harvard business review incentive plans

• Harvard Business School →
• Faculty & Research →
• January–February 2021
• Harvard Business Review

Compensation Packages That Actually Drive Performance

• Format: Print
• Find it at Harvard
• Register to Read

About The Author

Boris Groysberg

More from the authors.

• Faculty Research

East Rock Capital: 'Talent is the Best Asset Class'

• February 2024

CityScore: Big Data Comes to Boston

Adventures inc: 21st century brand building.

• East Rock Capital: 'Talent is the Best Asset Class'  By: Boris Groysberg, Sarah L. Abbott and Izzy Yeoh
• CityScore: Big Data Comes to Boston  By: Boris Groysberg and Sarah L. Abbott
• Adventures Inc: 21st Century Brand Building  By: Boris Groysberg and Sarah L. Abbott

• Browse All Articles
• Newsletter Sign-Up

MotivationandIncentives →

No results found in working knowledge.

• Were any results found in one of the other content buckets on the left?
• Try removing some search filters.
• Use different search filters.

• Editorial Team
• Editorial Policies
• Submit Manuscript
• Special Issues
• Free 2021 Digital Issues
• 2022 Fall Articles
• 2022 Summer Articles
• 2022 Spring Articles
• 2022 Winter Articles
• 2023 Summer Articles
• 2023 Spring/Winter Articles
• Papers in Future Issues
• Individual Subscription
• Library Subscription

A Grassroots Initiative to Bridge Practice, Education, and Research.

• Winter 2021 Issue
• Winter 2021 Articles

Pay for Performance: When Does It Fail?

Nirmalya Kumar Singapore Management University & INSEAD Emerging Markets Institute

Madan Pillutla London Business School

The consensus in social psychology is that monetary incentives for performance have a detrimental impact on individual performance. Yes, under certain specific and limited conditions, rewards can reduce performance. Yet pay for performance schemes are ubiquitous. How can we resolve this divergence between theoretical recommendations and observed practices? Nirmalya Kumar and Madan Pillutla recommend solving the problem by designing smarter incentives that avoid these detrimental effects.

In his classic 1993 Harvard Busi-ness Review article, Alfie Kohn argued:

“Certainly, the vast majority of U.S. corporations use some sort of program intended to motivate employees by tying compensation to one index of performance or another. But more striking is the rarely examined belief that people will do a better job if they have been promised some sort of incentive. This assumption and the practices associated with it are pervasive, but a growing collection of evidence supports an opposing view.” 1

Citing a body of psychological research, Kohn reasoned that incentives which rely on increasing extrinsic motivation unfortunately lead to lower intrinsic motivation and are therefore doomed to fail. He ended his article by concluding “bribes in the workplace simply can’t work .”

Monetary incentives can, and have been shown to, have negative effects, but these arise only under specific conditions which, for the most part, are not common in organizations.

Over the years, Alfie Kohn’s perspective has been reiterated by others, most recently by Daniel Pink. With over 25 million views, Pink’s TED Talk, “The Puzzle of Motivation” is among the ten most popular TED Talks of all time. Based on experiments conducted by psychologists over the past two decades, Pink concludes that, except when applied to the simplest tasks, monetary incentives, or what he calls “if, then rewards” fail to improve performance. This view reflects the current consensus in the social psychology literature. As Pfeffer observes: “liter-ally hundreds of studies and scores of systematic reviews on incentive studies consistently document the ineffectiveness of external rewards.”

Other scholars acknowledge that rewards may work, but only for those with low incomes. This view argues that, above a certain earning level, offering people incentives in the form of bonuses and higher pay is ineffective because it does not increase their happi-ness. Yet despite the prevalence of these views, pay for performance, in the form of bonuses, rewards, and incentives, is still ubiquitous in organizations. Even the CEOs of global companies and private equity managers receive a substantial portion of their earnings in the form of compensation for producing specific results. Making variable pay an integral and vital component of the design of wage systems is generally considered best practice. How, then, can we reconcile the deleterious effects of incentives documented in academic research with their popularity in practice? We have drawn upon our review of a considerable body of academic literature over the past two decades to demonstrate that the negative effects of pay for performance have been exaggerated. Monetary incentives can and have been shown to have negative effects, but these arise only under specific conditions which, for the most part, are not common in organizations. When designing their reward systems, managers need to understand the limiting conditions under which incentives work. By describing the circumstances in which incentives have been shown not to work, we will demonstrate that most of these circumstances are either inoperable in organizations or can be avoided by using our design recommendations.

The case against incentives is generally made on the basis of two motivational processes that are often conflated into one. First, that pay for performance does increase the worker’s motivation to do the task, but that, paradoxically, this over-motivation can actually decrease performance. Second, that there are circumstances in which offering pay for performance will counterintuitively cause the worker to be under-motivated to perform the tasks in question. There is some empirical evidence supporting the validity of these two motivational processes. Table 1 traces the overall framework for our article and the organization of our arguments.

The introduction, or use, of pay for performance schemes thus results in a different (more motivated, more productive) pool of employees, self-selecting themselves into an organization.

Before we examine the academic research that documents these two detrimental effects of pay for performance, it is important to note a general factor which limits most laboratory social psychology studies on this subject. While working in a laboratory does enhance internal validity by randomly assigning subjects to treatment or control conditions, it ignores the beneficial sorting effect which incentives have on performance. Lazear, for example, reported that the increase in the productivity of a company that switched from salaries to individual incentives was produced in equal parts by existing workers increasing their productivity (incentive effect) and by less productive workers quitting and being replaced by more productive ones (sorting effect). 2 The introduction, or use, of pay for performance schemes thus results in a different (more motivated, more productive) pool of employees, self-selecting themselves into an organization. Because we have here concerned ourselves only with the incentive effects and ignored the sorting effects, the detrimental influence of pay for performance in the many studies mentioned below is actually overstated when applied to practice.

Increased motivation leads to lower performance

Sometimes, the increased motivation to succeed which is inspired by higher incentives can have a detrimental effect on performance. Often referred to as “choking under pressure,” some workers have been found to respond to incentives by performing worse than expect-ed, given their skill and historical performance. Scholars offer two explanations for the paradoxical negative effects of this over-motivation.

Distraction

Proponents of distraction theory argue that the pressure induced by potential rewards fills our minds with irrelevant thoughts about the situation and the importance of earning the rewards. Our concerns about performance and the effects of earning or failing to earn the rewards compete for our attention, which was once focused solely on the task at hand.

A typical study of distraction theory asked participants to solve two types of math problems, with or without a monetary incentive. 3 Subjects were given a series of novel math problems that either required the use of working memory or that were heavily practiced and could therefore be retrieved from long term memory. 4 One set of subjects was given no incentive while the other was offered five dollars for solving the problems. Researchers found that the monetary incentive led to a deterioration in performance on working memory problems but not on long term memory ones. These results, as well as those from other studies, suggest that, because high incentives draw attention away from the task, jobs that require extensive use of working memory will tend to be the ones negatively affected by the offer of monetary rewards.

Almost all the empirical evidence in support of distraction theory is laboratory based. These studies have in common the use of discrete performance events with no opportunity to prepare differently after the incentives are announced. The findings can therefore be applied to organizational settings only to a limited extent.

While they might apply to relatively brief and clearly defined tasks (e.g., making an advertising pitch or a sales call to an important client), even here large incentives might cause the worker to prepare better, overcoming any potential distraction. Offering someone a million dollars to do well immediately prior to an advertising pitch might have unfavorable effects, but offering that same million three months prior would probably induce the worker to devote the intervening months to preparation and would therefore lead to better performance. And this latter scenario is far more characteristic of organizations.

Overthinking

Scholars of explicit monitoring theories propose that the pressure of high incentives increases anxiety and self-consciousness which, in turn, drive people to pay more attention to specific skill processes. Workers try harder to exert conscious control over the specific steps of what they need to accomplish in the hope that being scrupulously careful will increase their chances of success. However, researchers believe that attention to performance at such a minute level actually disrupts the automatic processes that would otherwise not require working memory.

The most commonly cited evidence for the detrimental effects of explicit monitoring is drawn from empirical studies conducted in the sports arena. For example, psychologist Rob Gray offered accomplished players high or low incentives to bat in a base-ball simulator.5 Batters in the high reward group were told, after they had completed a first set of trials, that they and a randomly assigned partner would each receive twenty dollars if they increased their performance by 15 percent in the next round. They were then told that the partner had already achieved the increase and that it was up to them to ensure that they both earned their reward. Batters in the low reward group were not promised anything. Researchers found an increase in batting errors and movement variability among the high reward group.

What is more interesting, though, is that the high reward group’s batting failure was accompanied by improved judgment (as assessed through verbal statements made during batting) about the direction in which they were moving the bat.

Further research suggests that it is not the incentives per se that cause the overthinking which under-mines performance, instead it is the accompanying pressure to monitor and report, referred to in the literature as procedural accountability. So the procedural accountability which often accompanies higher rewards is what drives overthinking, which does lead to more accurate judgment, but unfortunately also disrupts routine skills.

One simple way to reduce the detrimental impact of rewards on experts, then, would be to separate large performance-based rewards from procedural accountability.

One simple way to reduce the detrimental impact of rewards on experts, then, would be to separate large performance-based rewards from procedural accountability. This suggestion might not appeal to the many who view systematic organizational failures as arising from a lack of accountability for leaders. However, procedural accountability only damages the performance of experts and then only when they perform tasks for which their automatic responses tend to be correct. As the Nobel laureate Daniel Kahneman points out, workers apply such expertise only in performing tasks that are regular enough to be predictable, produce high quality and speedy feedback, and are performed repeatedly over a prolonged period, so that they become routine. These conditions occur in a limited number of jobs in a given organization (e.g., anesthesiologists, loan officers, software testers). Within this limited set of jobs, separating procedural account-ability from performance-based rewards can overcome the negative effects of incentives.

Higher incentives reduce motivation to perform

The explanation given more frequently by those who argue against pay for performance is that incentives ironically lower motivation to perform. In this scenario, the offer of rewards emphasizes the person’s monetary motivation, crowding out what academics consider to be “good motivations.” Two types of good motivation have been extensively researched in the context of the negative effects of incentives. For the most part, economists have focused on how incentives reduce workers’ motivation by undermining their sense of nobility. Meanwhile, social psychologists have concentrated on the detriment to intrinsic motivation.

People engage in a great many tasks because they see them as part of their duty or because they feel it demonstrates goodness of heart.

Undermining nobility

People engage in a great many tasks because they see them as part of their duty or because they feel it demonstrates goodness of heart. Examples include arriving on time and helping other people as well as going beyond their specific job requirements to benefit the organization. Paying people specifically for these actions tends to cheapen the good deed because it undermines how the activity is viewed, either by the actor or by her peers. People will thus perform the activity less in the face of monetary incentives.

People improve their reputations by performing good acts such as donating blood or volunteering for community projects. Their motivation to do good appears to depend upon the degree of personal sacrifice required. This sacrifice can be viewed as the act’s opportunity cost—the cost, to the individual, of other opportunities for personal benefit which they have given up in order to undertake this activity.

Perhaps the most recognized example of how incentives under-mine noble motives is Titmuss’ comparison of blood donation in the UK and US.6 His central finding was that, in the UK, where donors are not paid, both the quality and quantity of blood for transfusion were higher than in the US, where donors were paid. While it is not surprising that paying for blood drives down the quality, since it gives people an incentive to lie about whether they are sick, it is remarkable that the quantity per capita also goes down. Although Titmuss’ work has drawn considerable criticism over the years, primarily over the quality of his data, the idea that paying people for something they would have given willingly might undermine their motivation to give has survived the test of time. And Titmuss’ blood donation case is one of the examples used by Nobel laureate Jean Tirole in his threshold model for prosocial behavior.

Signalling nobility of character is a very important aspect of the threshold model. If the opportunity cost of noble behavior is too little, or is seen by others as too little, the individual’s motivation to perform the activity decreases correspondingly. For an activity to feel really worthwhile, people need to feel (and show) that they have incurred a significant cost. On the other hand, if the cost is too much, people will lose motivation. So there is a specific threshold at which people will perform a noble act; if the cost falls below or above a certain amount they will be less likely to participate. Paying for performance, then, may lower the opportunity costs to below the threshold and remove the opportunity to signal sacrifice, bringing about lower performance.

Recent research using large-scale field experiments shows that offering lottery tickets, gift cards, or noncash incentives such as T-shirts has a neutral or positive effect on the number of blood donors, particularly those who donate infrequently. Studies in domains other than blood donation support the conclusion that non-monetary incentives such as a ‘star performer’ award do not undermine participation the way monetary awards do and can actually increase noble behaviour. The motivating effect of these incentives is increased by making them public (as through award ceremonies).

However, the research that documents the undermining effects of monetary incentives is usually conducted with participants for whom the noble or pro-social task is not their main occupation. Non-financial rewards may be more effective in these cases because participants’ financial needs are being met else-where. We would therefore not expect financial reward to have the same undermining effect on people whose main job is the performance of these noble actions (like those employed in the charitable sector). For these individuals, pay for performance might still increase their performance of the noble behavior.

Transformation of frame

Paying for the performance of a task can transform an activity from a non-market based communal exchange (like helping out a col-league who is having trouble with a task or assuming their responsibilities when they are ill) to a market transaction. It puts a price on doing a previously voluntary activity, transforming how people view it. Faced with an incentive, people start to evaluate whether it is worth engaging in the activity for the amount in question.

To demonstrate this phenomenon, the economists Gneezy and Rustichini conducted an experiment using ten day care centers. They randomly chose six of the centers and introduced a small fine for parents who were more than ten minutes late to pick up their children. In day cares where the fine was introduced, parents immediately started arriving late, with tardiness eventually leveling out at about twice the pre-fine rate. Introducing a fine actually caused twice as many parents to be late! Tardiness was unchanged in the four day care centers with no fines. The fine had transformed how parents felt about their obligation towards the day care center workers. Instead of viewing it as their duty to pick up children on time and let the workers go home, parents now felt that their decision to arrive on time was an economic one in which they could pay for the privilege of being late.

The danger of undermining the sense of nobility is of interest to organizations because it suggests that mangers should be careful with how they offer incentives for the many behaviours they expect from workers outside their core job. While firms may wish to reward those who take on more of these organizational citizenship behaviours, they should avoid making that reward too transactional. A yearly 360-degree evaluation of helpfulness will probably produce better results than paying employees for each individual act. The latter method may lead them to start putting a price on each act, and then evaluating whether that price is worth their effort. Publicly giving people gifts or other non-cash awards is another way to avoid this pitfall.

By making the rewards a product of peer nomination, Google converts a cash payment into a symbol of appreciation. As a result, people are less likely to see the reward as cheapening their noble behavior.

Google appears to have discovered a way to pay people for being helpful without making it transactional. The company invites employees to nominate colleagues who have been helpful to receive small cash rewards. By making the rewards a product of peer nomination, Google converts a cash payment into a symbol of appreciation. As a result, people are less likely to see the reward as cheapening their noble behavior.

This emphasis on incentives causes people to feel a loss of autonomy. In the face of the extrinsic motivation of an incentive system people tend to lose their mastery orientation, the intrinsic motivation that drives the individual’s search for excellence.

Undermining intrinsic motivation

The most frequent argument against pay for performance, though, is actually not one of those we have presented above. Instead, the primary point of Kohn’s paper and the consensus among social psychologists, is that it promotes extrinsic motivation and reduces intrinsic motivation. Emphasizing incentives causes people to feel a loss of autonomy. In the face of the extrinsic motivation of an incentive system people tend to lose their mastery orientation, the intrinsic motivation that drives the individual’s search for excellence.

To understand this effect, and how organizations can guard against it, it is important to understand the difference between extrinsic and intrinsic motivation. Extrinsic motivation refers to behavior that is driven by external rewards such as money, fame, grades, and praise. Intrinsic motivation stems from an internal drive which allows intrinsically motivated individuals to experience personal enjoyment or satisfaction while performing certain activities. The activity provides its own inherent reward, so motivation for these activities is not dependent on external rewards.

The evidence for the undermining of intrinsic motivation

The evidence for how pay for performance can undermine intrinsic motivation is rooted in a body of literature led by Deci & Ryan. 7 These studies found that tangible rewards, especially monetary ones, tend to undermine participants’ intrinsic motivation. There are usually three phases to an experiment of this kind. In the first, subjects are given an interesting task (often a puzzle) and asked to work on it without payment. The experimenter then leaves the room and monitors whether and for how long they continue to work. This observation measures intrinsic motivation. In the second phase, participants are offered a payment to do a similar task. In the third and final phase, they are again asked to work on the interesting task without payment. Researchers found that, when not directly observed, participants engage less with the interesting task in the third phase than in the first phase. Scholars view this waning interest as indicative of a decrease in intrinsic motivation because the reward has been withdrawn. However, as the reader can likely surmise, despite the common conclusion that these studies constitute evidence of the detrimental effects of pay for performance, the broad inferences drawn from them are problematic. The undermining effect of rewards could be purely transitory. People may have a natural level of engagement in the task which is based on their intrinsic motivation. When the rewards increase their engagement, this level is exceeded such that when the reward is withdrawn, their engagement may be temporarily reduced while they recover from the excess engagement. In this case, they will revert back to normal in the long run. Furthermore, the undermining effect has been traced primarily with regard to interesting tasks, which might not constitute the majority of jobs in an organizations.

Using incentives without undermining intrinsic motivation

According to social psychologists, in order to understand the under-mining effects of rewards, we must consider how the recipients are likely to interpret them. Specifically, the effects of a reward depend on how it affects the recipient’s perceptions of autonomy and competence. When monetary incentives interfere with an individual’s sense of autonomy or competence, they tend to decrease intrinsic motivation.

Different kinds of incentives influence our sense of autonomy and competence in different ways and therefore have different effects on intrinsic motivation. In general terms, we can sort rewards into two types. Task contingent rewards are those that are given simply for engaging in or completing a task (e.g., a salesperson filling out sales call reports). Since the recipient is required to work on or complete the task in order to receive these rewards, they could be perceived as controlling. This sense thwarts the worker’s need for autonomy while providing minimal information about their competence. Because the loss of autonomy is accompanied by no corresponding increase in feelings of competence or mastery, task contingent rewards can reduce intrinsic motivation.

However, these negative effects do not make task contingent rewards inherently unsuitable for organizations. Organizations are rife with uninteresting and repetitive tasks in which a known process exists to create a desired outcome (e.g., production lines). These tasks carry little intrinsic motivation in any case, so the detrimental effects of incentives are less relevant. The extrinsic motivation engendered by incentives should help employees to engage more intensively with such an activity than they would otherwise.

Performance contingent rewards, by contrast, are those which are earned by performing a task well(e.g., a commission on sales or a profit linked bonus). These rewards certainly increase extrinsic motivation, but it is vital to ensure that the increase does not come at the cost of intrinsic motivation. Because most managerial performance in organizations requires teamwork, creativity, solving novel problems, learning, and judgment, for all of which intrinsic motivation is crucial, any pay for performance system that undermines intrinsic motivation is inherently counterproductive. The wise solution in this context is care-fully designed performance contingent rewards that enhance feelings of competence and do not under-mine autonomy.

Performance contingent rewards which reinforce a sense of competence can help offset any under-mining of autonomy. Likewise, if the person delivering the rewards has an appropriate interpersonal style, she can help to reduce the feeling that autonomy is being lost. From these principles we have devised five recommendations about designing and delivering performance-based rewards without undermining intrinsic motivation.

• Make sure that monetary incentives are accompanied by positive feedback and encouragement so that they don’t lead to a sense of lost autonomy. Using a coercive interpersonal style, for example making threats, will be seen as controlling and will therefore undermine intrinsic motivation. Offer performance-based incentives only for achievements beyond the minimum standard required for continued employment. Workers should be able to decide whether they want to earn a bonus without worrying about being fired. This freedom ensures that they do not feel a loss of autonomy.
• Incentives which depend on undefined performance standards or achievements which clearly rely on luck do not offer any feedback about the recipient’s competence and therefore do not compensate for any perceived loss of autonomy. Incentives should be based on specific standards which employees can understand and achieve through effort and skill.
• Incentives which are accompanied by information about the recipient’s performance relative to others will increase their sense of competence and correspondingly increase their intrinsic motivation.
• Do not offer performance-based incentives for trivial accomplishments which have little to do with competence.

Designing compensation systems is a complex but critical skill in running an effective organization. We have not attempted to cover the entire landscape of compensation, but rather to debunk the common belief that performance incentives have a negative effect. This broad, overarching conclusion which some authors have drawn is based on relatively narrow and specific studies. To make the blanket statement that “bribes in the workplace simply can’t work” or “if-then rewards never improve performance” is just not true.

We acknowledge that under specific conditions offering incentives can cause employees to choke because they are distracted or over-thinking. And, in certain limited situations, rewards can reduce performance by removing the sense of nobility or undermining intrinsic motivation. However, as Table 1 shows, thoughtful intervention can reduce or prevent these detrimental effects in organizational contexts. In short, not only is pay for performance an essential component in an effective manager’s toolkit, but by adopting these recommendations managers can learn to design smarter incentives.

Nirmalya Kumar is the Lee Kong Chian Professor of Marketing at Singapore Management University and a Distinguished Academic Fellow at INSEAD Emerging Markets Institute. As well as nine books and nine articles in Harvard Business Review, he has also published in the Academy of Management Journal, the Journal of Marketing, and the Journal of Marketing Research.

Madan Pillutla is a Professor of Organizational Behavior at the London Business School. In his research he uses social-psychological perspectives to understand organizational behaviors. His recent papers include an examination of the interplay between bias and self-interest in selection decisions (JPSP, 2018) and of the mobility of individuals of low socioeconomic status within organizations (Academy of Management Annals, 2019).

• For the general argument for negative impact of incentives, see Kohn, A. (1993). Why Incentive Plans Cannot Work. Harvard Business Review: September-October, 2-7; Pink, D. (2009). The Puzzle of Motivation. Retrieved from https://www.ted.com/talks/dan_pink_on_motivation?language=en; Pfeffer, J. (1998). The Human Equation: Building profits by putting people first. Boston, MA: Harvard Business School Press.
• Lazear, E.P. (2000). Performance Pay and Productivity. American Economic Review: 90, 1346-1361.
• Beilock, S. L., Kulp, C. A., Holt, L. E., & Carr, T. H. (2004). More on the fragility of performance: choking under pressure in mathematical problem solving. Journal of Experimental Psychology: General, 133(4), 584-600.
• Theorists see long term memory as the enduring stock of knowledge and skills, while working memory is limited to the very small proportion that is actively in use at any given time.
• For more on overthinking, see Gray, R. (2004). Attending to the execution of a complex sensorimotor skill: expertise differences, choking, and slumps. Journal of Experimental Psychology: Applied, 10(1), 42-54; DeCaro, M. S., Thomas, R. D., Albert, N. B., & Beilock, S. L. (2011). Choking under pressure: Multiple routes to skill failure. Journal of Experimental Psychology: General, 140(3), 390-406.; Kahneman, D. (2012). Thinking, Fast and Slow (London: Penguin Books)
• For incentives which undermine prosocial behavior, see Titmuss, R. (1970). The gift relationship. From human blood to social policy (Great Britain: George Allen and Unwin Ltd.).; Bénabou, R., & Tirole, J. (2006). Incentives and Prosocial Behavior. The American Economic Review, 96(5), 1652-1678.; Lacetera, N., Macis, M., & Slonim, R. (2012). Will there be blood? Incentives and displacement effects in pro-social behavior. American Economic Journal: Economic Policy, 4(1), 186-223.; Neckermann, S., & Frey, B. S. (2013). And the winner is…? The motivating power of employee awards. The Journal of Socio-Economics, 46, 66-77.; and Gneezy, U., & Rustichini, A. (2000). Fine is a price, Journal of Legal Studies, 29(1), 1-17.
• Deci, E.L. & R. M. Ryan, 1985. Intrinsic Motivation and Self-determination in Human Behavior (New York: Plenum)

RELATED ARTICLES MORE FROM AUTHOR

Praise for mbr.

[…] https://mbrjournal.com/2021/01/21/pay-for-performance-when-does-it-fail/ […]

Comments are closed.

View 2023 Issues View 2022 Issues View 2021 Issues

SUBSCRIBE TO OUR NEWSLETTER

Copyright © 2022 Management and Business Review . All Rights Reserved.

• Contributors

SEC Releases Final Rules Regarding Clawback Policies for Public Issuers

Gregory T. Grogan , Jamin R. Koslowe , and Karen Hsu Kelley are partners at Simpson Thacher & Bartlett LLP. This post is based on a Simpson Thacher memorandum by Mr. Grogan, Mr. Koslowe, Ms. Kelley, Partners Jeannine McSweeney , Charles Mathes and David E. Rubinsky . Related research from the Program on Corporate Governance includes Rationalizing the Dodd-Frank Clawback  (discussed on the Forum  here ) by Jesse Fried.

This Alert summarizes new Rule 10D-1 under the Securities Exchange Act of 1934 (the “Exchange Act”) as adopted and released by the Securities and Exchange Commission (the “SEC”) on October 26, 2022, requiring the recovery of erroneously awarded incentive-based compensation in the event that an issuer is required to prepare an accounting restatement.

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) added Section 10D to the Exchange Act, requiring the SEC to direct the national securities exchanges to establish listing standards that require issuers to develop and implement a clawback policy. The clawback policy must provide that, in the event an issuer is required to prepare an accounting restatement, the issuer will recover incentivebased compensation erroneously paid to its current or former executive officers based on any misstated financial reporting measure. The policy must apply to incentive compensation received during the three-year period preceding the date the issuer is required to prepare the accounting restatement.

In July 2015, the SEC proposed rules to implement Section 10D which we summarized in an earlier client memorandum . Following several comment periods, the SEC has now adopted the final rules , which largely track the previously proposed rules.

Effective Date of Final Rules

The final rules will become effective 60 days following publication of the adopting release in the Federal Register. [1] Exchanges will be required to file proposed listing standards no later than 90 days following publication of the release in the Federal Register, and the listing standards must be effective no later than one year following publication. Issuers subject to the listing standards will then be required to adopt a corresponding clawback policy no later than 60 days following the date on which the applicable listing standards become effective, and will thereafter be required to comply with related disclosure requirements.

Issuers Subject to the Final Rules

As under the proposed rules, final Rule 10D-1 generally applies to all listed issuers, including smaller reporting companies, emerging growth companies, foreign private issuers, controlled companies and issuers of debt and non-equity securities. The SEC apparently was unpersuaded by numerous commenters who questioned the utility and feasibility of applying the rules to foreign private issuers and certain other classes of issuers. The only exempted issuers under the final rules are issuers of security futures products, standardized options, unit investment trust securities and certain registered investment company securities.

Clawback Trigger and Covered Period

An issuer’s clawback policy must require recovery of incentive compensation erroneously paid during the three completed fiscal years immediately preceding the date on which the issuer is required to prepare an accounting restatement to correct an error that is material to previously issued financial statements. The final rules clarify that triggering restatements may include both (1) restatements that correct errors that are material to previously issued financial statements (commonly referred to as “Big R” restatements) and (2) restatements that correct errors that are not material to previously issued financial statements, but would result in a material misstatement if (a) the errors were left uncorrected in the current report or (b) the error correction was recognized in the current period (commonly referred to as “little r” restatements).

Although the Dodd-Frank Act did not require the SEC to mandate clawbacks in the context of “little r” restatements, the SEC previously expressed concern that excluding “little r” restatements from the scope of the rules might encourage opportunistic behavior by companies when choosing between a “Big R” and “little r” restatement. This requirement extends well beyond the reach of clawback policies currently adopted by most public companies and, when combined with other features of the rules, will likely lead to a significant increase in the number of required clawbacks.

As under the proposed rules, the final rules provide that the “date on which the issuer is required to prepare an accounting restatement” (which, in turn, triggers the three-year lookback for recoverable incentive compensation) will be deemed to be the earlier of:

• The date the issuer’s board of directors (or committee thereof) or the officer or officers of the issuer authorized to take such action if board action is not required, concludes, or reasonably should have concluded, that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws; or
• The date a court, regulator or other legally authorized body directs the issuer to prepare an accounting restatement.

Covered Executive Officers

The final rules define covered “executive officers” using the same definition used to determine an issuer’s Section 16 officers. This includes an issuer’s president, principal financial officer, principal accounting officer (or if there is no such accounting officer, the controller), any vice-president of the issuer in charge of a principal business unit, division, or function (such as sales, administration, or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for the issuer. The final rules also confirm that executive officers are subject to the clawback requirements without regard to any scienter or responsibility on their part related to the restatement or the mistaken payments. Moreover, the final rules prohibit issuers from insuring or indemnifying any executive officer or former executive officer against the loss of erroneously awarded compensation.

In a change from the proposed rules, the final rules will not require recovery of incentive-based compensation in circumstances where (i) the compensation was received by a person before beginning service as a covered executive officer or (ii) if that person did not serve as an executive officer at any time during the three-year lookback period for which the clawback rules apply.

Incentive Compensation Subject to Clawback

Similar to the proposed rules, the final rules define “incentive-based compensation” subject to the clawback policy to be “any compensation that is granted, earned, or vested based wholly or in part upon the attainment of any financial reporting measure.” The final rules clarify that “financial reporting measures” may include both GAAP and non-GAAP financial measures, and also includes measures linked to stock price and total shareholder return (TSR).

Specific examples of “incentive-based compensation” include, but are not limited to:

• Non-equity incentive plan awards that are earned based wholly or in part on satisfying a financial reporting measure performance goal;
• Bonuses paid from a “bonus pool,” the size of which is determined based wholly or in part on satisfying a financial reporting measure performance goal;
• Other cash awards based on satisfaction of a financial reporting measure performance goal;
• Restricted stock, restricted stock units, performance share units, stock options, and stock appreciation rights that are granted or become vested based wholly or in part on satisfying a financial reporting measure performance goal; and
• Proceeds received upon the sale of shares acquired through an incentive plan that were granted or vested based wholly or in part on satisfying a financial reporting measure performance goal.

Examples of compensation that is not “incentive-based compensation” for purposes of the final rules include, but are not limited to:

• Bonuses paid solely at the discretion of the compensation committee or board that are not paid from a “bonus pool” that is determined by satisfying a financial reporting measure performance goal;
• Bonuses paid solely upon satisfying one or more subjective standards (e.g., demonstrated leadership) and/or completion of a specified employment period;
• Non-equity incentive plan awards earned solely upon satisfying one or more strategic measures (e.g., consummating a merger or divestiture), or operational measures (e.g., opening a specified number of stores, completion of a project, increase in market share); and
• Equity awards for which the grant is not contingent upon achieving any financial reporting measure performance goal and vesting is contingent solely upon completion of a specified employment period and/or attaining one or more nonfinancial reporting measures (e.g., discretionary grants of time-vesting restricted stock, restricted stock units, stock options or stock appreciation rights).

Mandatory Recovery by Issuers and Related Disclosure Requirements

The final rules provide that a clawback policy must require the issuer to seek recovery of any incentive-based compensation paid to executive officers in excess of the amount that otherwise would have been received during the relevant three-year period had the compensation been determined based on the restated financial measure. The rules permit issuers to decline to seek such a recovery of payments only in very limited circumstances where:

• Direct expenses paid to third parties to assist in enforcing the policy would exceed the amount to be recovered and the issuer has made a reasonable attempt to recover;
• Recovery would violate home country law that existed at the time of adoption of the rule, and the issuer provides an opinion of counsel to that effect to the exchange; or
• Recovery would likely cause an otherwise tax-qualified retirement plan to fail to meet the requirements of the Internal Revenue Code.

Moreover, the final rules require issuers to file their clawback policy as an exhibit to their annual report and disclose in their annual report and in any proxy or information statements that call for disclosure pursuant to Item 402 of Regulation S-K, how they have applied the policy, including, as relevant:

• the date the issuer was required to prepare an accounting restatement and the aggregate dollar amount of erroneously awarded compensation attributable to such accounting restatement (including the estimates used in calculating the recoverable amount in the case of awards based on stock price or TSR);
• the aggregate amount of erroneously awarded incentive compensation that remains outstanding and any outstanding amounts due from any current or former named executive officer for 180 days or more, separately identified for each individual (or, if the amount of such erroneously awarded incentive compensation has not yet been determined as of the time of the report, disclosure of this fact and an explanation of the reasons why); and
• details regarding any reliance on the impracticability of recovery exceptions.

This disclosure will be required to be tagged in Inline XBRL.

The final rules also add a new instruction to the Summary Compensation Table requiring any amounts recovered pursuant to an issuer’s clawback policy to reduce the amount reported in the applicable column, as well as the “total” column” for the fiscal year in which the amount recovered initially was reported, and be identified by footnote. In addition, the final rules require new check-the-box disclosure on the cover of Forms 10-K, 20-F and 40-F that indicate separately (a) whether the financial statements of the registrant included in the filing reflect correction of an error to previously issued financial statements and (b) whether any of those error corrections are restatements that required a recovery analysis of incentive-based compensation received by any of the registrant’s executive officers during the relevant recovery period pursuant to Rule 10D-1.

Observations and Next Steps

Monitor the Effective Date of the Final Rules. Even though the final rules will become effective 60 days after publication in the Federal Register, the listing exchanges have up to 90 days post-publication to release their implementing rules which, in turn, must become effective within one year following the Federal Register publication date. Issuers will then have 60 days following the effective date of the listing exchange rules before they are required to implement the required clawback policy and comply with related disclosure requirements in subsequent proxy statements and annual reports.

Review Clawback Policies. Issuers should review their existing policies to consider potential updates that may be required under Rule 10D-1. However, issuers may want to wait for the listing exchanges to release their implementing rules before actually adopting or amending clawback policies to comply with the new rules.

Review Existing Incentive Compensation Plans and Agreements. Issuers should review their existing plans and agreements and consider incorporating language that specifically subject incentive compensation awards to any applicable clawback policies that the issuer may adopt from time to time.

Clawback Policies May Exceed Rule 10D-1 Requirements. It is important to note that Rule 10D-1 sets a baseline floor for minimum requirements that a clawback policy must meet, but does not prevent an issuer from adopting policies that would provide for recovery of compensation from individuals and in situations not specifically required by Rule 10D-1. For example, an issuer may choose to extend its clawback policy to cover individuals who are not executive officers and may also choose to implement clawbacks in situations not linked to financial restatements (e.g., situations involving employee misconduct or breaches of restrictive covenants).

Difficulties in Calculating Excess Compensation Amounts. The final rules may require issuers to conduct difficult and costly analyses to determine the amount of performance-based compensation that would have been paid to covered executives based upon restated financial reporting measures, particularly in situations involving updated TSR calculations or multiple performance measures. As the recalculation and related conclusions are required to be disclosed, there may be heightened scrutiny from plaintiffs’ lawyers challenging the methodology and/or the outcome of the issuer’s clawback analysis.

Impact on Prevalence of Incentive Compensation. The final rules may result in a shift in the balance of the total compensation provided to executive officers away from the types of incentive-based compensation awards that would be subject to the rules. For example, issuers may consider shifting a greater portion of executives’ total compensation into increases in discretionary bonuses or time-vesting equity awards in lieu of incentive-based compensation, in order to avoid the potential complexity of future mandated clawbacks. However, any such tendency may be mitigated by compensation committees’ and shareholders’ continued desire to substantially link executive pay to financial performance in the ordinary course.

1 As of the date of this Client Alert, the final rules have not yet been published in the Federal Register, but publication is anticipated within the coming weeks. (go back)

Supported By:

Subscribe or Follow

Program on corporate governance advisory board.

• William Ackman
• Peter Atkins
• Kerry E. Berchem
• Richard Brand
• Daniel Burch
• Arthur B. Crozier
• Renata J. Ferrari
• John Finley
• Carolyn Frantz
• Andrew Freedman
• Byron Georgiou
• Joseph Hall
• Jason M. Halper
• David Millstone
• Theodore Mirvis
• Maria Moats
• Erika Moore
• Morton Pierce
• Philip Richter
• Marc Trevino
• Steven J. Williams
• Daniel Wolf

HLS Faculty & Senior Fellows

• Lucian Bebchuk
• Robert Clark
• John Coates
• Stephen M. Davis
• Allen Ferrell
• Jesse Fried
• Oliver Hart
• Howell Jackson
• Kobi Kastiel
• Reinier Kraakman
• Mark Ramseyer
• Robert Sitkoff
• Holger Spamann
• Leo E. Strine, Jr.
• Guhan Subramanian
• Roberto Tallarita

There's one benefit that would entice people to sacrifice remote work, a survey found

• Housing benefits can lure employees back to the office and attract new talent.
• This is a focus as many employers try to bring workers back to the office after the COVID emergency.
• Tesla and Oracle have hatched plans to ease the cost of living for some workers.

Housing affordability is a problem in the US, and helping with those costs could be the carrot companies need to get employees back to the office .

In a survey of 1,020 employers and workers about office perks, performed by the bonding and insurance company JW Surety Bonds and published in January, 47% of respondents said they would be willing to return to the office in exchange for housing benefits. Additionally, 69% said they would be willing to change their job or career for employer-based housing benefits.

This comes as more companies institute return-to-office mandates, pitting employers and workers against each other. In fact, some employees quit instead of going back to the office. Now, some behemoth businesses, including Tesla and Oracle, are trying to use housing benefits to their advantage.

In a sign that housing assistance could be a stronger perk than more traditional offerings, 43% said they would take less vacation time in exchange for help with housing costs, and 30% said they would prefer housing assistance over a pay raise.

Ricardo Rodriguez, a creative-team member at JW Surety Bonds, believes housing assistance may become a major force in the job market in the next decade.

"As housing costs soar, these findings clearly indicate a trend of employer-based housing benefits gaining momentum," Rodriguez told Business Insider. "A strong interest in employer-based housing benefits could potentially redefine employee expectations of traditional compensation packages in the next 5 to 10 years."

Housing assistance may produce other benefits for companies

Edward L. Glaeser, a Harvard economist, and Atta Tarki, the founder of ECA Partners, an executive-search and project-based staffing firm, wrote for Harvard Business Review last year that companies looking to reduce their number of remote workers should consider housing assistance.

They pointed out that the cost of living in an area already influences wages and argued that more companies should get directly involved in those expenses for their employees by offering assistance in rental or mortgage subsidies, providing housing, or working with communities to build more affordable housing.

In the JW Surety Bonds survey, 25% of employers who responded said they're considering adding employee housing benefits in 2024, with an average assistance of $6,200 an employee. Additionally, about 70% of those planning to add a housing benefit said it would be used to entice workers back to the office.

However, getting more bodies in the office may not be the only benefit to a company.

The survey found that 77% of those already receiving employer-based housing benefits reported high job satisfaction, compared with 60% for those without the assistance.

Related stories

"It's crucial for companies to recognize that offering housing assistance is becoming a competitive necessity to attract and retain talent, as well as to maximize their employees' potential," Rodriguez said.

Some large companies are already adding housing assistance as an incentive

A February report from the real-estate firm Zillow found that homebuyers must make at least $106,000 to afford a house in the current market. In January 2020, people needed to earn about $59,000.

A report from Zillow published in February said home prices rose 42% during that month, while median income rose 23%.

With many Americans struggling to afford housing , assistance with rent or mortgages from employers could be more attractive than some traditional incentives.

Elon Musk's tunneling company, Boring, revealed plans in 2023 to build a 110-home subdivision for employees near the Austin suburb of Bastrop. The homes are expected to be offered as lease to own, with prices below market rate and close to facilities for Boring and other Musk-led businesses, Tesla and SpaceX.

One company that is already offering assistance is JBS Foods, a food-processing company.

JBS is spending more than $20 million to assist with housing expenses in eight cities across the US. The company owns apartment buildings for workers to rent in some communities. In others, it negotiates better housing prices or lending terms on behalf of employees.

Some companies are getting creative with housing assistance

A Washington Post-Ipsos poll of 1,148 full- and part-time workers published in May found that the biggest reason people wanted to work from home was avoiding commuting, with 48% of respondents naming that as the top factor.

The software company Oracle is one firm looking for ways to ease the commute of its employees. It's opening a $1.2 billion riverfront campus in Nashville , which could be completed by 2026 , and pledged $175 million for city infrastructure improvements. Part of that money is going to a new pedestrian bridge to connect the campus to a suburb on the other side.

Bobby Rolfe, the former commissioner of the Tennessee Department of Economic & Community Development who oversaw the negotiations with Oracle, told CNBC's "Cities of Success" in December that Oracle wanted its employees within 15 minutes of the office .

"Oracle's idea is, 'We want our employers to bike to work, hike to work, kayak to work, pick however you get to work but be within a very tight 15-minute radius," Rolfe said.

While Oracle's plan doesn't directly assist with housing costs, it could help employees save money on gas, free up their personal time, and decrease the need to own a vehicle.

Correction: An earlier version of this story incorrectly attributed the housing affordability data to Redfin. The report was produced by the real estate firm Zillow.

Have you taken a job that offered housing benefits and are willing to discuss how it changed your situation? Contact this reporter at [email protected] .

Watch: Nearly 50,000 tech workers have been laid off — but there's a hack to avoid layoffs

• Main content

• SUGGESTED TOPICS
• The Magazine
• Newsletters
• Managing Yourself
• Managing Teams
• Work-life Balance
• The Big Idea
• Data & Visuals
• Reading Lists
• Case Selections
• HBR Learning
• Topic Feeds
• Account Settings
• Email Preferences

Why Some Companies Grow Amid Uncertainty — and Others Don’t

• Simon Freakley
• David Garfield

A survey of 3,000 global executives suggests that it’s not strategic thinking that sets them apart. It’s their inclination to move quickly.

When you cannot base strategy on reasonably certain premises — or when those reasonable premises are undone by unforeseeable events — what is a company to do? You still have to make plans, allocate capital, and invest for the future. Some argue that agility is the key to thriving in disruptive times, but if all you do is pivot, you are just going around in circles. The annual AlixPartners Disruption Index surveys 3,000 global executives about what is knocking them sideways. Among other things, it shows that three out of five say that it is increasingly challenging to know which disruptive forces to prioritize. Amid all this, there is a group of companies doing very well: about one in five said their companies lead their industry in revenue growth. In this article, the authors dig into that 2024 data to find out what sets these companies apart, and what other companies can learn from them about setting growth strategy in an uncertain world.

Strategic planning plays a key role in helping companies anticipate and manage business cycles. But forces like emerging digital technologies, climate change, and deglobalization — not to mention “black swan” events like the Covid-19 pandemic and wars — have turned a rolling sea into a choppy one, where companies are beset by currents, crosscurrents, riptides, and squalls. This multiplicity of related, unrelated, and inter-related difficulties have one thing in common: They are unpredictable.

• SF Simon Freakley is the Chief Executive Officer of AlixPartners, a post he has held since 2015. He is based in New York.
• David Garfield is a Chicago-based partner and managing director of AlixPartners, and the global leader for the firm’s industry practices.

Partner Center

Brought to you by:

Best-Laid Incentive Plans (HBR Case Study)

By: Steven Kerr

Hiram Phillips couldn't have been in better spirits. The CFO and chief administrative officer of Rainbarrel Products, a diversified consumer-durables manufacturer, Phillips felt he'd single-handedly…

• Length: 1 page(s)
• Publication Date: Jan 1, 2003
• Discipline: Human Resource Management
• Product #: R0301X-PDF-ENG

What's included:

• Educator Copy

$4.95 per student

degree granting course

$8.95 per student

non-degree granting course

Get access to this material, plus much more with a free Educator Account:

• Access to world-famous HBS cases
• Up to 60% off materials for your students
• Resources for teaching online
• Tips and reviews from other Educators

Already registered? Sign in

• Student Registration
• Non-Academic Registration
• Included Materials

Hiram Phillips couldn't have been in better spirits. The CFO and chief administrative officer of Rainbarrel Products, a diversified consumer-durables manufacturer, Phillips felt he'd single-handedly turned the company's performance around. He'd been at Rainbarrel only a year, but the company's numbers had, according to his measures, already improved by leaps and bounds. Now the day had come for Hiram to share the positive results of his new performance management system with his colleagues. The corporate executive council was meeting, and even CEO Keith Randall was applauding the CFO's work. Everything looked positively rosy--until some questionable information began to trickle in from other meeting participants. It came to light, for instance, that R&D had developed a breakthrough product that was not being brought to market as quickly as it should have been--thanks to Hiram's inflexible budgeting process. An employee survey showed that workers were demoralized. And customers were complaining about Rainbarrel's service. The general message? The new performance metrics and incentives had indeed been affecting overall performance--but not for the better. Should Rainbarrel revisit its approach to performance management? In R0301A and R0301Z, commentators Stephen Kaufman, a senior lecturer at Harvard Business School; compensation consultant Steven Gross; retired U.S. Navy vice admiral and management consultant Diego Hernandez; and Barry Leskin, a consultant and former chief learning officer for ChevronTexaco, offer their advice on this fictional case study.

For teaching purposes, this is the case-only version of the HBR case study. The commentary-only version is reprint R0301Z. The complete case study and commentary is reprint R0301A.

Jan 1, 2003

Discipline:

Human Resource Management

Harvard Business Review Digital Article

R0301X-PDF-ENG

We use cookies to understand how you use our site and to improve your experience, including personalizing content. Learn More . By continuing to use our site, you accept our use of cookies and revised Privacy Policy .