Mental Health

Performance-Based Pay Works, But Only Under Some Conditions: Compensation Is Not One Size Fits All

incentive
Some managers respond to incentive pay by taking more risks, while others do not, and it all comes down to context and ambition. 401(K) 2012, cc by 2.0

What motivates you on the job?  A new study suggests performance-based pay does not ring everyone’s bell. Using a computer-based simulation, two researchers discovered some managers respond to incentive pay by taking more risks, while others do not, and it all comes down to context and ambition.

It sounds so simple: Pay employees based on their performance and, naturally, the company’s overall performance will improve. Yet, incentive compensation schemes don’t always work to improve a company's bottom line, Joyce Cong Ying Wang, a doctoral candidate at University of Texas at Dallas, explains. In fact, sometimes performance-based programs have resulted in mismanagement, corporate failures, or (surprise!) earnings manipulations. Extensive studies with mixed results suggest compensation is highly complex, influenced by any number of factors.

So Wang and her colleague Dr. Daniel Han Ming Chng, China Europe International Business School, decided to investigate. Under what conditions do performance-based pay schemes work?

Individual Managers, Unique Contexts

They hypothesized managers with greater career ambition and task attention would show they are responsive to incentive compensation by taking more strategic risks and making more strategic changes to their performance.

To test their theory, they created a model using a computer-based simulation and then enlisted the help of 216 part-time MBA students who worked as managers in public and private Chinese companies. The average age of the participants was 29.9 years, and 56 percent were male. Following individual psychological exams, the participants were randomly assigned to either a fixed compensation or incentive compensation arrangement, and these subgroups worked within either a scenario of performance growth or performance decline.

Participant/students played the role of a senior manager of a medical equipment company tasked to improve the performance of the company over six business quarters and to capture at least 40 percent of the market share. In each quarter, the participants had a $6 million discretionary budget to implement nine potential strategies. After submitting their decisions in each quarter, the participants received a firm performance report, including financial data and charts and a qualitative report. 

The researchers discovered an important variable for incentive compensation plans is whether a company is growing or declining.

“Despite incentives aimed to promote strategic risk taking, the participants were reluctant to increase their strategic risk behavior when their companies performed well,” wrote the authors.

By contrast, when the firm's performance declined, the managers were more willing to make strategic changes and take risks. The team also found managers with higher career ambition did respond more to incentive pay by taking more risks. The experiment also proved a manager’s task attention affected his or her response to incentive pay.

“When managers are offered incentive pay, if they are very attentive to tasks, they will take more risks. They tend to invest more strategically, and they also are more likely to change strategies," said Wang.

Based on these results, the authors say company executives need to design compensation packages to fit individual managers in their company. Only if a manager is ambitious and attentive to tasks is it appropriate to give them performance-based pay. At the same time, company leaders need to address general context. If their firm is experiencing growth, it's better for leaders to find ways other than performance-based compensation to motivate them.

Compensation is never one-size fits all, the researchers conclude.

"Managers, and people in general, have inertia where they tend to do what they feel comfortable doing,” Wang said. Though we all require an incentive to go beyond our comfort zones, our individual natures and the general environment must be considered to devise an appropriate pay plan.

Source: Chng DHM, Wang JCY. An experimental study of the interaction effects of incentive compensation, career ambition, and task attention on Chinese managers’ strategic risk behaviors. Journal of Organizational Behavior. 2016.

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