THE PITFALLS OF PAY-FOR-

PERFORMANCE

Pay-for-performance (PFP) is often seen as a virtually guaranteed means of achieving

employee alignment and motivation and hence superior business performance. But, as Wim
Van der Stede points out, PFP has its own potential pitfalls unless handled with care.

by Wim Van Der Stede

PFP is an incentive scheme in which for ‘pulse’ (ie for just being there) or for
employees receive extra, performance- seniority. Indeed, the primary rationale
dependent compensation for their work if for pay-for-performance is to differentiate
they reach certain performance targets. pay: to provide higher rewards for
The most common form of PFP incentive employees who make the largest
awards are cash bonuses. Nearly all firms contributions. By better recognising
above minimal size provide some form of employee contributions, firms can more
PFP to some employees, at least to effectively encourage outstanding
management level and above. But PFP performance.
schemes are also provided at non- PFP - what is there not to like?
management levels and are becoming
increasingly popular in the non-profit So what is there not to like about driving
sector, such as healthcare, where employees to work harder by offering
personnel are being rewarded for meeting them money for achieving certain
healthcare service delivery targets. performance targets? To answer this
question, let us examine the key thrust of
There are, of course, many benefits from PFP: stimulus. Stimulus has two
PFP for both the business and the elements, namely:
employee. The former gains, presumably,
from improved employee alignment and 1. informational - the PFP rewards
motivation (more of this, later). But PFP attract employees’ attention and
also makes compensation more variable inform or remind them of the
with business performance, allowing the importance of the rewarded
business to pay higher compensation only performance. Merely telling
when it can best afford it while reducing employees that customer service, for
compensation expenses when example, is important might have
performance is poor. The incentive some effect on their behaviours. But
payments are not entitlements and they including customer service measures
are not annuities: they are one-time in annual bonus plans is more likely to
payments based on performance. convince them to emphasise customer
Employees appreciate the extra cash, service. The rewards signal the
when they meet their performance goals. performance areas that are important
What’s more, employees often feel that and help employees decide how to
their efforts are rewarded more fairly as direct their efforts. Because money is
they are paid for performance rather than almost universally valued, monetary

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 THE PITFALLS OF PAY FOR PERFORMANCE

awards are highly effective in readily-available performance measures,

directing employees’ attention; and accounting or other.
2. motivational - some employees need Given that this measurement complication
incentives to exert the extra effort is likely to lead firms to emphasise the
required to perform tasks well: ie to more-easily measurable task by including
work hard, do a good job, and it in the incentive system, the result is that
succeed. Sometimes even the PFP system is likely to induce the
hardworking employees need employees to focus a disproportionate
incentives to overcome their natural amount of their attention to delivering
aversion to some difficult or tedious current performance at the expense of, in
actions that are in their organisation’s this example, developing new business.
best interest, such as working This is, ironically, testimony that PFP
cooperatively with other divisions to works - employees respond to what is
resolve customer complaints, making signalled by the incentive system as being
cold sales calls to get more business, important (the informational stimulus)
preparing paperwork, or training and what they are rewarded for (the
employees. motivational stimulus). But it comes at
the expense of devoting less attention to
For the above two reasons, one of the
important-yet-under/unrewarded activities
most widely-held beliefs about human
that are just as critical, sometimes even
behaviour in organisations is that
more critical, for success.
monetary incentives are the most
powerful drivers of performance. Weak incentives may be best
Distorted performance in multifaceted Therefore, when multitasking is desired –
jobs which arguably is the case for most jobs in
today’s developed economies – it may be
However, providing informational and
best to provide relatively weak incentives
motivational stimuli by connecting pay to
for any of the desired dimensions of
performance may be trickier than it
performance. Although this advice perhaps
appears. This is so primarily because most
seems paradoxical, this is so because PFP
jobs that employees perform in today’s
systems that are not well-calibrated across
economy are multi-faceted, consisting of
all the important dimensions of a job will
many desired activities which compete for
distort the effort allocation of employees
the job holder’s time and attention. A
because improving incentives for one task
good example of such multitasking, as
may worsen those for other tasks leading
this is often called, is delivering current
employees to overemphasise the better
performance at the same time as
compensated activity and undersupply the
developing new business. In addition to
other.
the challenge of that dual goal there is a
further complicating factor: delivering There is an abundance of examples
current performance is relatively easily illustrating this point, but consider the
measured in, say, accounting terms, following one*. City officials wanted to
whereas developing new business is much tackle overtime in a garbage collection
harder to define, less certain, slower to service. To motivate the garbage
emerge and harder to measure by any collectors to finish early, they were
offered an incentive scheme where they

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would be paid full time even if they Initiatives to use compensation packages
reported back early. And it worked! to attract and retain such employees often
Garbage collectors came back are seen as a key feature of a firm’s
consistently early and received full pay recruitment strategy aimed at building a
for the shift, which was apparently an performance-driven culture.
attractive deal for them. But despite this While this is quite a reasonable strategy to
good effect, there was also an increase in pursue, it is not without its downsides.
preventable traffic accidents, missed First, when incentives become
pickups of garbage, and trucks filled over increasingly leveraged - ie, when
the legal weight limit. By emphasising incentive pay becomes an increasingly
time in the incentive scheme, time is what important and larger part of employees’
they got or, rather, rushed time - at the total compensation packages - the
expense of safety, service, and obeying incentives are also more likely to have the
work rules. distorting effects discussed above,
I particularly like the above example especially when they are not carefully
because garbage collection is not exactly calibrated. Second, and related, when
what comes to mind when thinking of highly leveraged, it is not a stretch to see
multitasking, yet even this job is how quickly such compensation packages
apparently complex enough to be subject can turn a performance-driven culture into
to the effects of distorted incentives. a money-driven one. This has two
Consider, then, the complexity involved undesirable implications, of which
in determining appropriate weights on the businesses should be aware, namely:
multiple dimensions of, say, managerial • that those who come for the money
jobs, and one can see how easy it is for are also likely to leave for the money
incentives to have potentially damaging (despite this being counter to the
effects. The punch line is that there are intended effect of PFP on employee
very few jobs, even apparently simple retention); and
ones, where what is counted is all that
counts. • that evidence suggests that PFP
systems almost always lead to higher
Attracting the ‘wrong sort’ compensation.
Organisations not only turn to PFP Regarding the latter, to improve recruit-
systems to motivate employees who are ment, businesses will have to offer
already there, but also to attract talented compensation packages that are
employees of a desired profile. This is comparable, or even superior, to those
particularly so when businesses overtly offered by their competitors if they want
offer compensation packages with below- to attract employees from the same labour
average base salaries but with PFP pool. Thus, once introduced, PFP systems
compensation elements that provide the are likely to create a labour market that
opportunity to earn above-average total forces companies to follow suit in order to
compensation if excellent performance is attract talent without necessarily the
forthcoming. These packages tend to benefit of greater motivation and/or
appeal to employees who are retention. It is easy to see, then, how PFP
entrepreneurial, rather than risk averse, quickly becomes an institutionalised
and those who are confident about their practice or business necessity rather than
abilities to produce superior results.

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 THE PITFALLS OF PAY FOR PERFORMANCE

a motivational tool aimed at promoting a Moreover, although money clearly is a

performance-driven business culture. motivator for the vast majority of
employees, it is by no means the only
THREE POINTS TO CONSIDER IN YOUR
REWARD STRATEGY
thing that people value. Other research***
has shown that firms tend to over-estimate
• Incentive structure – badly structured
their employees’ concerns for financial
incentives are more likely to have unintended
rewards and under-estimate intrinsic job
consequences relative to weaker but possibly
features, such as their desire to build a
more complete incentives across all the
reputation; enjoy decision authority,
important dimensions of an employee’s job.
perform meaningful work, and be
• Incentive intensity – some of the downsides of appreciated. Not only can non-monetary
PFP systems are proportional to their intensity. rewards fulfil a potentially effective role
More is not always better and good incentive as part of an incentive package, they also
effects can sometimes already be achieved at place a smaller financial burden on the
relatively low levels beyond which the firm.
(un)desired incentive effects may decrease
Conclusion
(intensify) quickly.

• Money, money, money? Complement monetary When Warren Buffett recently started
incentives with various non-monetary rewards, looking for a ‘new Buffett’ to help him
which can have good effects and are often less run his investment empire, he reportedly
costly to the firm, yet valued by employees. said “job hoppers and money-grubbers
need not apply”. In so doing, Buffett
‘More’ PFP is not always ‘better’ highlighted the key point about PFP: that
How then to break free from these while money is an important motivator
unintended consequences? After all, with potentially good effects on
hardcore advocates of incentives could still performance, when it becomes the sole or
claim that this shows that incentives work! even just the predominant stimulus it is
I, too, believe that they work, but I do not likely to backfire on businesses’ ability to
believe that more is always better. As a attract, motivate, and retain the talented
matter of fact, some of the downsides of employees for which PFP was designed.
PFP systems seem to be proportional to Footnotes
their intensity. Whereas it is impossible to * Jeffrey Pfeffer and Robert I Sutton, ‘Hard
perfectly calibrate incentives in multitask facts, dangerous half-truths, and total
settings, even presumably relatively simple nonsense’ (HBS Press 2006, page 120).
ones, the negative side effects of ill-
** B R Bucklin and A M Dickinson, ‘Individual
calibration are exacerbated when incentive
monetary incentives: a review of different
pay constitutes a larger part of total
types of arrangements between performance
compensation. Interestingly, research**
and pay’, Journal of Organisational Behaviour
suggests that the positive effects of PFP
Management, 21, no.3 (2001), pp 45-137.
might already be achieved with a relatively
low incentive intensity, and that the *** Watson Wyatt Worldwide, ‘Strategic rewards:
motivational effects of PFP taper off quite maximising the return on your reward
quickly beyond a meaningful amount. investment’ (Company Survey Report, 2004)

Wim A Van der Stede is professor of management accountancy at the London School of
Economics and Political Science. Email: [email protected]

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