Why performance related pay doesn't work

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(MoneyWatch) In the last month, I've sat in three board meetings where pay was discussed. Because money is tight, in each case someone suggested lowering base pay and increasing incentives. This suggestion was followed by uncomfortable agreement: Uncomfortable because it feels stingy, agreement because it feels like the pay strategy will work. And in each case, I've asked: Where's the evidence that performance-related pay actually works? So far, no one has come up with a good answer.

According to economists George Akerlog and Rachel Kranton, there are four reasons why performance-related pay does not work:

1. It's often hard to judge performance. High flyers regularly do things they haven't been asked to do, put out fires before anyone can see them, reassure nervous customers and share ideas widely that make everyone around them more successful. Under no circumstances do you want people to stop doing this - but you can't measure it.

2. Big rewards encourage big risk taking. Most people don't understand risk/reward trade offs and so, offered big rewards, they are prepared to take big risks. This is quite often exactly what you do not want. A pay system that encourages the wrong behavior while not encouraging the best behavior is hard to applaud.

3. Smart people game the system. They either deliberately under-promise to make over-achieving easy, they fudge their numbers, achieve their targets unethically or time their performance according to compensation schedules instead of what's best for the customer or the company.

4. Extrinsic rewards crowd out internal motivation. In other words, if I'm offered a big reward for one thing, I'll forget all the other reasons I wanted to do my job in the first place. In any number of psychology experiments, if you reward people for doing something they enjoy anyway, their commitment and engagement decreases. And they lose interest in making any extra effort.

What all of this means is that however intuitive performance related pay seems, it doesn't work. You don't get better work when you try to motivate people this way; you get worse work and often less work. I am always struck that the people who propose performance-related schemes are never on them themselves. That tells me everything.

What's important to remember, however, is that on some level we are all on performance-related pay schemes - insofar as the ability of an employer to pay at all is heavily contingent on everyone doing a good job. When everyone performs, everyone gets paid. That, it turns out, is motivation enough.

  • Margaret Heffernan On Twitter»

    Margaret Heffernan has been CEO of five businesses in the United States and United Kingdom. A speaker and writer, her most recent book Willful Blindness was shortlisted for the Financial Times Best Business Book 2011. Visit her on www.MHeffernan.com.

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