How do decisions by senior executives in the ivory tower of the C-suite affect the quality of the judgments made by the troops at the front lines of a business? An obvious but overlooked answer: People do what you pay them to do.
Consider the example of consumer lending. Credit scores are used as an important measure of a prospective borrower’s credit worthiness. Lenders and credit card companies rely on credit scores to give assurance that loans will be repaid. The top end of the credit score scale is 850. Scores less than 640 are considered subprime.
Subprime scores indicate prospective borrowers with sketchy debt repayment history, and a greater risk of default. Despite the risk to lenders, plenty of subprime loans are made. Today subprime loans account for 40% of all new loans, a near-record high. The last time the subprime percentage was that high was just before the Great Recession.
Obviously, a loan applicant with a credit score of 800 is a much better credit risk than one with a score of 670. But is a loan applicant with a score of 650—just above the subprime cutoff—a materially better risk than another applicant with a score of 630? It is a close judgment call. And just the kind of “hard to tell” judgment rank-and-file employees make in a variety of industries—from health care, to investment advice, to lending—every day.
How does a company’s compensation structure influence these kind of judgments?
Imagine the following hypothetical scenario, which takes some liberties with reality to make a point. You are a senior executive of an auto loan company. The profitablity of your business is based on how many loans you can make, especially in a low-interest rate environment.
You are under pressure from shareholders and the board to increase loans made without increasing expenses. One way of doing so is to provide bonuses to the loan processors—the people who evaluate and approve the loans—so that those who process the most applications get paid the most. This way you will get more production out of your workforce without hiring new employees.
In structuring the bonus plan, you have a decision to make. You can reward total production, both loans rejected and those approved, or you can reward only approved loans. After all, your company only makes money from loans made, not from loans denied, so there is a rational for compensating based on loans actually approved.
Hopefully you will chose to compensate total loan applications processed. Increasing the total number of loans processed will increase the number of loans approved. The loan processor’s judgment on approval decisions should be unimpaired by the financial incentive, except to the extent they may be making quicker judgments by handling more applications in the same amount of time.
If you set compensation based on approved loans only, you are paying people to approve, not reject loans. Loans will be approved that perhaps should be rejected, because it is what you are paying people to do.
Your loan processors will still reject the obviously creditworthy applications. But what about those close judgment calls? When you are paying people to approve and not reject, they will do what you pay them to do. The close calls will be decided in favor of approval. The short-term result will be an increased loan business. The long-term result, however, likely will be more loan defaults, which will be bad for the business, the customers, and the economy. But you will have increased profits, short-term.
You might think that between the two compensation structures the one that rewards only approved loads would be so obviously a problem it would never be used. But history suggests that time and time again companies create incentive structures, often unintentionally, to reward behavior that produces long-term harm, at best, and sometimes unethical and even illegal behavior at worst.
In the late 1990s many of the major accounting firms, law firms, and banks set up businesses selling aggressive tax shelters to wealthy individuals. Compensation structures were aimed at incenting an increasing amount of sales. As the shelters slid over the line from overly-aggressive shelters to illegal shelters, the firms’ employees continued to sell the tax shelters. They did what they were paid to do. Because of the close nature of some of the judgments they were making, it was easy to rationalize bad judgments because the end result—getting more sales—is what they were being paid to do.
Recently, federal regulators announced plans to tighten standards for investment advisers who make investment recommendations for retirement accounts. The new rules will require investment advisers to disclose their compensation for the investments they are recommending.
The proposed regulation recognizes that an investment adviser who is paid more for selling an investment that returns 5.5 percent per year than one that returns 6.0 percent per year is more likely to sell the lower-yielding investment rather than another that returns slightly more for the investor. This is another example of people doing what they are paid to do.
A final example: a recent investigation by The Wall Street Journal discovered that long-term medical care facilities hold or release patients based on a complex compensation scheme set up by Medicare. The facilities can earn much more from Medicare by releasing a patient from care on the 24th day of care as compared to the 23rd day. Guess what? Release dates on the 24th day of care are much greater than on the 23rd. The medical facilities are simply doing what Medicare is paying them to do.
So decision-makers need to be very mindful of the messages they are sending employees or vendors by the incentive structures they set up. Be careful what you pay for, because your wish may come true.