Ahead of the curve: The future of performance management (part 4 of 5)

Part 4 of 5

Take the anxiety out of compensation

The next step companies can take to move performance management from the industrial to the digital era is to take the anxiety out of compensation. But this move requires managers to make some counterintuitive decisions.

Conventional wisdom links performance evaluations, ratings, and compensation. This seems completely appropriate: most people think that stronger performance deserves more pay, weaker performance less. To meet these expectations, mean performance levels would be pegged around the market average. Over performance would beat the market rate, to attract and retain top talent. And poor scores would bring employees below the market average, to provide a disincentive for underperformance. This logic is appealing and consistent with the Gaussian view. In fact, the distribution guide, with its target percentages across different ratings, gives companies a simple template for calculating differentiated pay while helping them to stay within an overall compensation budget. No doubt, this is one of the reasons for the prevalence of the Gaussian view.

This approach, however, has a number of problems. First, the cart sometimes goes before the horse: managers use desired compensation distributions to reverse engineer ratings. To pay Tom x and Maggie y, the evaluator must find that Tom exceeds expectations that Maggie merely meets. That kind of reverse engineering of ratings from a priori pay decisions often plays out over several performance cycles and can lead to cynical outcomes—“last year, I looked out for you; this year, Maggie, you will have to take a hit for the team.” These practices, more than flaws in the Gaussian concept itself, discredit the performance system and often drown out valuable feedback. They breed cynicism, demotivate employees, and can make them combative, not collaborative.

Second, linking performance ratings and compensation in this way ignores recent findings in the cognitive sciences and behavioral economics. The research of Nobel laureate Daniel Kahneman and others suggests that employees may worry excessively about the pay implications of even small differences in ratings, so that the fear of potential losses, however small, should influence behavior twice as much as potential gains do. Although this idea is counterintuitive, linking performance with pay can demotivate employees even if the link produces only small net variances in compensation.

Since only a few employees are standouts, it makes little sense to risk demotivating the broad majority by linking pay and performance. More and more technology companies, for instance, have done away with performance-related bonuses. Instead, they offer a competitive base salary and peg bonuses (sometimes paid in shares or share options) to the company’s overall performance. Employees are free to focus on doing great work, to develop, and even to make mistakes—without having to worry about the implications of marginal rating differences on their compensation. However, most of these companies pay out special rewards, including discretionary pay, to truly outstanding performers: “10x coders get 10x pay” is the common way this principle is framed. Still, companies can remove a major driver of anxiety for the broad majority of employees.

Finally, researchers such as Dan Pink say that the things which really motivate people to perform well are feelings like autonomy, mastery, and purpose. In our experience, these increase as workers gain access to assets, priority projects, and customers and receive displays of loyalty and recognition. Snapping the link between performance and compensation allows companies to worry less about tracking, rating, and their consequences and more about building capabilities and inspiring employees to stretch their skills and aptitudes.

A large Middle Eastern technology company recently conducted a thorough study of what motivates its employees, looking at combinations of more than 100 variables to understand what fired up the best people. Variables studied included multiple kinds of compensation, where employees worked, the size of teams, tenure, and performance ratings from colleagues and managers. The company found that meaning—seeing purpose and value in work—was the single most important factor, accounting for 50 percent of all movement in the motivation score. It wasn’t compensation. In some cases, higher-paid staff were markedly less motivated than others. The company halted a plan to boost compensation by $100 million to match its competitors.

Leaders shouldn’t, however, delude themselves into thinking that cutting costs is another reason for decoupling compensation from performance evaluations. Many of the companies that have moved in this direction use generous stock awards that make employees up and down the line feel not only well compensated but also like owners. Companies lacking shares as currency may find it harder to make the numbers work unless they can materially boost corporate performance.

Source: McKinsey Quarterly, May 2016