Compensation Issues

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Performance-based pay isn't suited for executives: Here's why

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As much as 60 percent to 80 percent of senior executives' pay is often tied to performance metrics. However, research on incentives and motivation shows there is no material benefit to having variable executive compensation packages, largely because the nature of their work is not suited to performance-based pay.

In fact, performance-based pay can actually yield negative outcomes for companies, according to an article in the Harvard Business Review by Dan Cable, PhD, a professor of organizational behavior at the London Business School, and Freek Vermeulen, PhD, an associate professor of strategy and entrepreneurship at the London Business School.

In the article, Drs. Cable and Vermeulen argue in favor of abolishing pay-for-performance for senior leaders altogether, proposing instead most firms should pay their top executives a fixed salary. While they don't suggest CEOs and other top leaders should be paid less, they contend there is "no compelling evidence that such [pay-for-performance] arrangements actually benefit the companies making the payouts."

Their argument is based on five insights from their research.

1. Performance-related incentives are only effective for routine tasks. The higher the incentive, the more productive people are on routine tasks, according to a study conducted at Durham, N.C.-based Duke University.

However, the same study showed that variable pay can be detrimental when the task at hand is not standard and requires creativity. Even when individuals had the incentive to earn an additional month's salary for high performance, variable pay impacted their quality of work.

The responsibilities and tasks required of a senior leader are not routine. Rather, they need to be innovative, creative, open to change and adept to developing solutions to non-routine problems, according to Drs. Cable and Vermeulen.

2. Fixating on performance can lower it. Instead, framing goals around learning — such as acquiring new skills, mastering how to handle a new situation — leads to improved performance.

"Learning goals are more effective at improving performance precisely because they do the opposite of most executive incentives: they draw attention away from the end result and focus instead on the discovery of novel strategies and processes to attain the desired results," Drs. Cable and Vermeulen wrote.

3. Intrinsic motivation is more powerful than external incentives. The goal of variable pay is to increase people's extrinsic motivation. However, intrinsic motivation — desiring to do things to fulfill one's own sense of achievement and fulfillment — is essential to creativity and innovation, according to Drs. Cable and Vermeulen. Importantly, when financial incentives are implemented, executives' intrinsic motivation takes a hit.

4. Contingent pay often leads to cheating. When a substantial portion of a person's pay is tied to variable financial incentives, he or she is more likely to cheat, according to Drs. Cable and Vermeulen. For instance, various studies have showed "paying CEOs based on stock options significantly increases the likelihood of earnings manipulations, shareholder lawsuits and product safety problems," they wrote.

5. No measurement system is perfect. For a complex job such as CEO or another senior executive, it is impossible to precisely measure someone's actual performance because their work includes various stakeholders' interests, tangible and intangible resources and both long- and short-term effects. Additionally, most boards understand they have a limited view of those within the company.

"Even when performance seems easy to measure, because it is unambiguous and objective, there is usually a catch, and the measure will still turn out to be flawed," Drs. Cable and Vermeulen wrote.

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