If bonus or “incentive pay” schemes work so well for senior executives and bankers, why does everyone not get them? After all, many jobs involve making important decisions or taking risks. Is there anything about corporate decisions and financial risks that makes these categories of work special in terms of how they need to be incentivised and rewarded?
The conventional answer is that a bonus scheme or incentive plan will indeed encourage the recipients to make more money for the shareholders or clients on whose behalf they act. And while there were some unfortunate abuses in the past, the schemes have been altered to focus on longer-term shareholder returns and to enable clawbacks. However, the conventional answer does not address my question: there are many workers acting as agents on behalf of others (taxpayers, shareholders, clients), so why are bonus and incentive schemes not more common?
A classic paper on the “principal-agent problem” (how you encourage somebody else to act in your best interests rather than theirs when you hire them) by Bengt Holmstrom and Paul Milgrom pointed out that the conventional answer makes the mistake of assuming that jobs are simple and consist only of one task. In reality, agents — such as executives acting on behalf of shareholders — have multiple tasks with many dimensions. Some of these will be easier to measure than others.