Performance-related pay doesn't encourage performance

25 Jun 2009

(orig. article http://www.management-issues.com/2009/6/25/research/performance-related-pay-doesnt-encourage-performance.asp?section=research&id=5640&specifier=&is_authenticated=0&reference=)

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