Performance pay is nothing new. We're all familiar with piece-rate pay, spot bonuses, annual incentive plans, and the like. Many organizations have incorporated some form of pay for performance into their total rewards strategy. Even though performance pay is a household word, there's still one remaining mystery surrounding it: figuring out when it will work and when it won't. Despite years of research by scholars and practitioners alike, we still don't have a well-developed understanding of the contexts in which performance pay will (won't) be effective.
A new line of research, however, may hold some promise for developing this understanding. Bengt Holmström, who is not a household name (unless you're an economist!) discussed this line of research in his speech in December of 2016 when he won the 2016 Nobel Memorial Prize in Economic Sciences.
Holmström has studied incentive contracts for a good portion of his career. His research began with models narrowly focused on pay for performance, as did many other scholars’ research programs. As noted by Holmström in his speech, the study of incentives has been somewhat oversimplified. The majority of research focuses on simple incentive schemes: a linear incentive in addition to a fixed wage or a bonus for performance above some minimum threshold. The problem with this type of analysis, he says, is that it cannot tell us why different incentives are used in different contexts.
Even more sophisticated models of performance pay fall short because, in my opinion, they are not couched in terms of job design. Too often our discussion of pay for performance is limited to contexts like organizational culture, performance evaluation and measurement, employee engagement and the like. Thinking about performance pay in terms of job design, however, is something that has been missing from the discussion. Luckily, Holmström’s research can help us with this.
In a marked departure from his initial research program, Holmström has expanded his research to encompass the design of coherent incentive systems incorporating nonfinancial instruments for complex job designs. One of the things I find most interesting about his work is the role multitasking plays in determining the (in)effectiveness of performance pay.
In the modern workplace, many employees are multitasking. The recognition of this led to a change in the focus of research; rather than figuring out how to get an employee to “work hard enough” on a single task, we now have to address how employees allocate their efforts across tasks in support of the organization’s strategic objectives.
As noted by Holmström, “[w]hen tasks are interdependent, the optimal design needs to consider [the employee’s] incentives in totality. Knowing [the employee’s] full portfolio of activities – what his authority and responsibilities are – is essential for designing a coherent, balanced solution that takes into account the interdependencies.”
This is difficult under the best circumstances, but is even more challenging when “easy-to-measure” and “hard-to-measure” activities compete for a worker’s attention. Consider, for example, the case in which an employee has two tasks: a quantitative, easy-to-measure task like sales volume, and a qualitative, hard-to-measure task like quality of customer service. Employers may be tempted to strongly incentivize quantity, since it is easily measured. However, strongly incentivizing quantity “devalues” the importance of quality, and employees may sacrifice quality in favor of quantity. Thus, reducing the intensity of the incentive for quantity can incentivize quality. The question then becomes the amount by which the intensity is decreased to strike a balance between incentivizing both quantity and quality.
As it turns out, properly structuring incentives in this two-task model is difficult enough. The difficulty compounds exponentially when tasks are added; all interdependencies must be examined and understood. Think about how many tasks you perform as part of your regular day. If you have five tasks that you regularly perform, there are 120 different ways to arrange those tasks in ordinally (from “most important” to “least important”). Imagine having to cardinally rank those tasks, quantifying how much more important one task is relative to the others... You’ll have to solve this challenge to properly weight the intensity of each incentive.
To me, this is the biggest insight from Holmström’s research. As he notes in his speech, “[b]ecause the opportunity cost of providing incentives for any given task depends on all the incentives for the other tasks, one should always consider the full portfolio of [employee] tasks when designing incentives.” I think that the key to understanding when performance pay will and will not work is when we understand the "work" itself.
Stephanie Thomas, Ph.D., is a Lecturer in the Department of Economics at Cornell University. She teaches undergraduate and graduate courses on economic theory and labor economics in the College of Arts and Sciences and in Cornell’s School of Industrial and Labor Relations. Throughout her career, Stephanie has completed research on a variety of topics including wage determination, pay gaps and inequality, and performance-based compensation systems. She frequently provides expert commentary in media outlets such as The New York Times, CBC, and NPR, and has published papers in a variety of journals.