Why performance pay may underperform

Tim Harford wrote an interesting piece last month about performance pay. He wrote:

Here’s an age-old management conundrum: who should be rewarded for high performance, and how? As Diane Coyle, the economist and former adviser to the UK Treasury, recently observed in this newspaper, the answer to the question is usually self-serving. Simple and easily monitored jobs, such as flipping burgers, are natural candidates for performance incentives. Yet somehow it’s the inhabitants of the C-suite who tend to pick up bonuses, despite the fact that their complex, hard-to-measure jobs are poorly suited to the crude nature of performance-related pay.

Harford (as always) does a great job of summarising the state of research in this area. He correctly identifies that financial rewards don't work in all situations. I'm going to use this post to highlight the factors that must be in place for a performance pay scheme to work well - the absence of one or more of these factors will lead to a performance pay scheme that won't work so well.

First though, some background. Why have performance pay? Employers face a problem we refer to as the principal-agent problem (a specific type of moral hazard). The employer (the principal) engages an employee (the agent) to work on their behalf. However, the goals of the employee are rarely perfectly aligned with the goals of the employer. So, because the employer cannot easily monitor all of the employee's activities, the employee can engage in activities that are not necessarily in the best interests of the employer (like goofing off). Rewarding employees for meeting set targets (and performance pay more generally) is one way of re-aligning the interests of the employee with those of the employer (other options include closer monitoring of employees, and paying efficiency wages, which I have previously discussed here). However, for performance pay to work well a number of things factors need to be present.

First, employees must respond to incentives. This seems like a given, since one of the assumptions economists make is that people respond to incentives. However, it might not always be true. If employees are already highly paid, and the performance payment is small, it might not be enough incentive to encourage greater work effort. So, if you are selling farm machinery, for performance pay to work well your salespeople must be willing to try to earn more sales to capture the performance pay (e.g. commissions).

Second, employees' output must be sensitive to their effort. If employees work harder but the additional effort does not enable them to produce (or sell) more, then rewarding them with performance pay simply won't work well. Why waste your time working harder if it doesn't lead to more output (and higher pay)? So, for performance pay to work well your farm machinery salespeople must be able to sell more tractors if they work harder (at trade shows, visiting potential clients, etc.).

Third, employees' output must be measured easily. If you are going to reward employees for their performance, you must be able to objectively measure their performance. On top of that, employees must be able to believe that the measurement of their performance is accurate. Measurements that are not credible will not encourage employees to work harder. So, for performance pay to work you must be able to know how many tractors each salesperson is selling.

Fourth, employees must not be too risk averse. Risk averse people prefer a higher degree of certainty. Performance pay reduces the certainty of employees' incomes, so if they are highly risk averse they will prefer to work elsewhere (this may or may not be a good thing!). So, your farm machinery salespeople must be willing to accept some likely fluctuations in their salary (as their sales increase or decrease from month to month).

Finally, the level of risk that is beyond the employees' control must be low. If employees' performance depends on their own effort, but also on other factors that are beyond their control, then rewarding high performance may not necessarily increase work effort. This will be a greater problem the greater the share of employee performance that is driven by the external factors. So, if farm machinery sales are driven more by the weather and how farm profits are going, and less by the efforts of the individual salespeople themselves, it will not work so well.

On that last point though, one work-around is to reward employees for their relative performance, i.e. their performance relative to their peers, to industry benchmarks, or to agreed targets. However, it is possible to take performance pay too far - to the extent where competition between different employees is encouraged to an unhealthy extent. In any case, performance pay is one method of dealing with underperforming employees - but if the factors noted above are not present the performance pay scheme itself may well underperform.