Why Pay for Performance Should Get the Sack

The following article discusses the problems with perfoamcne pay in the financial sector, the heat of capitalism. Extrapolating this compensation gimmick to educators as corporate education reformers are seeking to do continues to be proven problematic

By Bruno S. Frey, Professor of Economics at the University of Zurich and Margit Osterloh, Professor (em.) for Business Administration and Management of Technology and Innovation, University of Zürich; and Professor, Warwick Business School. Cross posted from VoxEU

As the bonus culture in the financial sector once again comes under attack, this column rubbishes the typical defence that banks need to pay top dollar to attract the best talent.

Scientific literature has extensively dealt with variable pay-for-performance. Despite the fact that serious problems linked to this approach have thus become obvious, many authors continue to support compensation according to predetermined performance criteria because they are committed to the traditional concept of the ’homo oeconomicus’.
Overall, there has been a marked change of opinion in academia (see for instance Bryson and Freeman 2008 on this site). The idea that people are solely self-interested and materially orientated has been thrown overboard by leading scholars. Empirical research, in particular experimental research, has shown that under suitable conditions human beings care for the wellbeing of other persons. Above all, they are not solely interested in material gains (see eg Frey and Osterloh 2002). Recognition by co-workers is greatly important. Many workers are intrinsically motivated, ie they perform work for its own sake because it is found challenging and worth undertaking. This applies not only to qualified employees but also to persons fulfilling simple tasks. They often are proud of their work and performance.

There are four major arguments against variable pay-for-performance:

• In a modern economy, it is practically impossible to determine tasks that are to be fulfilled in the future precisely enough so that variable pay-for-performance can be applied. In a society continually faced with new challenges, superiors oftentimes find it impossible to fix ex ante what an employee will have to do in the future.
• It would be naïve to assume that the persons subjected to variable pay-for-performance would accept the respective criteria in a passive way and fulfil their work accordingly. Rather, they spend much energy and time trying to manipulate these criteria in their favour. This is facilitated by the fact that employees often know the specific features of their work better than their superiors. The wage explosions observable in many sectors of the economy can at least partly be attributed to such manipulations, eg when managers are able to contract easily achievable performance goals.
• Variable pay-for-performance results in employees restricting their work to those areas covered by the performance criteria. In the literature, this is known as the ’multiple tasking’ problem. This may induce employees to spend considerable time and energy during their work trying to find a better-paid job with another firm. They therefore neglect their tasks insofar as they are not contractually fixed by the performance criteria.
• Variable pay-for-performance tends to crowd out intrinsic work motivation and therewith the joy of fulfilling a particular task. However, such motivation is of great importance in a modern economy because it supports innovation and helps to fulfil tasks going beyond the ordinary.

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Merit Pay: The End Of Innocence?

The current teacher salary scale has come under increasing fire, and for a reason. Systems where people are treated more or less the same suffer from two basic problems. First, there will always be a number of "free riders". Second, and relatedly, some people may feel their contributions aren’t sufficiently recognized. So, what are good alternatives? I am not sure; but based on decades worth of economic and psychological research, measures such as merit pay are not it.

Although individual pay for performance (or merit pay) is a widespread practice among U.S. businesses, the research on its effectiveness shows it to be of limited utility (see here, here, here, and here), mostly because it’s easy for its benefits to be swamped by unintended consequences. Indeed, psychological research indicates that a focus on financial rewards may serve to (a) reduce intrinsic motivation, (b) heighten stress to the point that it impairs performance, and (c) promote a narrow focus reducing how well people do in all dimensions except the one being measured.

In 1971, a research psychologist named Edward Deci published a paper concluding that, while verbal reinforcement and positive feedback tends to strengthen intrinsic motivation, monetary rewards tend to weaken it. In 1999, Deci and his colleagues published a meta-analysis of 128 studies (see here), again concluding that, when people do things in exchange for external rewards, their intrinsic motivation tends to diminish. That is, once a certain activity is associated with a tangible reward, such as money, people will be less inclined to participate in the task when the reward is not present. Deci concluded that extrinsic rewards make it harder for people to sustain self-motivation.

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