What should a Compensation Reward for?

In today’s world given the premise that “People respond to incentives”, we in our personal and professional roles are goaled to achieve desired outcomes- of course, it has to do only with ‘Gain’ as a desired outcome. For instance, we want our kids to attain 99.99% in exams. We want our management team at office to focus only on “Outcomes”.

But then this is all so good under another premise “All humans are rationale in their decisions at all times.” Without overstating, this fact was ‘never’ true ever since it was premised in all of the key economic theories.

If a doctor performs an operation and the patient survives, this is weighted higher than if the patient dies. Extending the logic further, is doctor’s decision to follow a particular operation procedure driven by his past experience or based on the medical records presented to him?

It can safely be argued that any of the approach followed – experience or existing medical records- the outcome is unknown. This means the factor of ‘luck’ on whether the patient survives or dies is significant enough to ignore. So if a compensation structure premised purely on the ‘outcome’ of the patient surviving then the probability of Doctor earning a reward is 50%.

If the Doctor is assumed to be the rare individual who is ‘rational’ all the time, he will stick to the same process that is most appropriate whether this rewards him or not. If this is true,on the contrary, the probability of success is equally higher when a bad processes is followed. Hence, a compensation structure should also factor in a process of effective risk management. For e.g. an inappropriate compensation structure will not help reduce dependence on a single large customer.

Given the intricacies involved in fixing an appropriate compensation structure a due consideration to:

a. Absolute wealth of an employee- He is prone to take more risks since personally he has limited risks for failed outcomes.

b. Compensation relative to an average employee- It should be only to ‘differentiate’ optimally. It cannot be 200% more than what an average employee is currently earning. If this is the case then it points to the notion that shareholders believe in Super Hero who is in limited supply in industry.