Movement to curb executive perks could stifle the innovation that companies need, according to MIT Sloan professor

Research shows that rewarding long-term success while not punishing early failure is the best way to promote creativity

CAMBRIDGE, Mass., May 5, 2009 — While the public clamors for executives to pay for the woes of the economy, curbs on bonuses, stock options and golden parachutes could backfire by discouraging innovation, according to Gustavo Manso, assistant professor of finance at MIT's Sloan School of Management.

“If you want people to be creative, you have to give them slack to try new things and make mistakes,” says Manso, an expert in motivational strategies.

“At the same time, you need to reward for long-term success to motivate individuals to search for better ways of doing things.”

Manso bases his conclusions, in part, on an unusual experiment he and a colleague conducted recently involving virtual lemonade stands. Volunteers were divided into three groups. The first was paid a flat wage to manage the lemonade stand; the second, a flat percentage of the profits. The third group was not paid anything at first but was told to expect 50 percent of the profits in the second half of the experiment.

The third group was far more likely to find the best location for the lemonade stand and generate higher profits.

The researchers also introduced the notion of golden parachutes by offering different deals to two groups of subjects. Both were told they would get 50 percent of the profits in the second half of the experiment. Both also were told if they were not generating profits, the experiment would be called off early.

The researchers then told one group that a termination bonus would be provided if the experiment ended early. The other group was not offered a bonus. The group offered the bonuses was significantly more likely to choose the best business strategy for the lemonade stand.

Manso's conclusions clash with current public sentiment in the United States against executive perks and calls for managers to be held to strict performance standards. Companies that received federal bailout money have had executive salaries capped. Firms not receiving bailout money also have been affected as shareholders have clamored for strict limits on executive pay.

According to Manso, these curbs on compensation could discourage the very innovation that companies and the broader economy desperately need to recover from the economic slump.

“Trying to prevent the use of some of these instruments may be harmful for companies that are using them in good faith to promote innovation,” Manso says.

Manso also recommends long-term contracts for executives whose jobs require innovation and creativity. “It gives them the job security needed to go out and try new business strategies,” he says.

In another project, Manso studied incentives for academics in the life sciences. He found that scientists who received longer-term grants tended to do more ground-breaking research and come up with more important discoveries than scientists who had shorter-term grants.

The key to encouraging innovation is having the right combination of incentives, according to Manso. “Tolerance for early failure allows you to go out and try things. Reward for long-term success gives you the incentive to search for the best way of doing things,” he says.

Golden parachutes in business, tenure in academia, and lenient conditions for bankruptcy are all things that encourage creativity and innovation, he says.

Manso points out that innovation is not desirable in some jobs, and for them, other compensation schemes should be used. For workers assigned routine tasks, he suggests a “pay-for-performance” approach-in which employees are rewarded consistently for productivity.

Manso says the recent spectacular failures on Wall Street and unsuccessful innovations like mortgage-backed securities do not invalidate his ideas. In those cases, the compensation schemes may have been weighted too heavily toward short-term success, he speculates.

“One possible explanation is that the incentives were wrong-that they had golden parachutes and severance payments, and they also had rewards for short-term profits. That's the wrong combination,” he says.

Manso understands the outrage people feel toward high paid executives getting bonuses at failing companies.

“It makes sense, but we just need to be careful about the adverse effects actions might have,” he says.

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