Fair base salary and audits can decrease likelihood of fraud
Target-based bonuses are a common form of incentives but often encourage employees, including the top brass, to lie about their performance, according to a new study.
People are more likely to lie about their performance if they know they will be rewarded for attaining a specific target, found the study by professors at the University of Guelph in Guelph, Ont., and Ryerson University in Toronto.
“Whenever you hold out massive carrots and create intense pressure to deliver, the organization has to worry about how the recipient of the bonus might be motivated to look for shortcuts,” said Chris Bart, founder and principal of The Director’s College, a joint venture of Hamilton’s McMaster University and the Conference Board of Canada.
In the study, subjects were given seven letters and asked to spell different words. They were told they would either be rewarded for making nine words (target-based), on a per-word basis (piece rate) or for being among those with the most words spelled (tournament).
Of those with a target of nine words, 46 per cent exaggerated their scores, compared to just 25 per cent of those under the piece-rate system and 26 per cent under the tournament system, found the study.
“The temptation is there — one little lie and you get the bonus,” said Francis Tapon, professor of finance at the University of Guelph and co-author of Are you Paying Your Employees to Cheat?
Participants were more likely to cheat the closer they came to hitting the target. This was likely because participants felt they had worked hard and deserved to be paid for their efforts, said Tapon.
Not all performance-based bonuses are bad but the bonus needs to be structured a certain way to boost performance, not cheating, he said.
“With piece rate, having no target, you just didn’t know how much to lie for, whereas with the (target-based) bonus, it was simple. You claimed one or two words and you were above your target,” said Tapon.
However, the piece-rate system is difficult to translate into any activity that is not routine, said Stephen Griggs, executive director of the Canadian Coalition for Good Governance.
“If you’re the CEO of a company that has a lot of moving parts, piece work would be a meaningless way to try to compensate a CEO,” he said.
But it’s not impossible to design incentive programs under a piece-rate scheme, said Tapon. Bonuses can be set up to pay out for each completed deal or if a specific level of economic value added is achieved. This latter measure is much more difficult to fake than earnings per share, a common criterion in target-based incentive programs, said Tapon.
Any bonus program that sets a profit target without any restraints around budget or what can’t be cut to achieve those targets encourages executives to focus only on the short-term results, said Bart. The long-term consequences could include decreased innovation and product sales due to cuts to research and development or future deficits if too much money is spent on marketing products.
“In order to accomplish some short-term performance, they sacrifice the long-term sustainability of the organization,” said Bart.
Instead, the programs should be carefully crafted with limitations that help executives focus on the bigger picture, not just the immediate bottom line, he said.
Good bonus programs should have built-in checks and balances that encourage the right kind of behaviour and discourage the wrong kind, such as excessive risk-taking, said Griggs. So an executive would receive more money for doing the right things but see her bonus shrink if she performed any of the “bad” behaviours, he said.
“In theory, all executive compensation should be incenting management to achieve the corporate objectives,” said Griggs.
If an incentive program makes up the majority of a compensation package, an organization is going to attract people who take more risks and may be willing to cheat to make their numbers, said Tapon. While these people tend to be harder workers and more aggressive, they can also end up running a business into the ground, he said.
“You should not (create) an environment where most of the compensation is under incentive compensation. That’s courting disaster,” said Tapon.
Scotiabank focuses on making its incentive programs fair and reasonable, said Laura Thanasse, senior vice-president of total rewards at the bank in Toronto. All of the targets are set within Scotiabank’s risk appetite to ensure they don’t encourage risky behaviour, she said. And before any bonus is paid out, the numbers must be verified by either an internal or external audit, depending on the target.
“Our programs are based on paying for actual results,” she said.
The bank also ensures employees are paid a fair base salary and for those in risk-taking roles, incentive plans have a deferred component that vests over a period of three to 10 years to ensure action taken in the short term has a positive, long-term effect, said Thanasse.
But people will eventually figure out a way to “game the system,” said Tapon.
“People always try to minimize their effort and maximize their gain. Compensation schemes work well for a while and then you have to tweak them,” he said.
