Cafe Economics | Niranjan Rajadhyaksha

http://www.livemint.com/2008/09/09223604/Problem-with-variable-pay.html?h=B

It has
been estimated that about one-third to half of all American workers
have part of their earnings tied to the overall performance of the
firms that employ them, through profit sharing, direct ownership or
stock options.

This particular tide is rising in India as
well. In a recent survey of 540 locally owned, foreign-owned and joint
venture companies conducted by consulting firm Hewitt Associates, 95%
of the respondents said they had variable pay plans in 2007. The use of
stock options, too, is growing, with most large companies listed on the
stock exchange giving their employees the option to buy shares at a
later date and at a predetermined price.

Tying
an individual’s performance to the overall performance of a company
seems a good idea. The interests of shareholders and employees are
aligned. You really care whether the company prospers or goes down the
tube. Some economists have shown that both employee productivity and
company growth are higher when employees have a stake in the growth of
the firm that employs them. There is some form of incentive
compatibility.

But there are several problems as well, though
they will tend to remain under the surface when profits are growing
rapidly and stock prices are soaring. But I suspect that the coming
slowdown in profit growth (which will hurt variable payments to
employees) and the decline in stock prices (which will send stock
options below their strike price, or under water) will lead to growing
employee dissatisfaction in the quarters ahead.

Are company human resource departments ready for this?

There
has been a lot of research by economists in recent years about the
system of paying workers — either directly through variable pay or
indirectly through stock ownership — based on company performance
rather than the market price of labour. There is even a name for these
arrangements: shared capitalism.

The first big problem in
shared capitalism is what is called the free rider problem. Say you are
one of the hundreds of employees who will get paid a large chunk of
their salary in the form of variable pay. Individually, you have little
direct impact on the overall performance of the company: You are a cog
in the wheel. There is, thus, an incentive to take it easy in office;
you hope the other cogs will work hard enough to help the company meet
its goal. You are what economists call a free rider.

This
would be less of a problem when the economy is booming. Companies find
it relatively easy to meet their sales and profit targets, and so
everybody walks away with an impressive stash of money. Free riders are
less likely to be abhorred. But the mood could change in a downturn.
The ant may ask why the grasshopper is getting the same variable pay
deal as it is. There could be tensions in cubicle land.

The
other problem is more personal. You have already bet your human capital
on one company. Shared capitalism ensures that you are also betting
large parts of your financial capital on the same company. It’s a poor
diversification of risks—too many eggs have been placed in this one
basket.

In a new paper published this month by the National
Bureau of Economic Research, an American research outfit, three
economists have examined issues of risk and the lack of diversification
in shared capitalism. “Since shared capitalism, especially in the form
of employee stock ownership and stock options, is an investment, we
need to examine it from the critical perspective of risk,” write Joseph
R. Blasi of Rutgers University, Douglas L. Kruse of Rutgets University
and Harry M. Markowitz of the Rady School of Management in California.
(Markowitz is a pioneer of the modern theory of portfolio choice, for
which he won the Nobel Prize in economics in 1990.)

They ask
whether risk is really “the Achilles heel of employee ownership”. There
is little doubt that employees with stock ownership or options have put
too much risk in one basket. But Blasi, Kruse and Markowitz show that a
lot also depends on each individual’s view of risk and the culture of
the companies they work in.

For example, risk-averse
employees are less likely to respond to the incentives provided by
stock options. Employees who feel they are underpaid are more likely to
look at the payments from ownership as wage substitutes rather than
added incentives.

And a lot also depends on workplace
culture. “In the absence of empowerment, shared capitalism may easily
be seen as nothing more than increased income risk, whereas empowerment
creates a greater sense that one can affect workplace performance and
rewards under shared capitalism.”

In other words: The success
or failure of variable pay and stock option schemes depends on the
context, both personal and organizational. This is something that
Indian companies, too, will have to understand if the current headwinds
continue to blow them off their path.