Nobel prize winners shine light on best compensation practices

Advisers backing performance-based pay should be aware of its downside

Oct 11, 2016 @ 1:32 pm

By Liz Skinner

Two American professors known partly for showing the value of performance-based compensation practices won the Nobel Prize for Economic Sciences on Monday.

Bengt Holmstrom, a Harvard University professor, and Oliver Hart, a professor at the Massachusetts Institute of Technology, together were awarded the prize by the Royal Swedish Academy of Sciences for their work designing contracts that companies use with employees and customers.

Much of Mr. Holmstrom's renowned contract theory centers on incentive pay practices, seeking to minimize the conflicted interests between owners and workers, the academy said in announcing the award. The theory supports incentivizing employees to work in their employer's best interest through compensation.

(More: How to calculate a fair salary for a new hire)

“How do you balance incentive pay, which makes maybe [people] be more motivated, but how do you avoid bonuses and incentive pay leading to wrong decisions being made in companies?” Mr. Holmstrom said in an interview posted Monday on the Nobel Prize Twitter feed. “The theory is super useful to explain that problem.”

As financial advisory firms have grown larger over the past decade, more have embraced incentive compensation.

“A small but growing minority group of advisers are developing incentive compensation based on performance, usually based on performance of the firm and performance of the employee,” said Philip Palaveev, chief executive of The Ensemble Practice. “For that to work well, the firm needs to have a mechanism for evaluating the performance of the employee.”

That can be tricky, he said.

When performance evaluations are tied to pay it can discourage managers from giving bad reviews, even when deserved, because they know it will cause a difference in how much that employee takes home, Mr. Palaveev said. In these cases, costs rise for firms because employees are being compensated at a certain level when they may not be generating the results to really deserve that amount of pay.

Additionally, it can encourage fudging of the data — for instance, someone may try to show more new clients came in before a certain deadline than really did.

“In the absence of proper management and a good culture, performance-based compensation can fail miserably,” Mr. Palaveev said.

Mr. Holmstrom's work also backs the value of deferred compensation, another popular pay practice of withholding compensation for a period to review an employee's work.

He's also advocated linking evaluations to the stock performance of a company's industry, rather than just the stock price of the employee's firm. That particular thought hasn't really caught on though.

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