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Archive for the ‘Compensation’ Category

You Might Learn Something from a Pirate

Posted by Alex Drexel on October 4, 2009

BlackbeardAn article by Caleb Crain in the September 7th New Yorker provides a fascinating look into the business of being a pirate in the 17th century.  They were in some respects, quite forward thinking for their time when it came to keeping the crew aligned and motivated.  Most of us wouldn’t associate pay equity, performance based compensation and incentives, healthcare, democratic/bottom-up approaches to decision making, and racial tolerance with pirates, but research suggests otherwise.  Most of those practices came from the necessity of circumstances, rather than the existence of any higher ideals.

Before anyone was accepted into the crew, they had to agree to articles that dictated how booty, power and responsibility were shared on the ship – it created an at-will association that provided order.  Crew members knew in advance of any activity exactly what share they would receive and any add-on incentives they would be awarded for specific accomplishments.  Furthermore, an attempt was made to balance the shares paid out to the internal worth of each job – this included pegging the share the Pirate CEO (lead captain) received relative to the average man on deck.

For example, before the buccaneers, led by Captain Morgan, attacked Panama in 1670, it was agreed that Morgan would get 1/100 of the loot, while the rest would be divided in shares among the men.  Captains under Morgan got 8 shares, while each man got a single share. Those with specific skills received additional amounts; each participating surgeon got 200 pesos and any carpenters got an additional 100.  And there was incentive pay; anyone who captured a Spanish flag received 50 pesos, and the act of throwing a grenade into a fort got you 5 extra shiny pesos.  The agreement provided insurance against disability where the loss of an eye would yield 100 pesos and 1500 would be received in the unfortunate event of losing both legs!

Risk taking behavior was further encouraged through a crude form of estate planning (called matelotage), where two pirates agreed to keep the loot of whoever died first and distribute a portion to the dead man’s friends and family.

The system of paying out shares made every crew member an owner-operator which provided some alignment around the primary goal.  The democratic nature of decision making helped create buy-in and a sense of fairness among those who voluntarily served on the ship.  All decisions were voted on, including determining who would fill the role of captain.  The captain would have the authority to make executive decisions only in the heat of battle, otherwise, the crew members would have their say.  The captain could be deposed at any time by a vote, and was more or less seen as like any other crew member – the captain slept on deck with the rest of the men.

So while no one would agree with their profession, you might start to wonder if your organization is run as well as a pirate ship.  Is it?

Posted in Compensation, engagement, goals, leadership, management, teams | Tagged: | 5 Comments »

An Economist’s View of Compensation and Honesty

Posted by Alex Drexel on November 13, 2008

I always liked the field of economics because it allows us to model complex situations (given simplifying assumptions) which then give us insight into the relationships between variables and how they might react given some kind of change. The analysis becomes even more intriguing when we try and model human behavior. So let’s take a walk down memory lane for those of you took a microeconomics class in college as we apply some of what we learned to ‘ourselves’ and the failure of a rewards system.

Economists often refer to the concept of utility – it’s basically a measurement of value or happiness someone derives from a transaction. We can apply this concept to the amount of value a worker derives from their employment. After a bit of research into a worker’s preferences, we can start to build a utility function where overall value of employment is dependent on a number of factors; e.g. U = (1/2 Compensation + 1/2 Flexible hours). As you can see, the function expresses how utility is affected as each factor is adjusted, and it also shows the tradeoffs someone must make if they want to keep a constant level of utility when factors are adjusted up or down. The tradeoffs a person is willing to make at a constant level of utility is expressed in graphical form as an Indifference Curve; a person is willing to be on any point of the indifference curve since the amount of utility they derive will be the same no matter where they are on the curve.

Now that we have a function that captures preferences, we also need one that captures the constraints on those preferences – we all would like as much compensation and flexible hours as possible, but there are practical limits to these amounts and they must be recognized in tandem with individual preferences as we try and use this model to predict behavior. In order to maximize utility, an individual will make a choice where their indifference curve is tangent to the constraints they face (see graph below).

Indifference Curve 

The graph explains a situation where an employee’s utility is a function of money and honesty. Based on the slope of their indifference curve at various levels, they are willing to compromise honesty for more money.

An example of this situation could be where Jim, who works for a bond rating agency, is paid an annual bonus based on the revenue generated by his company. If Jim is honest and gives a poor rating for a mortgage backed security, the investment bank who paid the rating agency to rate the security may take their business somewhere else and the resulting revenue loss for the agency would impact the Jim’s bonus. This constraint placed on Jim by the incentive plan is represented by the line titled “Incentive Plan 1”. If we match this constraint with Jim’s preferences for money and honesty, Jim would choose HA amount of honesty in the report he produces and $A amount of bonus. If Jim isn’t too worried about his personal reputation (and more about his income), such an incentive plan would consistently produce inaccurate ratings and could damage the long term revenues for the firm. A company can adjust the constraints they place on employees by adjusting their incentive systems – this will impact the choices people make. If the agency changes its bonus formula for Jim so that less of it is dependent on short term revenue, it will cause the constraint curve to shift downward – this yields a higher level of honesty for Jim (HA->HB) and greater long term profits for the rating agency via stronger brand/reputation for the analysis they produce.

It’s hard to measure the preferences of individuals. We will all have different indifference curves; Al Capone’s indifference curve in the model above will look quite different to Mother Teresa’s. But measuring preferences at an aggregate level is a more realistic exercise. As compensation professionals design incentive plans, it’s important for them to recognize that, on average, employees will reach a point where they will be willing to ‘game the system’, manipulate performance measures or make some other compromise in their interests of maximizing utility. Therefore, it’s not enough to hire ‘honest people’ – you need to look at your rewards structure.

– Alex Capone

Posted in Compensation | Tagged: , , , , | 3 Comments »