect Goals. (you measure the right thing, but at the wrong level). This is the most common problem for most compensation. Again, clawbacks would be unfair in this scenario.

More time and effort in the diagnosis, design, evaluation, analysis and communication of compensation plans are your only defenses against the second and third issue. I believe to many company give short shrift to the initial thought process. Even when the initial process was excellent, the design is seldom revisited often enough to keep up with the changes in the market, staff, company and product or service.

P.S. One of the main reasons I love performance-based equity as a long-term compensation solution is that you can build in various levers, both upside and downside, to allow for both over and under performance. But, that;s a posting for another day.

[michael schrage]

a quick response to dan's thoughtful post:

a 'healthy' discussion of the clawback options could have helpful and constructive impact on the (re)design of 2) and 3) ...

clawbacks should not be allowed to (pun intended) compensate for idiotic and foolish incentive designs....that said, discussing clawbacks should better illuminate the metrics and goals issues outlined above

[E. James (Jim) Brennan]

Although quite positively constructive and useful so far, this discussion could easily devolve into a debate about the utility of any situationally appropriate adjustment mechanism or protective device. Why have wrenches at home when every piece of equipment purchased assembled is supposed to operate properly? Heavy coats should be unnecessary, as long as you live in a temperate climate.

Reality rears its ugly head: things ain't perfect. Plan designers, program creaters, schemers and those who overrule them or bastardize/alter well-built original systems will screw them up. Some are simply lazy and incompetent and generate crap. Stuff happens. Sometimes you need to wear galoshes; sometimes you don't.

As long as the perfect remains the enemy of the good, we will have imperfections in everything.

[Ann Bares]

Paul:

Good thoughts - and certainly a position's "line of sight" to metrics (the ability to influence them) is an important consideration in plan design. Although I also believe that there are circumstances where it is appropriate to use incentives - ideally as part of a broad education/involvement effort - to stretch employees' perception of their role and influence by giving them a stake in the success of their colleagues and of the organization overall. To your examples, however, this clearly has to be done thoughtfully and appropriately.

I don't disagree about the importance of behaviors versus outcomes on the overall scheme of performance management and rewards. But in the case of cash incentives, wherre the size of award tends to reflect a more significant sum and where the purpose often includes allowing some portion of cash comp to vary with performance, I hesitate to put too great a direct emphasis on behaviors. For one thing, they are tough to measure objectively and hanging a lot of cash on that delicate measurement can often pervert it. For another thing, there is the question of funding the cash awards, which can be tough to do without hooking them, at least partly, to economic outcomes.

I believe in the importance of behaviors - and I'd love to be convinced that I'm wrong on this, but it hasn't happened yet. What might I be overlooking in my thoughts process?

[Ann Bares]

Michael:

Thanks for your response and your participation in the conversation - much appreciated. I think I respectfully disagree that we are overinvesting in the design of incentives. To Dan's point, I think the opposite is true. Having had the opportunity to do a lot of post-mortems on failed incentive plans over the past couple of decades, my experience would suggest that failures can nearly always be linked back to an underinvestment in design and - particularly - an underinvestment in the initial time spent on discovery and diagnosis of the situation at which we are aiming the incentives.

I also worry that wide use of clawbacks, particularly among non-executive staff, would come at a significant cost to trust in the employment relationship ... something few organizations can afford.

Additionally, in many of the cases surfaced as evidence of the need for clawbacks, the underlying issue is one of time horizon. If we cannot truly judge performance on a quarterly or annual timetable, then perhaps we need to extend the time horizon of performance measurement and rewards -- either entirely or by putting some kind of holdback in place through which we can "true things up" at the appropriate point.

Only when sufficient time is spent in upfront understanding and diagnosis, and when performance measurement and reward timing has been carefully considered, is there a place to discuss the possibility of an appropriate role for clawbacks. That's where my 20+ years of messing with people's pay leaves me!

[Ann Bares]

Jim:

Appreciate the thoughts. While not wanting to negate the utility of adjustment mechanisms, I still lean toward the advantages of being proactive versus leaving too many of our eggs in the "back-end-adjustment-mechanism" basket. I can't help comparing it to investing in sound lending policies, practices and standards versus relying on foreclosures to fix any problems.

Dan:

Sounds like my experience parallels yours - and brings me to the same place of believing the problem is much more about a severe underinvestment in design and, particularly, in the upfront assessment of the context and circumstances within which the performance challenges exist. There is an undeniable action bias with incentives that drives people to solve the problem before they have any sense of the root cause!

Thanks - both - for weighing in!

[michael schrage]

obviously, your experience(s)in 'performance incentives design' have been different than my own...unfortunately,what your argument is quite damning: that is, organizations unverinvest - i.e., do a bad job - of designing 'high impact' incentives...

i'll cheerfully be acknowledge that good incentives design upfront is imperative - and if it isn't, someone doesn't deserve their job...

but i'd equally comfortable arguing that clawback debates can - and should - inform those upfront designs...

[Ann Bares]

Thanks, Michael. Your article has brought attention to what is probably an under-discussed topic among reward professionals ... and you've firmly challenged us on some of our beliefs and assumptions regarding incentive design, always a good thing. I appreciate your point of view and your willingness to participate in the debate here!

[E. James (Jim) Brennan]

Note that this wonderful discussion has concentrated on outlier cases. In any sample of observations, there will be outliers. Even the best-designed incentive progam can't violate the realistic laws of statistics that say that there will be standard deviation from the norm and some "aberrations" will occur. Some retroactive correctional mechanisms like clawbacks make sense to me, but their degree of criticality and extent of application will depend on both the integrity of the orginal plan and its ability to perfectly predict the future. Unless you can accurately anticipate every possible variable such as changing circumstances, "gamers", new priorities, and so on, there will always be SOME need of a remedial mechanism.

Saying there should never be any role for clawbacks is like saying we shouldn't have hospitals for emergencies, brakes on cars, appeals courts, or any other process to deal with error.

[GRETASIMS]

All people deserve very good life time and home loans or just financial loan can make it much better. Because freedom is grounded on money.