Why Compensation Systems Fail

When Hanoi was under French colonial rule, they discovered that their villages had a rat problem. So the regime created a bounty program that paid a reward for each rat killed. To get paid, people would provide a severed rat tail and get a little cash. Colonial officials, however, began noticing rats in Hanoi with no tails.

The Vietnamese rat catchers would capture rats, lop off their tails, and then release them back into the sewers so that they could procreate and produce more rats, thereby increasing the rat catchers’ revenue.

People respond to incentives by doing what is in their best interests. The great Charlie Munger calls this the Incentive Super-Response Tendency.

“Never, ever, think about something else when you should be thinking about the power of incentives.”

— Charlie Munger

If you’re trying to change a behaviour, reason will take you only so far. Sometimes the solution to a behaviour problem is simply to revisit incentives and make sure they align with the desired goal.

If you pay your lawyer by the hour, it only motivates them to drag on your case. If you reward your employees based on the hours put into work, theoretically it makes sense for them to use the office space as their residence.

Having said that, it doesn’t mean that you don’t set any metrics for measurement. Lack of metrics makes you heavily prone to availability bias. The more you see of an employee, the more they smile, the more they (once in a while) pitch you good ideas, the more biased you become to compensate them well during appraisal. Most employees would figure out how to exploit this, and come under your good graces.

However, it can be difficult to find out what kind of incentive systems would work, for example, for your company, or for your team. A good way to approach this problem is using German mathematician Carl Gustav Jacob Jacobi’s method of Inversion.

Rather than thinking about what sorts of incentives work for companies, let’s try to understand why a lot of them fail. First, most of them are hard to explain. They are overly complicated and wordy, and rarely can anybody explain them without jargon, or referring to a handbook. Second, they are abstract, and there’s no good way to measure them. “Excellent job” becomes more about how your manager feels about your job, and less about how excellent a job you have done. Third, the rewards are small and untimely, such as yearly bonuses. A year-end bonus isn’t nearly as effective as a weekly bonus. A year-end review isn’t nearly as useful as immediate feedback. It’s simple. Fourth, the programs are designed such that they can be gamed by the people in it, and they game it more than often.

In conclusion, good incentives systems should be:

  1. Straightforward.
  2. Measurable.
  3. Immediate
  4. Ungameable.

The issue of setting compensation seems to be struggled with in every organisation. Most are pretty lazy about it, and hire someone else to take care of it. Some leaders, however, are different. A good example is Ken Iverson who ran Nucor, the steel company, for 31 years from 1967 to 1998.

Under Iverson, compensation at Nucor had two components: A small but meaningful base pay and a very simple weekly bonus based on production. It’s eminently clear to them what the employees will be paid for: making more steel. It’s simple. One’s compensation is never at the hands of someone who may or may not like them.

Iverson details his thoughts in his masterful memoir Plain Talk:

“The real beauty of Nucor’s compensation system, in my opinion, is that there is nothing to discuss. Daily output and corresponding bonus earnings are posted, so employees know exactly what their bonus will be before they tear open their pay envelopes. No judgment. No negotiation. No surprises.”

Not just while designing incentive systems for companies and teams, keep the Incentive Super-Response Tendency in mind whenever you are dealing with anything that has some kind of incentive attached to it. For example, in negotiations and arguments, in volunteer programs, while teaching your kids, training your dog, etc.

Remember, all men and animals respond better to incentives than reasons. And, incentives doesn’t necessarily have to be money-related. There are other forms as well, such as social status, adrenaline rush, fun, dopamine hit, etc.

“A man has an acculturated nature making him a pretty decent fellow, and yet, driven both consciously and subconsciously by incentives, he drifts into immoral behaviour in order to get what he wants.”

— Charlie Munger.

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