The issue with Short-Term Incentives

This morning I came across this article from Bloomberg: the estimated cost of Brexit has been, so far, of a staggering 170 billion $, and is apparently increasing. This is more than the total contribution that the UK has given to the EU since when it joined. The entire issue of Brexit has been nonsense for me, but as I shared this post on Linkedin this morning, the point that I wanted to reflect on is how did we get there. How could politicians (and that’s many of them, not just one) pursue a policy so expensive for the entire nation?

My comment to the post referred to the issue of Short-Term Incentives. From this point of view, Politicians act very similarly to Managers. Their time horizon is shorter and shorter (an election maybe, often less due to the constant political agitation that many countries have had recently). Same for Executives, pushed between yearly budgets and quarterly reports to the analyst. Taking decisions that are valid for the Long Term is becoming more and more complex. And this comes at a moment where analytics, AI, make predictions a lot easier than in the past, which should simplify decision-making.

The issue is not new. A famous HBR article from Alfred Rappaport of 1978 challenged the relationship between Executive Incentives and Corporate Growth.

Managers, like other people, act in their self-interest.

Alfred Rappaort, Executive Incentives vs. Corporate Growth, HBR, July 1978

Many cases have been brought up to show how powerful the focus on short-term incentive can be in distracting managers (and politicians) from promoting their organisation interests (or those of a country). And research has confirmed this tendency multiple times. The topic of incentives has become more and more a topic of economic research, spanning accounting and directly impacting policies.

This is why when we design an organization, we need to clearly think of the incentive systems from the very beginning. I’m not simply referring to the stricter definition of Incentives as monetary incentives, but to the fuller extent of the reward system, which includes all non-financials rewards as well.

Key Pillars for Incentives Design

We have seen multiple aspects that should be considered when designing an incentive system. The first element is that there needs to be a direct link to Governance and Strategy. Only by correctly aligning with these two elements, an incentive system can work.

A second element is related to motivation. As the work of Daniel Pink Drive has shown, managers tend to have a strong bias in favour of extrinsic incentives, whereas the scientific evidence favour a lot more intrinsic motivation drivers such as Purpose. Which means that any of our Incentive Systems need to include both the financial aspect (monetary incentives) and non-financial one (growth, career, recognition etc.).

The third aspect is related to the evaluation of performance. A bit part of incentives is meant to reward performance: but how do we evaluate this? We have seen multiple times how measurements are often flawed.

These three aspects impact what I think should be three design principles for Incentive Design (as part of a correct organisation design strategy):

1. Consistency: the Incentive System needs to support the organisation purpose and strategy. It may sound dull, but most companies simply have profit-sharing systems which are not really linked to the way that individuals serve the purpose of the organisation.
2. Link time horizons: any Incentive System needs to link in short, medium and long term view in a consistent way.
3. Alignment: this is where many Incentive Systems fail today, as they do not ensure alignment across the organisation, and lead to short term and individualistic views. The cascading of goals and metrics is usually the culprit, and we need to consider this very carefully in our design activity.

Conclusion

There is much more about Rewards and Compensation than short-term incentives. With this short post I just wanted to raise awareness on the fact that incentive systems influence any organisation, wether we want it or not. Countries have more complex rules, and democracy in itself provides limits in the way incentive mechanism can work. Companies might seem to be more flexible in this design: the reality, however, is that also here most of the financial rewarding schemes are simply a “copy and paste” between companies, often propagated by “benchmarking” exercises.

As we continue to mix Motivation and Compensation, failing to create instead deliberate connections between individual goals and corporate purpose, and a holistic and Human-Centered view on Incentives as part of your organisation design effort, we will continue to be at risk of short term solutions that are detrimental to the growth of our organisation.

Cover Photo by Philip Veater on Unsplash