Tournament theory – the worst argument ever for overpaying executives

The executives in your company may be paid way more than they’re worth, but don’t worry – it’s for your own good.

That’s the point of a recent Forbes article defending overpaid executives which contains the single most disingenuous and illogical argument it has ever been my misfortune to see in a business context. From the article:

The ugly truth is that your boss is probably overpaid–and it’s for your benefit, not his. Why? It might be because he isn’t being paid for the work he does but, rather, to inspire you. In other words, we work our socks off in underpaying jobs in the hope that one day we’ll win the rat race and become overpaid fat cats ourselves. Economists call this “tournament theory.”

The article is based on a 25 year old economic paper on how tournament theory can be used to rank employees and allocate rewards like promotions and raises, arguing that:

1. Performance is hard to quantify, therefore rewards like promotions and raises are decided more by luck than by qualifications or results
2. Since rewards are mostly based on luck they need to be big or people won’t want to work hard to get them
3. Overpaying executives motivates others to work hard because they can rise to the same position
4. The tournament system is good for the company

I beg to differ. Here’s my step-by-step debunking to make sure we never have to see this horrible argument used to defend overpaid executives again.

1: Performance is hard to quantify, therefore rewards like promotions and raises are decided more by luck than by qualifications or results

From the article: …Managers find it hard to spot an excellent performance. It is a rare job where workers can be fairly paid according to some objective criteria.

This argument basically says that evaluating performance is tricky… so we shouldn’t even try to make salaries fair.

It’s clear to me that the most fair way to reward people at work is according to what they’re worth for the company based on their performance and results. This can be difficult to evaluate, but to simply give up and accept that rewards are mostly random seems silly and unfair. Even if we can’t find a system that’s 100% fair, we can try to make it as fair as possible.

2: Since rewards are mostly based on luck, they need to be big or people won’t want to work to get them

From the article: the more luck is involved in work, the larger the pay gaps should be between the winners and the losers. If Jack’s promotion is 90% luck and 10% effort, Jack may be inclined to goof off–unless, of course, the rewards for promotion are absolutely astronomical.

So: Promotions are mostly a matter of luck, and in order for this to work, the randomly awarded benefits have to be huge.

Am I the only one here thinking that it would make more sense to try to make rewards less dependent on luck rather than increase the rewards?

3: Overpaying executives motivates others to work hard because they can rise to the same position

No, this is fundamentally wrong. In fact, when rewards are the primary motivational factor most people become less efficient – especially when the rewards are unfairly decided. Alfie Kohn’s article on Myths About Money and Motivation is a great paper on this, based on massive psychological research.

Even if this kind of motivation did work, it could only work on those employees who have a reasonable shot at getting one of the overpaid jobs. But the majority of employees have long since accepted that they’re never going to be VPs or CEOs and for them the tournament system can only be demotivating because they see others getting unfairly large rewards that they will never get, no matter how well they perform.

4: The tournament system is good for the company

I think this system is little short of a disaster for businesses, resulting mostly in frustration among employees who are consistently not rewarded for doing great work. This frustration results in a loss of motivation and happiness at work and consequently to lower productivity and higher employee turnover and absenteeism, just to mention a few issues that can cost companies millions.

Also, a recent article in the New Yorker James Surowiecki points out that companies that overpay their CEOs have worse performance than others. One quote from the article:

One recent study of the market between 1992 and 2001 by economists at Rutgers and Penn State found that the more a C.E.O. was paid, relative to his peers, the more likely his company was to underperform in the stock market.

There are a few additional misconceptions in the article that need debunking.

Stock options

From the article: Tournaments also help protect workers against risks they cannot control. Companies can be affected by recessions, unexpected competition and hurricanes. As long as every worker is equally affected, the incentives to try hard remain the same. Trying to encourage performance through, say, stock options would unnecessarily expose workers to risks without really encouraging them to work harder.

First of all, I think it’s touching that companies want to protect their people by not giving them stock options.

At the same time, most CEO’s and other top executives do get stock options, because common wisdom dictates that this motivates them to better performance.

So in summation: Stock options for employees are dangerous and not really motivating. Stock options for executives are essential to motivate them. All clear?

The evidence

From the article: Lazear and Rozen’s tournament theory has stood the test of time and been supported by many subsequent pieces of empirical research.

There’s also massive amounts of research pointing out the opposite – I mentioned some examples above.

Suddenly everything is clear

From the article: Economists don’t even pretend that your boss deserves his salary. Suddenly, everything is clear.

But apparently some of them pretend that this is a good system, one that inspires employees to do their best at work and creates good performance in a company. Some of them even say that it’s good for the employees.

I find it more likely that these theories are floated in an attempt to make an unfair but ingrained business practice survive a little longer against the onslaughts of common sense. Like all such attempts it’s ultimately doomed to fail.

Did I miss any more fallacies in the original article? Tell me about them in a comment.

What to do instead

Alfie Kohn’s recommendation is simple: Pay people as fairly as you can. Then focus on other things than rewards.

True motivation and great performance at work is never about salary – very few people do their best work while wondering how much cash they will make from it.

The tournament argument completely fails to appreciate this and that’s why companies who choose this approach are forever doomed to sub-standard performance, massive frustration and zero motivation.

If you liked this post I’m pretty sure you’ll also enjoy these:

• Why secret salaries are a baaaaaad idea
• High CEO pay = low performance
• Things that don’t make people happy at work – but many people think they do