Why Bonus Systems Don’t Work

The last time I shared my advice on how to fix a bonus system it was something along the lines “get rid of that crap altogether; it is beyond any repair.” The system I’ve just mentioned wasn’t extraordinarily flawed – an incentive money system in the company next door can work exactly like that one.

Still, get rid of that crap.

It may even be way above average bonus system.

Get rid of it.

It doesn’t work. It can’t.

OK, let me start with a confession. Throughout my career I designed a couple of bonus systems. For quite a lot of time I was a firm believer that this is the way to go. The simple observation that every single bonus system I’d seen was flawed big time was more a motivation to finally get it right than a source for doubts that we may be trying to do the wrong thing righter.

Eventually I started questioning the role of money as a motivational mechanism. Dan Pink’s TED talk is a classic on this subject.

OK, I get the message already. Money doesn’t motivate. It doesn’t mean that it doesn’t yield positive outcome. I mean, it makes people happier, doesn’t it?

Well, sort of.

I think we should start with how people perceive the money they get. Is $100 worth the same for everyone in a team? I guess we all sense that this isn’t the case.

“People’s choices are based not on dollar values but on the psychological values of outcomes, their utilities.”

~Daniel Kahneman

In other words everyone may translate $100 to something different. In fact, I might have been happy with such a bonus last year but now, since my salary is higher, I’d need to get higher bonus to be equally happy.

It basically means that we just can’t get the incentive money distribution right. Depending on who performed best, a different amount of money would be needed to make people feel equally happy. At the same time it means that people who performed equally well should get different bonuses because they have different concepts of utility. That just doesn’t feel right.

By the way this is exactly why we typically speak about money in terms of percentages, not the absolute values. “I got 10% raise,” not “I got $100 raise.” The former gives at least some insight how much I value the raise.

That’s not all though.

“For financial outcomes, the usual reference point is the status quo, but it can also be the outcome that you expect, or perhaps the outcome to which you feel entitled, for example, the raise or bonus that your colleagues receive.”

~Daniel Kahneman

Even bigger problem is with the reference point we use. Not only is it about how much I value $100 but also how much I expect I deserve. In other words, in a normal situation I might have been totally happy with $100 but I know that everyone around is getting $500. This means that it is suddenly only $100 and I’m going to feel miserably.

There are many drivers to what we consider the reference point. One very interesting thing is that after a couple of situations when I got bonus money it becomes the new normal. I expect to get it again. I doesn’t matter that my performance in the next project wasn’t that stellar anymore. My reference point evolved.

Believing that, in this case, incentive money is still completely optional and the default situation is that I don’t get any is just fooling oneself. In fact, every fat bonus I get simply makes me adjust my reference point. It isn’t something managers would like to see I guess.

Unfortunately, it’s even worse than that.

My reference point may change the utility of a bonus I get to negative values. I would consider outcomes that are better than the reference point as gains. Those that are worse than the reference point are loses. In other words if my status quo is set at $500 and I got only $100 I feel like I’ve lost $400. Someone paid me money just to make me feel miserable. Congratulations!

“The happiness (people) experience is determined by the recent change in their wealth”

~Daniel Kahneman

Considering the fact that change in the wealth isn’t measured in absolute numbers but against the reference point I see two ways to keep people happy. One would be to pay them more and more every single time, because then we don’t need to care about their raising expectations. Another one would be to set expectations on a constant level and focus on all the other happiness drivers that are available.

I don’t think I need to mention how much “brilliance” is in the former idea. The latter means no bonus system at all.

We can’t make bonus system right. The best we can do is damage control. The obvious follow-up question would be: so why the hell are we spending money to make people unhappy and harm our organization?

One common answer I hear is that getting rid of bonus system would make people unhappy too. Oh yes, it will. I mean you’ve set that expectance that people would get bonuses. You’ve changed their reference point. Yet still the choice you have is between keeping (most) people unhappy in the long run (and continuously paying for that) and getting rid of the dysfunctional mechanism. The latter may be painful in a short term but at least that’s one-time change.

So yes, this is my advice: get rid of that crap altogether.

When you think how people perceive money you understand that no matter how hard you try you’re not going to make it work.