Compensation & Incentives: Practice vs. Theory

Baker, Jensen & Murphy’s primary concern: Research evidence suggests that, contrary to many firms’ claims that their pay system is based on merit, many business organizations do not do a very good job of tying pay to performance.

Why is this? Some psychologists suggest that monetary rewards are counter-productive. Reasons they offer: Rewards encourage people to focus narrowly on a task, to do it as quickly as possible, and to take few risks Extrinsic rewards can erode intrinsic interest People come to see themselves as being controlled by a reward

Other merit-pay critics suggest that there are significant adverse side effects that are costly to employee morale and productivity such as: Problems associated with horizontal equity concerns (the equal and fair treatment of employees at the same level in an organization) Problems associated with imperfect performance measurement

B,J &M suggests that the lack of pay-for- performance plans are the result of the extreme effectiveness of pay-for-performance systems. That is, such schemes motivate people to do exactly what they are told to do Large monetary incentives result in inadequate specification of exactly what is expected of people and, thus, how their performance should be measured Such schemes encourage employees to spend effort lobbying about how their performance should be measured

Objective Performance measurements Pay-for-performance systems that are based on objectives measures such as sales, divisional profits, production levels, etc. Problems include: Many of such measures are achieved by joint efforts and, thus, disallows for the observance of individual contributions Many of such measures result in resourceful employees “gaming the system” Many of such systems are hard to change Determining the correct objective measure of employee performance is often impossible The compensation system that results from this set of forces appears to be one with little or no pay for performance

Subjective Performance Measurement Pay-for-performance systems that are based on measurements that take the form of human judgments and opinions. Problems include: Employees do not trust superiors to accurately evaluate their performance Superiors dislike the conflicts that arise with disgruntled employees

Promotion-based incentive systems Systems where wage levels and job titles in a hierarchical organization are tied to job levels in the firm. Purpose of this type of system: To match individuals to the jobs for which they’re best suited To provide incentives for lower level employees who value the pay and prestige associated with a higher rank in an organization

Concerns: Promotion-based incentive systems Promotions depend upon the probability of promotion which is dependent upon the identity, expected horizon of the incumbent superior Requires organization growth to feed the reward system

Bonus-based incentive systems Systems where bonus compensation is based on some measure of the current year’s performance. Major advantage: Provide incentives for all individuals in the organization, regardless of their ability, position, or promotion opportunities

Promotion-based incentive systems vs. Bonus-based incentive systems Promotion-based Most useful In large organizations with many hierarchical levels In growing industries because there are more new jobs to feed the reward system Bonus-based Most useful In higher levels in the organization since the probability of future promotion is lower In declining industries because there are fewer jobs to feed the reward system

Tournament promotion systems Systems in which the best performer at each level is promoted to the next higher level. Major Problem In many cases, the best performer at one level in the hierarchy is not the best candidate for the job one level up Most useful In cases where the required talents for the next level in the hierarchy are the same as the talents required to win the tournament in the current job.

Tenure/Up-or-out Systems Systems where employees who satisfy some sufficient level of job performance according to some measure criterion are promoted and receive a grant of partnership or lifetime employment while the others are forced to leave the organization. Major problem: Loss of employees who are often highly productive to the organization in a capacity other that which is used as the measure criterion Most useful: In situations where human capital, creativity, and an unstructured environment is critical to the production process; generally, in relatively small organizations with few hierarchical levels (e.g., colleges/universities, law firms; exception, the military)

Profit-Sharing Plans Systems where an individual’s compensation is tied to the overall performance of the firm. Problem: The free-rider problem Most useful: When rewards and punishments are based on individual performance and not strictly on team performance. That is, the mutual monitoring that result from this system leads to the shirkers being punished.

Three dimensions of a firm’s compensation policy The level: the expected total cost (value) of the pay package to the employer (employee) The functional form: defines the relation between pay and performance and the definition of performance The composition: defines the relative amounts of the components of the package (e.g., cash compensation, fringe benefits, etc.)

How do managers in hierarchical organizations differ from principals modeled in the principal- agent literature? Principals in this literature are 100% owners of the alienable residual claims to the cash flows which is the primary characteristic that provides incentives for him/her to structure contracts that maximize the welfare of both the manager and the employee. The substitute mechanisms for this 100% ownership in organizations are various incentive contracts and direct-monitoring provisions. The current absence of pay-for-performance compensation schemes in organizations suggests that managers have less incentives to structure contracts that maximize the welfare of both the manager and the employee.

THE END!