This bonus plan didn’t work; let’s do more of it

Posted by Marc Hodak on November 9, 2015 under Executive compensation, Invisible trade-offs, Pay for performance, Unintended consequences | Be the First to Comment

This story starts with a dig:

Massey Energy was one of a handful of mining and energy companies that tied its chief executive officer’s bonus to safety performance in 2010. Today, former CEO Donald Blankenship goes to trial on charges stemming from a West Virginia mine explosion that killed 29 workers, the U.S. industry’s deadliest in almost four decades.

The story goes on to note that in the mining industry there is no correlation between having executive bonuses tied to safety metrics and the actual result of safer mines. In fact, many of the safest companies offer no safety bonuses for their top executives. Nevertheless, all of the people interviewed in the article claim that CEO incentives ought to be tied to safety much more than they are today.

The head of corporate governance at CalPERS wants higher safety bonuses because “health and safety is absolutely the foundation of the company’s license to operate, its reputation, its operational risk and, of course, ultimately financial success.” The fact that Massey’s mining deaths led directly to the company’s demise well illustrates that link.

But the CalPERS comment raises an interesting question, one that might help explain the lack of a link between bonuses for safety and safety results. If a CEO’s bonus is based largely on the firm’s financial success, and health and safety are “absolutely the foundation of the company’s … financial success.” then a separate reward for safety appears, at the very least, redundant to rewarding financial performance. In other words, a focus on profitability ought to drive a sensible focus on safety. So, what’s wrong with doubling down on safety with a redundant reward? Wouldn’t that simply make companies even safer? While this seems to make intuitive sense, the evidence shows otherwise.

So, don’t incentives matter? Yes, they do. A lot. It’s just that organizational incentives are tricky. The effect of incentive plans on organizations can be thought of similarly to the effects of drugs on the body. Every drug has both intended effects and side effects, plus potential interactions with other drugs. Good medicine means creating or prescribing drugs whose intended effects are not outweighed by their side effects and negative interactions. This takes a lot more than intuition.

In the case of mine safety, it helps to recognize that the relationship between safety and financial success goes both ways. Safer firms are indeed more financially successful, as CalPERS asserts, but financially successful firms are also much safer. In fact, the effect of financial strength enabling safer operations very likely overwhelms the effect of direct incentives for safety. Safety bonuses, especially in an annual incentive plan, very likely encourage over-investment in things that make safety numbers temporarily look better. This, in turn, means underinvestment in things that result in higher returns over time, which would enable safer operations in the future.

Well, that’s what the economic theory and empirical evidence suggest, anyway. When studying side effects and interactions, though, it pays to look beyond the high-level results to understand the mechanism driving them.

Here is what distinct safety bonuses looks like inside an organization. We begin by setting up specific safety targets for bonuses apart from overall profitability goals. Now, suppose we are getting toward the end of the year, and (for whatever reason) management is certain to miss their profit goals, but might still make their safety goals. In that scenario, it would pay for management to significantly over-invest in assuring they make the safety goal, even if it deteriorates profit more than they otherwise would absent this incentive. Remember, they are below the point where incremental gains or losses in profit make any difference to their pay. This behavior would hurt profitability–and, thus, safety–down the road.

On the other hand, let’s say that they are falling irrecoverably short on their safety goals, but may yet make their profitability goals. Absent separate safety goals, managers in that situation may think, “Yeah, we can probably get away with sacrificing safety for profits in the short run, but we need to be careful about that because it may cause us more problems down the road.” (And, perhaps, “it would be wrong.”) So, they would spread their cuts broadly, not entirely ignoring safety costs, but not focusing on them, either. But with safety being distinct from profits in the bonus plan, it literally pays for management to focus their cuts on safety in order to make their profit goals. If these scenarios play out just once every few years, that’s enough to create a change in the culture where intrinsic motivation to always make the right trade-offs is crowded out by extrinsic motivation to “make the numbers.”

As someone who sells incentives for a living, I know their limitations. A good bonus program will not overcome bad management, e.g., managers who don’t recognize the impact of safety on profitability. There are too many ways to game the numbers. Our best hope is that ignorant or myopic managers can be trained to look more holistically at their business to see the clear benefits of safer operations. Or, don’t promote bad managers into top positions. Good managers, even those faced with perverse incentives, will generally try to do the right thing, such as striking the best balance between safety and profitability today in a way that enhances profitability (and, thus, safety) tomorrow. They may even do so in the face of perverse incentives. But good managers don’t deserve to face perverse incentives, situations where they are hurt by doing the right thing, which is what separate bonuses for safety can create. If we really believe that safety is crucial to profitability, then it should be enough to encourage a healthy, long-term focus on profitability.