by Bruno S. Frey and Margit Osterloh
Time frame: next week | Degree of difficulty: operationally easy, psychologically hard | Barrier: greed, economic theory
We’ve talked about this since the financial meltdown. Now it’s time to do it: Unlink pay from performance. The evidence keeps growing that pay for performance is ineffective. It also may induce executives to take company-killing risks. There are other ways to motivate employees that yield better results at lower cost.
Thanks mainly to provisions linked to performance, CEO compensation has skyrocketed in recent decades, while its correlation with actual corporate performance has remained as weak as ever. This has been most true in the U.S., where among the S&P 500 the ratio of average CEO pay to average employee salary went from about 40:1 in the 1970s to 325:1 in 2010. The ratio isn’t as extreme in most other countries, but the trend is the same. Below the top level, mismatches between pay and performance aren’t so acute. But all variable-pay-for-performance schemes still suffer from four inescapable flaws:
1. In a modern economy, where new challenges emerge constantly, it’s impossible to determine the tasks that will need to be done in the future precisely enough for variable pay for performance to work well.
2. People subject to variable pay for performance don’t passively accept the criteria. They spend a lot of time and energy trying to manipulate the criteria in their favor, helped by the fact that they often know the specifics of their work better than their superiors do.
3. Variable pay for performance often leads employees to focus exclusively on areas covered by the criteria and neglect other important tasks. This is known as the “multiple tasking” problem.
4. Variable pay for performance tends to crowd out intrinsic motivation and thus the joy of fulfilling work. Such motivation is of great importance to business, because it supports innovation and encourages beyond-the-ordinary contributions.
The idea that people work only for money has been thrown overboard by leading scholars. Research has shown that human beings are not interested solely in material gain. They care for the well-being of other individuals and value recognition from coworkers. Many employees apply themselves because they find their work challenging and worthwhile. These nonmaterial motivations point to better ways to get results from the members of an organization.
One way is to select employees more carefully, hiring people who are truly interested in the work—not people whose primary goal is earning the highest pay. Another approach is to pay fixed compensation but adjust it on the basis of a comprehensive evaluation of employees’ work after some time. This avoids the multiple-tasking problem. At the end of the year companies can also distribute part of their profits to employees according to their contribution to overall performance, rather than preset criteria. Awards and recognition are effective motivators as well. Research suggests that effort increases among both the winners and other employees when awards are given out.
Variable pay for performance, while it may seem attractive in theory, creates more problems than it solves. There’s no proof that it helps achieve its intended purposes, and other approaches not only work better but also strengthen employee loyalty.
Bruno S. Frey is the Distinguished Professor of Behavioural Science at the UK’s Warwick Business School and a professor of economics at the University of Zurich. Margit Osterloh is a professor of management science at Warwick Business School.