How perverse incentives distort individual and corporate performance

Consider a salesperson who has reached his bonus cap three months before fiscal year-end. Any achievement after that is not only unrewarded, but is actually penalized in the sense of creating higher future performance expectations and targets.

That’s called ratcheting.

A creative person with good relationships can conspire with their customer to squirrel away sales into the following year, i.e., the opposite of channel stuffing. Thus, a sales person may end up in an informal and unreported financial agreement with a customer to delay recording a sale that may run afoul of revenue recognition rules. Material? Maybe. A breach of ethics and compliance? Definitely.

Sales executives have long responded to target- or goal-setting with sandbagging, i.e., pushing the easiest targets possible to insure “achievable” goals. This is especially true for goals tied to incentives. Junior sales managers play this game with those senior sales executives as they roll up their forecasts and targets. Business unit leaders respond by implementing “stretch goals,” which can easily run far ahead of market realities.

This multilayer organizational dance can result in goals unmoored from reality. It is inherently dishonest. If you are a compliance manager and have not witnessed one of these roll up meetings, now is a good time to start. After all, how can we expect integrity in incentive plans if the process is based on deliberate hedging and stretching during the forecasting period?

Let’s remember, there’s nothing wrong with stretch goals per se, as long as they aren’t tied to incentives with all-or-nothing payouts. And there is nothing wrong with cross-selling. Wells Fargo’s reasonable expectation that their branch teams would cross-sell might have compelled employees to be legitimately creative in cross-selling their services. If you belong to a gym, you have probably been incentivized to bring in potential members through gift cards, free training sessions, and the like. That’s cross-selling. You use existing customers as a base to grow the enterprise.

But communicating to employees that they will be sharply penalized for failing to achieve those goals creates a strong likelihood of risky behavior. Stretch goals, by their nature, have a tenuous relationship to market potential. Harsh consequences for not achieving those targets can endanger ethics, culture, and compliance.

Identifying unrealistic goals is a key element of an incentive mine sweep. You might start by asking for unfiltered, and perhaps anonymous, information from your line personnel about their perceptions of existing compensation structures and engage a market study to better understand industry growth patterns. Indexing your goals to the market, and getting unfettered data from those whose compensation is linked to “pay for performance,” might provide surprising results, which allow you to disarm those mines before they are front-page news.

In the next post, we’ll conclude our discussion of perverse incentives with some “search and destroy” advice.

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Richard Bistrong is a contributing editor of the FCPA Blog and CEO of Front-Line Anti-Bribery LLC. In 2010 he pleaded guilty to a conspiracy to violate the FCPA and served fourteen-and-a-half months at a U.S. federal prison camp. He now consults, writes and speaks about compliance issues. In 2015 he was named one of Ethisphere’s 100 Most Influential in Business Ethics. He can be contacted by email here and on twitter @richardbistrong.

Marc Hodak is Partner at Farient Advisors, an independent executive compensation and performance advisory firm. He has taught corporate governance as a professor at NYU’s Stern School and as visiting lecturer at the University of St. Gallen in Switzerland. He can be contacted here.

This post was adapted from an article that appeared in Compliance Week “Is It Time For An Incentive Mine-Sweep?” by the same authors.