The "Perverse" Incentives Caused by Guaranteed Bonuses

Last Updated Aug 28, 2009 11:06 AM EDT

Stock options and grants were once the lure of choice used by companies to attract top talent. No longer, thanks to a dour stock market and regulatory scrutiny of stock option programs.

Now it's guaranteed bonuses that employers are using to bait the hook. Come work for us and we will guarantee you X salary, a Y bonus, and and maybe even give you additional bonuses based on how much business you generate.

But any pay scheme that rewards employees for production while insulating them from downside risk motivates them to take careless, company-harming bets.

That's the argument made by Harvard professor Lucian Bebchuk in a recent Wall Street Journal op-ed. (Subscription required)

"Guaranteed bonuses create perverse incentives to take excessive risks, and they consequently could well be worse for incentives than straight salary."
Downside Motivation

A better package (from the employer's view) would be to give a higher floor salary to cover the minimum required and use bonuses to reward levels of performance. That would make bonus compensation sensitive to both up and down risks, says Bebchuk, the Friedman Professor of Law, Economics, and Finance.

Another method of controlling risk taken by your employees? Stop hiring alpha males and females. Read my BNET colleague Stacy Blakman's take on this, Testosterone Affects Financial Risk Taking, Study Finds.

  • Sean Silverthorne

    Sean Silverthorne is the editor of HBS Working Knowledge, which provides a first look at the research and ideas of Harvard Business School faculty. Working Knowledge, which won a Webby award in 2007, currently records 4 million unique visitors a year. He has been with HBS since 2001.

    Silverthorne has 28 years experience in print and online journalism. Before arriving at HBS, he was a senior editor at CNET and executive editor of ZDNET News. While at At Ziff-Davis, Silverthorne also worked on the daily technology TV show The Site, and was a senior editor at PC Week Inside, which chronicled the business of the technology industry. He has held several reporting and editing roles on a variety of newspapers, and was Investor Business Daily's first journalist based in Silicon Valley.