Incentives in business are often held up as wonderful examples for schools and especially for the people who work in schools. Look, critics say, if principals and teachers were rewarded for excellent performance and penalized for poor performance - if they were given real incentives the way people in business are -- we'd have much better schools. One of the incentives that is most often proposed is merit pay because this kind of thing is said to work so well in the private sector.
I've often spoken in favor of incentives, and I still think they are one of the keys to improving the U.S. education system. But getting incentives right -- so they encourage the kind of behavior you want -- is a lot harder than most people think. Just look at the recent stories about top executives in big U.S. companies who continue to get astronomical salaries, even when their companies are failing. As a cover story from the Economist (Feb. 1-7, 1992) says, some of these people look a lot more like buccaneers than entrepreneurs.
When people talk about financial rewards for merit, they usually think of innovators like Apple Computer's Steve Jobs or Microsoft's Bill Gates who built multi-billion-dollar businesses with their own ideas and energy. But that's not what the Economist is talking about: "What grates is the sight of bosses of the biggest firms getting entrepreneurial rewards for doing the job of a corporate bureaucrat."
The theory of financial incentives for people who run a company -- as opposed to those who develop a new product or start a business from scratch - is that top executives are more likely to work hard for a company's long-term health and success if they have a financial stake in that success over and above their salary. You might call this a kind of merit pay for CEOs. And in this country, we think that the bigger the stake the more likely a top executive is to do his job well.
Is this true? They don't think so in Germany and Japan. Top German and Japanese executives are given no added financial incentives to spur them on to success. They also get lower base salaries than American CEOs. And in Japan, top executives make less money in relation to the average worker than their American counterparts: An American CEO's pay is about 85 times more than an average worker's; a Japanese CEO's is only 17 to 24 times more.
Furthermore, as the Economist tells us, the incentives offered to a U.S. executive usually kick in no matter what kind of job he is doing. Take the stock option. This is what causes the sudden bulges in the salaries of top executives. For example, the $86-million paycheck that Roberto Goizueta, the chairman of Coca-Cola, got last year was based largely on stock options. This arrangement authorizes an executive to buy a big chunk of the company's stock at a fixed price -- usually the price the day the option was offered -- for a certain period of time, like 10 years. If the stock goes up, the executive can sell the stock and pocket the profits
without spending any of his own money. If the stock goes down, he can hold on to the option until it runs out. In principle, this gives a top executive an excellent incentive to devote all his energy and creativity to making the company more profitable because it ties a big hunk of money directly to the performance of the company.
In practice, the stock option is often set up so it offers no incentive at all -- or the wrong kind of incentive. For example, if you can begin exercising your option in six months and sell all your stock within four years -- and the Economist says this is common where's the incentive to work for the long-term health and success of the company? This kind of incentive could even cause a top executive to ignore long-term performance and concentrate on a big splash in the short term, so he could take the money and run.
And what about the stick? If the value of the stock falls instead of rising, a board often simply reissues the option or changes it to allow the executive to buy at a lower price. This is like telling your kid that you'll get him a new car if he keeps a B average -- and ground him ifhe falls below C+ -- and then getting him the car anyway when he gets a C average.
This is only one of a number of complicated techniques for tying executive compensation to performance, and according to the Economist, none of these executive merit pay schemes works very well. This may be because corporate boards, which are made up mostly of other executives from the company and other heads of companies, are inclined to be sympathetic to one of their own. Or it may be that the real incentive for many top executives is figuring out how to get the most out of their incentive plan.
Does this mean incentives don't work? Would Coca-Cola's chairman have done just as much if he had been able to look forward only to $800,000 instead of one hundred times that amount? Some people maintain that you can't buy imagination and leadership -- and that big financial incentives are corrupting rather than liberating.
Critics of our schools are right to raise the question of incentives. We can raise exactly the same question about business. And we have a couple of answers already: You can't come along and in five minutes devise some simple incentive structure that will ensure the kind of behavior you want. Getting incentives right is not easy, and even when you do, they require constant monitoring and experimentation. That's as true for business as it is for the schools.