Behavioral Economics for Leaders

CHAPTER 37Nobody Wants to Be Below Average; How Performance Bonuses Can Hurt Productivity and Job Satisfaction

Many companies pay bonuses to members of their workforce to reward them for services rendered or as an incentive for their work going forward. When designing a bonus system, several things can go wrong.

More than one‐half of the world’s 500 top‐earning companies globally use relative remuneration systems. This means that employees get a base salary and on top of it are entitled to bonus payments. The bonuses depend on the performance of one worker compared to others. The bonuses are intended to reward employees for good performance; at the same time, they provide an incentive for a high level of work commitment in the future.

Quite a few things can go wrong, though, when designing relative remuneration systems, as a study by my Cologne‐based colleagues Axel Ockenfels, Dirk Sliwka, and Peter Werner reveals. The three authors had the opportunity to analyze the data of a multinational corporation related to bonus payments in locations in the United States and in Germany. In both countries, managers are rewarded by bonus payments, whose amount depends on their supervisor’s performance reviews. The bonus scheme has the same structure in both countries but differs in a crucial detail regarding the last step in determining the amount of the bonus.

In a first step, the people in one department are evaluated by their managers on a five‐tier scale. The scale covers the ratings ...