Performance-related pay doesn't encourage performance

2009

The clue ought to be in the name. Performance-related pay is pay for performance, and the better performance you turn in and the harder you work the more you will get to take home. Except, academics are now suggesting, more often than not the opposite may be the case.

New research by the London School of Economics has argued that, far from encouraging people to strive to reach the heights, performance-related pay often does the opposite and encourages people to work less hard.

An analysis of 51 separate experimental studies of financial incentives in employment relations found what the school has described as "overwhelming evidence" that these incentives could reduce an employee's natural inclination to complete a task and derive pleasure from doing so.

The findings are, of course, deeply controversial, given the depths of anger still felt by many over the role of performance-related pay in causing or contributing to the current economic crisis.

"We find that financial incentives may indeed reduce intrinsic motivation and diminish ethical or other reasons for complying with workplace social norms such as fairness," argued Dr Bernd Irlenbusch, from the LSE's Department of Management.

"As a consequence, the provision of incentives can result in a negative impact on overall performance," he added.

Companies therefore needed to be aware that the provision of performance-related pay could result in a net reduction of motivation across a team or organisation, he suggested.

Organisations also needed to be looking closely at how they designed effective workplace incentives in the future.

The full research is due to be unveiled next week at a round-table debate, and will include further research by the school suggesting that extra incentives can lead high-ability workers to form teams with similarly skilled colleagues rather than workers they are socially connected to.

Yet socially connected workers tend to work together better and produce better results, meaning that, as a consequence, increased incentives can even reduce a firm's average productivity.

The LSE academics are by no means the only ones questioning received wisdoms over executive and performance-related pay at the moment.

Harvard Business School's V G Narayanan , writing in this month in the Harvard Business Review, has argued forcefully that a wholesale rethink is needed on executive pay, not just tinkering around the edges.

Narayanan, Thomas D Casserly Jr professor of business administration at the school, has suggested that, rather than politicians or the public asking how much should chief executives be paid (a question, he argues, more born of jealousy than anything else), they should be asking "how should they paid" and the less pithy but just as important, "should changes in the way CEOs are paid be mandatory or voluntary?".

"Pay must be structured to attract the right executives and give executives effective incentives to lead their companies to great performance," he agreed.

"The poor showing of too many firms, despite ample CEO salaries and equity packages, and excessive compensation at times of poor performance shows that pay typically isn't structured correctly and that executive compensation practices need serious reform," he added.

All too often, executive incentives were (and still are) based mostly on short-term financial metrics and shareholder returns.

Therefore, financial results tended to be the consequence of a firm's strategy formulation and implementation.

"Effective incentive systems should focus on effective organizational learning and growth, process improvements, and customer-related metrics and milestones," he advised.

"In addition, companies should design compensation packages to attract the right people for implementing the company's strategy. For instance, below market salaries coupled with aggressive incentive pay linked to individual performance is likely to attract self-motivated entrepreneurial individuals.

"Companies also need to assure their executives longer tenure and horizons. A CEO who is afraid of being fired for not making short-term financials will not focus on the long term.

"A board that is actively engaged in strategy formulation and implementation and compensates a CEO for strategy implementation milestones and monitoring long-term performance is more likely to understand, appreciate, and encourage a CEO's efforts even if they yield short-term financial results that are below expectations," emphasised Narayanan.

There was an urgent need for boards to evaluate their executives' performance annually to determine their progress on long-term goals.

Simultaneously, boards needed to engage more in active succession planning so they did not find themselves looking for a "superstar CEO" to rescue them from financial problems.

"It is precisely in those situations that CEOs are able to negotiate outrageous compensation packages," said Narayanan.

"Simultaneously, companies should get rid of egregious practices such as over the top severance packages (more than two times annual compensation), grossing up taxes, defined-benefits plans, guaranteed returns on deferred compensation, accelerated vesting in the event of change in control, and time-based vesting of restricted stock," he added.

"It would be highly unfortunate if, as now seems possible, massive amounts of regulation and active government intervention were to be the dominant forces determining how American executives are compensated," he suggested.

Initiatives such as caps on pay, shareholder "say on pay" and ceilings on ratios of CEO pay to worker pay, appointment of a "federal compensation Tsar" and labelling of incentive pay as pay that causes excessive risk all simply reduced innovation and hurt shareholders, he argued.

"Governmental and shareholder second-guessing on pay would create an environment of fear in which no board would dare try an approach that's different from the herd's or that is tailored to the company's particular strategy," said Narayanan.

"While compensation reform is needed, it must come from within--from executives and boards, acting in the company's best interests," he added.

Management-Issues columnist Bob Selden also highlighted the limitations of performance-related pay back in January 2008.

He argued that performance-related pay, by running contrary to teamwork, could ultimately damage organisational effectiveness and the loss of expertise just when it is needed most.

"Many organisations today are looking to increase their bottom line by paying their people to improve individual performance. For instance, it is now quite common for a large percentage of a person's salary (particularly senior managers) to be based on their performance, with a smaller component made up of base salary," he said.

"Why do organisations continue to throw money at performance issues? If organisations were better managed and led, would there still be the need to offer people incentives to perform?" he questioned.

In companies that were well-managed and where people were led really well, enjoyment and engagement could become much more important factors than simply salary or performance-related pay and bonuses, he suggested.