Why (Almost) All Bonuses Are A Bad Idea

04/20/2009 05:12 am ET | Updated May 25, 2011

In December, at a press conference, then President-Elect Obama observed, in commenting on the financial crisis, that people need to ask themselves not only "is it profitable," but also "is it right." But what does "right" mean, and why should we expect or demand that the lords of finance ask themselves that question and then act on the basis of the answer they get?

An avalanche of outrage has been expressed over the millions of dollars in bonuses paid to the AIG employees most responsible for the collapse of that company. This is just a louder, and more insistent version of the outrage expressed at bonuses revealed before. How could anyone at Merrill Lynch, for example, merit a bonus when its losses in the last year exceed its profits for the last forty. We should be outraged by undeserved bonuses. But we ought to be thinking bigger. Why are we paying bonuses at all? Why pay people extra -- often a lot extra -- just for doing their jobs? Pay them a nice salary. Give them a promotion. But a bonus?

What's wrong with a bonus, especially with a culture of bonuses? Consider: you're shopping for a new flat-screen TV and think you've settled on a moderately-priced model. The salesperson is trying to convince you that you'd be much happier with a higher-end TV. Perhaps you would, and the salesperson obviously knows more about this stuff than you do. Can you trust the salesperson's expertise? Are you more likely to trust the salesperson if she's paid a salary or if she's paid a commission on sales dollars?

Or consider: you meet with your financial planner who makes a bunch of suggestions about what you should sell and buy in these volatile times. The financial planner knows more than you do. Do you take his advice? Are you more likely to trust his advice if you're paying him by the hour or if he's earning a commission on every trade?

While there is no guarantee that salespeople and financial planners who do not get commissions will have their customer/client's interests at heart and give good advice, we can be pretty certain that they won't face the conflict between "what's good for me" and "what's good for the customer" that is built into sales commissions.

Well, most bonuses are just commissions by another name. The employee asks herself, "on what does my bonus depend? What will they be measuring?" and then acts in a way that will make what is being measured as impressive as possible. Say yes to any mortgage, no matter how unsound the applicant's finances, because the more mortgages you say yes to, the more mortgages can be securitized, the more fees your firm will earn, and the bigger your bonus will be. Give a high rating to any new bond issue because the more high ratings you give, the more bonds you will be asked to assess in the future, the more fees your firm will earn, and the bigger your bonus will be.

Someone might respond to this argument by saying that the problem isn't with giving bonuses, it's with giving bonuses for the wrong things. We should be giving bonuses for activities that serve the long-term interests and not the short-term interests of the company. And we can add "claw-backs" to bonuses, as some have recently proposed, so that the people who earn big bonuses will have to give them back if the company suffers tomorrow for what they do today. But this is a little disingenuous. Working in a way that serves the well-being of the company is what "doing your job" is all about. The culture of bonuses is there for a reason -- as an implicit instruction to employees that one thing matters above all else.

It is a truism that you should "be careful what you measure, for what you measure is what you'll get." Just as true is that "you should be careful what you pay for, for what you pay for is what you'll get." And whether it is traders trying to improve the corporate bottom line, or teachers trying to improve the standardized test scores of their students, bonuses encourage a narrowness of vision and aspiration that results in consequences like the ones we're living through today.

The culture of bonuses will do nothing to encourage the financiers who hold our futures in their hands to ask themselves not only "is it profitable," but also "is it right." And no amount of oversight and regulation can overcome an industry that does not take "is it right" seriously.

At his inaugural, President Obama called on all Americans to be virtuous. "Virtue" is an old-fashioned word, but Obama evoked it because, as he said, it is part of our national heritage and it is "true." We shouldn't have to pay people bonuses to do the right thing. We want a society in which people do the right thing because it's the right thing. Perhaps we can use the egregious case of AIG as an opportunity to rethink the culture of bonuses more generally, and to find out what it takes to foster institutions in which people routinely ask "is it right?"