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Performance Pay Does Not Even Work in Business

Friday March 23, 2012

The secret is well and truly out about performance pay – it just does not work even in business. But education policy makers are not hearing it.

Leading international business academics say that performance-related pay does not work in business and should be scrapped. An article in a recent issue of the prestigious Harvard Business Review says that the evidence keeps growing that pay for performance is ineffective. It says that there are other ways to motivate employees that yield better results at lower cost.

Variable pay for performance, while it may seem attractive in theory, creates more problems than it solves. There’s no proof that it helps achieve its intended purposes, and other approaches not only work better but also strengthen employee loyalty.

The authors show that performance pay for business leaders has led to skyrocketing CEO salaries in recent decades. However, salary increases bear little relationship with actual corporate performance and, according to the authors, remains as “weak as ever”.

Other business academics concur. For example, Jeffrey Pfeffer, Professor of Organizational Behaviour at the Stanford Graduate School of Business says that “the relationship between pay and performance is astonishingly small”. He cites the finding of an academic review of research studies on performance pay in the business sector that firm performance accounted for less than 5% of the variation in CEO pay.

In testimony to the US Congress on performance pay, Pfeffer said:

...the idea that individual pay for performance will enhance organizational operations rests on a set of assumptions. Once those assumptions are spelled out and confronted with the evidence, it is clear that many – maybe all – do not hold in most organizations….the evidence for the effectiveness of individual pay for performance is mixed, at best – not because pay systems don’t motivate behaviour, but more frequently, because such systems effectively motivate the wrong behaviour.

There is also little evidence that performance related pay (PRP) schemes work in the public sector as shown by a comprehensive OECD study that concluded:

Evidence cited in this book indicates that the impact of PRP on motivation is ambivalent: while it appears to motivate a minority of staff, it seems that a large majority often do not see PRP as an incentive. While base pay as it relates to the wider “market” is important, supplementary pay increases for performance are a second-rank incentive for most government employees, especially those in non-managerial roles. Job content and career development prospects have been found to be the strongest incentives for public employees. PRP is unlikely to motivate a substantial majority of staff, irrespective of the design. [p.14]

The Harvard Business Review article says that all pay-for-performance schemes still suffer from four inescapable flaws:

1. In a modern economy, where new challenges emerge constantly, it’s impossible to determine the tasks that will need to be done in the future precisely enough for variable pay for performance to work well.

2. People subject to pay for performance do not passively accept the criteria on which pay is based. They spend a lot of time and energy trying to manipulate the criteria in their favour, helped by the fact that they often know the specifics of their work better than their supervisors do.

3. Variable pay for performance often leads employees to focus exclusively on areas covered by the criteria and neglect other important tasks.

4. Variable pay for performance tends to crowd out intrinsic motivation and thus the joy of fulfilling work. Such motivation is of great importance to business, because it supports innovation and encourages beyond-the-ordinary contributions.

The authors say that extensive research has rejected the idea that people only work for money. Instead, people care for the well-being of other individuals and value recognition from co-workers. Many employees apply themselves because they find their work challenging and worthwhile. These non-material motivations point to better ways to get results from the members of an organization.

The authors suggest that one way is to select staff more carefully, hiring people who are truly interested in the work and not people whose primary goal is earning the highest pay. Another approach is to pay fixed compensation but adjust it on the basis of a comprehensive evaluation of employees’ work after some time. This avoids the problem of employees focusing only on the criteria used to reward performance. They say that awards and recognition are effective motivators as well.

Professor Pfeffer says that “the best way to encourage performance is to build a high performance culture”. This applies just as much, perhaps even more, to teaching as to business. It is expert advice that education policy makers would do well to heed.

Trevor Cobbold

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