The Limits of Monetary Incentives

Monetary incentives are the bedrock of today’s employee motivation and change management programs. The logic is simple and straightforward: change the monetary incentives and the desired behavior will occur. The theoretical basis for money as an effective motivator is well researched. Generally, several studies have shown that money is effective in attracting, motivating, and retaining employees, and creating a high performance culture.

But strong and pervasive, financial incentives also have serious limitations. Recent findings in psychology suggest that monetary incentives should be used with caution and complemented by nonmonetary ones. Let me explain.

Monetary incentives tend to be most effective when there is a clear and immediate causal link between an individual action and a desired outcome, and when the desired outcome is easily measurable. For example, monetary incentives are effective in encouraging improved sales activities, such as incentivizing insurance agents (individually or as teams) to sell insurance products, or in investment banks. But in other situations, they may be counterproductive.

First, they tend to draw attention to and focus on activities and outcomes that are remunerated, while other activities, important as they may be for an organization, may not receive much attention. For example, when monetary incentives promote the achievement of the year’s budget, many firms observe short-term-oriented behavior at the expense of long-term investments.

Second, financial incentives can also reduce desired social behavior, such as cross-unit collaboration. In a study published in 2002, Ernst Fehr of the University of Zurich and Armin Falk of the University of Bonn showed that monetary incentives targeted at promoting moral behavior may achieve the opposite and, in fact, undermine moral behavior.

Third, monetary incentives used inappropriately can change the expectations of what people consider moral behavior. When monetary incentives replace moral incentives, this can lead to people changing the standards of what they perceive to be right or wrong.

Fourth, excessive monetary rewards can lead to people cheating, especially if controls are lax and the chances of being caught are small.

Building Effective Incentive Systems

By and large, money seems to be a hygiene factor, important for recruiting and retention, and important for creating a performance culture. Monetary incentives tend to be most appropriate when they lead to measurable, direct results that have an impact on the bottom line (profit and loss statement) or key performance indicators (KPI) clearly linked to the desired and incentivized behavior.

Money also works well when there is little room for cheating, that is, when there are no excessive rewards and when controls are rigorous. As mentioned earlier, monetary incentives typically work well with sales jobs.

However, money is not a great motivator. When basic factors such as fair and sufficient pay are in place, the additional performance boost from financial incentives is minimal, and nonmonetary incentives then become better motivators. These may include achievement, meaning, recognition, the intrinsic nature of the work itself, autonomy, opportunity for growth and advancement. As an example, 3M and Google provide free time to their employees so that they can spend work hours on special pet projects they are passionate about pursuing.

Ideally, therefore, a system will combine monetary and nonmonetary incentives. While highly effective, the use of nonmonetary incentives is more demanding—in two ways—for those, the leaders, who have to administer them.

First, the application of social recognition and performance feedback requires leadership skills. Social recognition, and performance feedback are most effective when:

  • Conveyed in a positive manner
  • Delivered immediately after observing performance levels
  • Represented visually, such as in graph or chart form
  • Specific to the behavior that is being targeted for feedback
  • Leaders consequently need to be trained to administer nonmonetary incentives effectively

Second, the use of nonmonetary incentives requires a high level of integrity and ethical behavior from leaders. The administration of nonmonetary incentives is effective only when the administering leader visibly performs the expected social behavior. In other words, role modeling is essential.

More generally, and for both monetary as well as nonmonetary incentives, an effective incentive system needs to meet six criteria. First, people know their roles and understand exactly what is expected of them. Second, people have the capabilities, authority, information, and resources required to deliver on the results expected. Third, people know exactly what good looks like, so the key factor in unleashing higher performance is motivation and the will to demonstrate the required behaviors. Fourth, bonuses are appropriately tied to good behavior and good outcomes. Fifth, the organization uses a fair and accurate system to measure outcomes and assess performance (while controlling compliance with regulations and policies). Sixth and last, people get frequent and constructive feedback on whether and how past performance deviates from desired standards.

Author of "Serial Innovators: Firms That Change The World" (Wiley), Claudio Feser is a director of McKinsey & Company, where he leads the McKinsey CEO Network that focuses on CEO training and coaching. Feser previously managed McKinsey offices in Switzerland and Greece.