Study: Deferred Comp Boosts Ethics

We have a fresh bit of ethics and compliance academic research to start our week: a study from Australia demonstrating that deferred compensation is indeed a good way to curb misconduct risk among employees — and can even boost employee productivity, too. 

The study comes from Elizabeth Sheedy, business professor at Macquarie University and director of the GRC Institute in Australia. Sheedy and two research associates, Le Zhang and Yin Liao, published a paper last week in the Journal of Banking and Finance exploring how financial firms can structure deferred compensation policies to reduce the risk of employee misconduct without driving talented employees to other fields.

penaltyThis is important because deferred compensation is one of those ideas that sounds like a sensible compliance policy (“Commit misconduct on the job and you can kiss that long-term bonus goodbye!”) but it’s been more difficult to implement in practice than one might assume. For example, some management teams worry that strict deferred compensation plans might drive their best employees to other firms with more forgiving plans. Other companies haven’t wanted to implement the idea at scale without clear proof that it will work. Such proof isn’t easy to get, since you’d need years to collect and analyze the data.

Sheedy’s team tried to solve this riddle with a controlled experiment they conducted in a laboratory setting. They had students and financial professionals work their way through a hypothetical tournament, rewarding participants according to several tiers of compensation — including a tier of deferred compensation that hinged on their ethical conduct.  

The result? Longer time horizons for compensation “will, as anticipated, significantly reduce misconduct,” Sheedy wrote. “Interestingly, it suggests that longer compensation horizons, combined with a deferral premium, will also improve productivity due to favorable self-selection effects.” 

Compensation Theories

Sheedy and her team begin with the premise that a company’s ability to monitor employee transactions is imperfect. At least some workers will engage in misconduct, and the compliance function won’t catch every instance of misconduct right away. This means the company needs more time to review employee transactions after they happen. Therefore the company should withhold some portion of compensation, to give itself that extra time to identify incidents of noncompliance.

Sheedy & Co. then go a step further. They reason that an “inherently more compliant” employee would actually prefer this system of deferred compensation, because it weeds out unethical coworkers who just want to cheat and get paid quickly. Those unethical types won’t want the extra scrutiny that comes with deferred compensation, so they bolt. 

As the authors say in their paper: 

An innately compliant person will prefer variable & deferred over variable & immediate payment due to enhanced monitoring. (S)he would not want to be competing against those that can attain high rankings by breaching the policy. Therefore, we hypothesize that more compliant individuals would prefer variable/deferred to variable/immediate if the deferral premium provided is sufficient.

So those more compliant employees might want a bit more compensation in total, because they need to wait longer to receive it all — but they wouldn’t be fazed by a longer waiting period conceptually, because they know they’ve got nothing to hide.

That was the hypothesis. Then Sheedy’s team performed their laboratory exercise using a mock financial services firm, where participants had to complete as many transactions as possible according to company policy about trading risk and potential losses. Participants also chose whether they wanted some performance-based pay right away, or greater performance-based pay after a deferral period.

The details of the experiment are laid out in Sheedy’s paper if you want to read them. The bottom line: more use of deferred compensation “would be a positive for the industry. Not only would misconduct likely be reduced due to better monitoring, but the ability to attract talented graduates would be enhanced, leading to overall enhanced productivity.” (If only such practices had been in place for firms like, I dunno, Wells Fargo.)

The Productivity Premium

So we have one conclusion, that deferred compensation plans can help a company reduce incidents of misconduct. That’s excellent news, but I’m even more intrigued by Sheedy’s second conclusion: that deferred compensation plans, rather than driving away your best employees, actually makes employee productivity go up

Sheedy found that when employees could choose between some compensation now or more compensation later, the more productive employees tended to choose deferred compensation. Why? Her conclusion here is worth quoting at length:

Those selecting variable/immediate payment are more likely to violate policies in order to enhance relative performance… In contrast, a productive individual can select the variable/deferred structure, confident of achieving a high ranking without the need to violate policy. A compliant and productive individual has nothing to fear from the increase in scrutiny and may even welcome the opportunity to demonstrate his or her skill under stricter conditions.

Quite simply, your best employees aren’t afraid of high ethical standards, and might even welcome such standards, because that lets them prove their worth and achievement even more. And then they get more money, too.

That certainly feels right to me. The best sales executives I’ve met over the years are repulsed by the idea of cheating to hit a sales quota. They want to win because they’re the best in their field — not because they offered a kickback or colluded with rivals. Of course people with an attitude like that would be high-performance employees. 

Compliance officers can use this study as fodder when talking with HR executives and leaders of your First Line operating units about compensation plans. Bring it to the compensation committee of the board, so those directors can structure executive pay packages smartly. 

The lesson here is that deferred compensation is nothing to fear. It helps to drive down corporate misconduct and helps to support a high ethics, high performance culture. What’s not to like about that? 

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