Business owners who want to pay employees for performance should take a good look at what happens during the off-season of any professional sport. They should, that is, if they want to learn how not to do performance-based pay.
That’s the conclusion of Lamar Pierce, a strategy professor at Washington University in St. Louis, Mo., who said bidding wars for top free agent athletes tend to inflate salaries unjustifiably. In a paper, called “The Psychological Costs of Pay-for-Performance: Implications for the Strategic Compensation of Employees,” Pierce said an elite performer like Albert Pujols, who labors for the St. Louis Cardinals and is considered by many today’s best baseball player, expects to be the best-paid player. However, because the major league's current top earner, New York Yankee Alex Rodriguez, is overpaid based on his recent performance under a long-term contract, Pujols too will be overpaid, later if not today, Pierce says.
The difficulties with pay-for-performance are, if anything, worse in business. For one thing, Pierce notes, a sports metric such as a batting average is easier to figure and harder to dispute than, say, quality of customer service or effectiveness of a public relations campaign. In the absence of indisputably objective performance measurement, employees get upset if told they earn less than others because they don’t perform as well. “It’s really hard for people to rationally understand and accept how good they actually are,” Pierce says.
Despite these and other issues, paying for performance is becoming almost the norm. A 2010 survey by staffing firm Kelly Services found 25 percent of workers had some of their pay tied to meeting performance targets. And Priya Kapila, a manager with CBIZ Human Capital Services in St. Louis, said continuing economic uncertainty has made across-the-board salary increases and cost of living adjustments increasingly uncommon. “Not only bonuses are based on performance, but salary is as well,” Kapila says.
The problem with performance-based pay
Paying for performance is supposed to motivate people to perform better. However, Pierce says, it can actually demotivate people who feel they’re being unfairly paid less than others. “Everyone is above average in their own mind, and usually that’s an understatement,” Pierce says. Employees who feel they're underpaid may be less productive, or even actively sabotage the company’s output, he warns.
Managers aren’t immune to this syndrome, says Kapila. When companies ask supervisors to rate employees as part of a performance-based compensation system, managers tend to rank all their employees as all-stars. “Everybody’s rated excellent so everybody’s getting an above-average increase,” Kapila says.
Even when employees aren’t upset by the ranking system, they may sabotage each other’s work so they can qualify for better pay, Pierce says. Basing incentives on team rather than individual performance can help with that problem. However, top performers tend to dislike team-based incentives, because they feel some team members are coasting or not contributing their share. That can lead to turnover among the best employees, he says.
Determined to pay for performance?
A business owner bent on trying performance-based pay should focus on creating easily measured, clearly objective, highly relevant metrics on which he can base incentives. Job descriptions can suggest what you should measure, Kapila says. To get around managers’ tendency to rank all their own employees highly, have managers get together to talk about measures, calibrate their scales and agree what it means to be highly rated.
Other elements of successful pay-for-performance systems include ongoing training, frequent reinforcement and leadership from the top to get the whole organization committed to the plan. Evaluations should be followed up on, to let employees know how well they are progressing toward getting a more positive evaluation. And incentives, whether raises or bonuses, should be made more often than annually, perhaps as frequently as quarterly.
Is bypassing performance the answer?
Perhaps the best approach, Pierce says, is to pay employees based on a standard scale, plus incentives for superior performance. When salaries and raises aren’t based on performance, it limits the Alex Rodriguez scenario, where a former top performer is still getting top wages. But it’s not a good idea to set scales too low, he says. Instead, aim to pay a little better than the average, which will reduce turnover and keep employees motivated to hang onto jobs that they can’t easily replace.
It’s also a good idea to keep what everybody’s earning a secret. This isn’t always possible in the case of government employees, where salaries are often a matter of public record. But in many workplaces, companies can refrain from publicizing salaries and bonuses, and workers can be urged to keep them private. “People think about this very differently based on whether those numbers are public or not,” Pierce says of performance-based pay.
The fate of performance-based pay
Paying for performance will always be easier to do with athletes and factory workers—where performance may be easier to measure—and harder to do with CEOs, government employees and service industry workers, says Pierce. Service industry output, in general, is less easily measured and productivity tends to be team-based, complicating efforts to pay for performance. That’s a problem for performance-based-pay, since Western economies are undergoing a long-term shift toward more service-sector businesses and jobs. “As work becomes less separable, it’s going to become more difficult,” Pierce says.
Shorter-term, Kapila expects that an improving economy and lower unemployment will encourage more across-the-board raises and cost-of-living adjustments. But she doesn’t expect performance-based compensation to lose much ground, if any. “We’re seeing across industries an increasing shift toward pay for performance,” she says.
Whether or not the economy experiences an upswing soon, Pierce suggests keeping an eye out for opportunities to motivate top performers with richer benefits—such as flexible schedules, time off and health benefits—rather than purely financial incentives. Employees value those perks highly, he says, and using them may help get around the apparently hard-wired demand for fairness—or even outright equality—that humans have when it comes to who gets paid what.
In much the same way that Albert Pujols is likely to be more concerned about out-earning Alex Rodriguez than anything else, nonsuperstar employees just want to think they’re getting a fair deal. “A lot of people would rather make $50,000 when everybody else is making $50,000 than make $75,000 when everybody else is making $100,000,” says Pierce.