Find a winning combination

15 April 2012 • By Stephen Overell

Does linking reward to performance pay off? With strong opinions on both sides, the argument looks set to rumble on

Anyone who thought the financial crisis might wobble the half-century old corporate love affair with performance-related pay might have to reconsider. In fact, with concerns about performance topping executive worry lists, firms are looking to their pay systems to help improve it.

Two-thirds of employers use performance pay in its assorted manifestations (bonuses, profit-related pay, individual and collective incentives and so on), according to the Chartered Institute of Personnel and Development (CIPD); the vast majority of respondents to the CIPD’s 2011 Reward Survey were planning to review their pay arrangements with a view to enhancing the performance-pay link.

Stuart Hyland, UK head of reward consulting at the Hay Group, says: “Performance-related pay has grown in its significance. Employers are thinking much harder about the behaviour they are trying to encourage and how to target it better.”

Are businesses choosing the right means to the desired end? The research literature is bitterly divided about performance related pay, and critics appear to be in the ascendancy.

In a Harvard Business Review article, two management professors based at Warwick Business School, Bruno Frey and Margit Osterloh, argue the post-crisis era is the moment to detach pay from performance. It does not motivate and what’s worse, it may hide the intrinsic motivations of work – doing a good job in which one can take pride in the company of people one generally likes. At senior levels, it encourages executives to take company-killing risks while neglecting other critical aspects of their jobs.

Richard Lambert, the former director general of the CBI, also says firms should ditch the fancy performance metrics. Many firms are paying for luck: reward packages seem to follow the performance of markets which employees have little control rather than their firm or business unit.

It is also divisive. In a modern economy that values teamwork and good relationships, isolating the impact of an individual is extremely difficult. Especially the individuals in the top roles – after all, did the pharaohs build the pyramids?

Yet there are opposing arguments – and not just from consultants and executives whose living is at stake. In their paper CEO Compensation and Firm Performance, Dennis Michaud and Yunwei Gai of Yale School of Management say that of various types of incentive, bonuses do correlate positively with increased returns for investors. (However, they conclude that when performance and pay are decided at the same time, the relationship disappears.)

For others, performance pay rests on ethical as much as efficiency grounds. A vital argument is that fairness is best served by recognising different levels of effort and talent rather than paying everyone the same – and it is an argument that workforces increasingly seem to accept.

Some startling claims have been. The interim report of the Commission on Fair Pay in the Public Sector, a body set up at David Cameron’s behest to examine rising senior public sector salaries stated: “By supporting greater aspiration and work incentives, pay that is proportional to effort may in turn reinforce social cohesion. If the distribution of reward is not perceived as proportionate and/or the product of fair process, this could undermine social trust more generally, encouraging people to become suspicious of one another and to contribute less to public goods.”

And yet successive studies have noted the stark contrast between approval for the principle of performance pay and disenchantment with the practice. Which means firms that have it (the vast majority) tend to fiddle regularly with their pay arrangements to correct unfairness – itself a potentially significant management distraction.

Alastair Hatchett, director of specialist pay research organisation IDS, says: “Schemes are constantly changing because people are uncomfortable with how it gets distributed.”