Behavioural models of pay, and the agency problem
One of the primary criteria in designing any system of pay is to influence the recipients' behaviour.
Traditional pay structures work on the assumption that people behave rationally. Thus, they will pay people for generating profits for their company; on the basis that if you pay them more for higher profits, they will generate more profits. This has the attraction of simplifying the manager's job - assume that the employee can figure out the best way to make profits, and leave it to them.
However, this structure has at least three intrinsic problems. One is asymmetry: you can pay someone for making profits, but you can't penalise them for making losses. Virtually no employee will work for a company if there are circumstances in which they would have to pay for the privilege.
The other is the agency problem: the employee has control over the company's resources but does not get all of the benefits of using them in the most productive way. Thus, a temptation exists for them to use these resources for their own private benefit.
The final problem is that it is based on a false assumption. People do not behave in the traditional "rational" utility-maximising way.
If, instead, we apply some of the results of behavioural economics, we may be able to design a pay structure in which the same behaviour is in the interest of both firm and employee.
Some of the most important results of behavioural studies include:
- People are more likely to act in their short-term interest than their long-term interest. Many different behavioural experiments have demonstrated this. We can reflect this in pay and management structures which provide immediate reward for doing things that are unambiguously in the interest of the company. This is challenging, because it isn't always obvious in the short term what the company's interests are. But if we have a way to, for example, measure the amount of risk that is being taken in an investment portfolio, and give bankers an immediate reward when that risk is reduced, this may help to override their longer-term tendency to manipulate the system in their own interests.
- People are loss averse. This means that it has more impact on someone to lose £1000 of money that they already have, than to gain £1000 that they don't have. To take advantage of this, a clawback provision would probably be effective. As suggested in a number of articles recently, bankers could be obliged to return some past bonuses if a company goes on to make losses on positions they took in previous years.
- People are motivated by social factors. This result is informed more by traditional psychology than by behavioural economics. But a number of social factors - status in a group and adoption of social norms - compete with individual self-interest to influence our behaviour. Companies and their ecology provide two of the strongest social groups for many employees - their colleagues and competitors. By creating measures of status within those groups, and linking those to social norms related to the long-term stability and growth of the company, managers could create influences that might dominate financial incentives.
Money, in some ways, is just another social status marker anyway. Anecdotally it seems likely that people work hard to increase their bonus not mainly because of the associated material benefits but because it governs their place in the hierarchy of their social group.
- People are, under some circumstances, risk-seeking. Traditional economic theory says that people will give up some rewards in order to avoid risky situations. Recent behavioural research says that, sometimes, the opposite holds. Thus, particularly in situations where the risk of something happening is very small (perhaps less than 0.1%) people will sometimes make decisions that increase this risk instead of reducing it. Clearly that can cause major problems when they are managing large amounts of money - just look at Bernie Madoff, Jerome Kerviel or Nick Leeson to see the results. So if a third party can monitor traders' behaviour and take a dispassionate view of the risks, they could help to provide a rational discipline which helps reduce them.
While traders would at first no doubt resist having someone monitoring all the choices they make, it is possible to demonstrate that this is in their own interest. In software development we sometimes use a technique called pair programming which has two programmers working at the same keyboard writing the same piece of code. While most programmers find this distracting and wasteful at first, the resulting improvement in quality and reliability - and often productivity - becomes clear in many situations, and most programmers who regularly work this way are won over.