Performance-based pay may lead to problems including fines — and even a tarnished brand

Paying staff based on how well they perform makes a lot of sense. Or does it? Two professors who won the Nobel Prize for Economic Sciences earlier this month studied performance-based compensation practices — and reported back a cautionary tale. Yes, incentives can motivate the right employees, but depending how metrics are designed and calculated, they can encourage disastrous behavior — and the firm will ultimately pay big, sometimes with fines, other times with a tarnished brand. Think Wells Fargo, where thousands of employees opened fake customer accounts to boost their own sales numbers and rake in higher bonuses — the costs and headaches to clients be damned. The extent of the damage to Wells Fargo is inestimable at this point, but it's safe to say it'll be huge and reverberate to other areas of its business. Think Morgan Stanley, which was charged in Massachusetts with conducting an unethical sales contest in which financial advisers were incentivized to get clients to take loans against their investment accounts. Even pay based on performance outside of sales targets can prove troublesome. As InvestmentNews reporter Liz Skinner found in her story on the Nobel winners' work and how it relates to advisers, compensation tied to performance can deter managers from giving bad reviews — even when deserved. As Philip Palaveev, CEO of The Ensemble Practice, noted that in these instances the firms' costs rise because employees are paid at a level above what is justified relative to the productivity of coworkers. He also said it could inspire the fudging of data to shift, for example, the onboarding of clients into a quarter that fits the adviser versus reality. (More: How to calculate a fair salary for a new hire) “In the absence of proper management and a good culture, performance-based compensation can fail miserably,” Mr. Palaveev said. The lesson seems to be that performance is subjective, and it needs to be gauged in that light. Tying pay or bonuses squarely to figures that can be manipulated is a sure route to trickery that will not deliver a positive return on investment to a firm.