Creating A Performance Based Pay System

There are few concepts in the business world which capture people’s attention more than employee benefits. After all, however interesting such abstract concepts as financial markets, return on equity and leverage ratios may be, there is something about the size, shape and nature of our pay check which seems to have a direct line to the attention centre of our brain.

Much experimentation and research has been done on the topic of incentives, both in the academic and business worlds, and most researchers have aligned themselves around two main schools of thought.

The first camp is that of the sceptics. They argue that performance based pay schemes consistently fail to produce lasting changes in attitude and behaviour; instead, they only temporarily change the way we behave.

One of the primary arguments of the sceptics is that extrinsic motivators (pay, bonus, vacation, perks) cannot substitute or drive intrinsic motivation. Basically, if you hate your job, your pay check won’t make up for that. Anyone who has ever worked in a role he hated, with a team he didn’t fit in, can certainly recognize the wisdom of that argument. Moreover, the sceptics argue, while it is obvious that cutting pay is de-motivating, there is no reason to believe doubling someone’s pay would result in better work, once above a certain threshold.

Also, the sceptics point out that there are studies (“Why Some Long-Term Incentives Fail”, by Jude Rich and John Larson) which show no correlation between executive incentive plans and increased returns to shareholders, with one potential explanation being that reward systems discourage exploration and risk-taking. The argument is that if the reward is significant, people will do exactly what they are asked to do, and choose not to explore riskier but potentially more lucrative ideas, lest the reward be withdrawn.

Reward systems are also regarded by sceptics as a primary cause of communication disruptions and failing morale. This problem, the sceptics argue, is even more exacerbated when there is a limited pool of employee benefits; in those types of situations, one person’s gain is another one’s loss, and it is only a matter of time before employees start regarding each other as competitors rather than colleagues. Moreover, this type of competition is often publicized through corporate-wide newsletters, memos and announcements.

On the other hand, the camp of the supporters argues that reward systems not only work, but are also fairer to employees, managers and shareholders alike.

According to the supporters, the core of the issue stems from the nature of the principal/agent relationship. This kind of relationship, or the agency relationship, as the economists call it, occurs whenever one party (the principal) hires another party (the agent) to take actions or make decisions that affect the payoff to the principal. This type of relationship is widely applicable in the business world. An agency relationship occurs when shareholders of a company select the management team who will take decisions that will impact their wealth; likewise, whenever a manager hires an employee to take actions or decisions, the same type of relationship occurs, since the poor performance of an employee will directly and negatively reflect impact the manager’s performance.

A non-obvious side effect of the agency relationship is favouritism; a study by Bandiera, Barankay and Rasul, conducted on a fruit farm in England, found, perhaps unsurprisingly, that some supervisors tended to help favoured workers more, who in turn earned higher wages as a result. Interestingly, favouritism stopped, and overall efficiency increased, when the farm started paying the supervisors themselves according to the productivity of the workers.

Performance based bay systems, supporters argue, simply align the interests of the parties in a way that fixed-pay systems cannot do. The agent earns more when the principal earns more, and less when the principal earns less, and so is more willing to take actions that benefit the principal. Furthermore, in practice, it is not only the size, but the nature of the reward that varies as well. For example, the residential real estate firm Century 21 hosts a free vacation to a luxury resort for agents who meet performance goals, while Reagan Outdoor Advertising announces its employee-of-the-month on billboards near the company’s headquarters. In practice, status and luxury seem to be just as good motivating factors as money, for some people.

The debate will likely continue for some time, and both sides have valid arguments and examples. But perhaps, with such a sensitive topic, extra care should be taken not to dismiss a good idea because of some poor implementation examples. If people do exactly what they are rewarded to do, then managers should carefully choose what they reward. If some individual reward systems promote unhealthy competition, then perhaps team-based incentives are more appropriate.

While there is no definitive answer, there are three key guidelines which a manager can use to think about reward systems in practical terms.

First, one should consider the factors underlying the agency relationship; what affects the payoff to the principal? What decisions do employees take which affect the company’s bottom line? The answer to that question may not be immediately obvious, as some decisions are neither formal, nor visible. For example, how long of a coffee break do I take? Do I double-check that I have all the tools and materials I need before heading out to a client? Should I spend half an hour over lunch sharing my experience and best practices with the new guy in the team?

Second, one should also consider what exactly is under the employees’ control. How do the actions of other parties influence the ability of the employee to control the outcome? Does someone else control the flow of raw material to my work station? It is important to carefully assess the effect of such decision spillover effects, in order to avoid building a system which can be perceived as unfair.

Third, one should consider the nature of the rewards themselves. Some organizational cultures may value status or recognition over money; it is important to recognize this fact in order to design appropriate rewards. Providing monetary rewards when public recognition is expected means not only wasted money, but may even be perceived as insulting in some cases.

It is therefore important to recognize employee benefits as a powerful tool, perhaps the most important way to set the tone of the organizational culture. The corollary to that statement is that if change is needed in the culture of an organization, its reward system is oftentimes a good place to start.

Ultimately, while it may be perfectly possible to run a successful organization without a performance based system, a wise manager should carefully consider whether such an organization is as successful as it could have been otherwise.