The pay-for-motivation confusion

Should executives be paid for their performance? Some think that performance based pay is important for motivating executives, others think just the opposite is true. Both are wrong. The confusion comes from the meaning of the word motivation. Motivation is not only about motivating people, it's also about people being motivated. Variable pay allows boards to pay for the results they expect, irrespective of motivating or not motivating their team.

Stakeholder: Executives

Risk: Retention

Management: Don't think motivation, think compensation in executive pay

For a long time, there has been a lively debate about abandoning performance based pay for executives. The fixed pay proponents argue that variable pay doesn't motivate executives. On that level, for these complex tasks, performance based pay just doesn't work. Even worse, variable pay may jeopardize motivation as manifested in an often-quoted experiment on collecting donations.

What do you think about performance pay? The answer lies hidden in the meaning of the word motivation.

Less motivation with variable pay

In the study called Pay enough or don’t pay at all, by now famous among compensation experts, students were asked to collect donations for the Red Cross. The collections decreased when a small financial reward was offered. They increased again, when the amount was much higher, but even being paid the high amount yielded lower donation collections than in the case where no rewards were offered at all.

In other words, the personal motivation for doing something good for other people was stronger than even big financial awards. This personal motivation is referred to as intrinsic motivation by the professionals. Intrinsic motivation may be reduced if financial rewards come into play. The effect of reducing intrinsic motivation by financial rewards is called the crowding out effect of financial rewards. If you like this topic, there is a broader analysis by Prof. Bruno S. Frey on the crowding out effect: Motivation and Crowding Theory.

In Pay enough or don’t pay at all, a second group of students were asked to perform an intelligence test. Just as in the crowding out effect of intrinsic motivation, the average test scores decreased when a small financial award was introduced. However, the scores increased when a high amount was paid to a level even above the case where no incentive was used.

High risk with high variable pay

Does this mean that you should use large financial incentives? Not necessarily: High incentives have a high risk of the psychological phenomena “Cracking under Pressure”: Research conducted by the US Federal Reserve of Chicago found that high incentives typically lead to lower performance: In the experiment Large Stakes and Big Mistakes, Indian villagers were offered small, medium and large amounts of money for solving a variety of tasks. The villagers receiving the large amounts performed worst. This isn't only the case in India: The same happened to students from the 美国麻省理工学院 for tasks involving adding up numbers.

One of the dangers of offering a bonus for a specific objective is that it crowds out performance on objectives that receive no bonus. If you measure and incentivize for task A, people disregard task B, C and D, etc. This is is documented in Fairness and Incentives in a Multi-task Principal–Agent Model.

Worse, incentives may kill conscience as shown in Killing Conscience: The Unintended Behavioral Consequences of "Pay for Performance?

Why pay-for-motivation research is irrelevant

These insights are not new and it is quite surprising that they still move the emotions of compensation experts. As a matter of fact, the meta-study that analyzed 39 empirical studies on the impact of financial incentives on performance is already 25 years old and has found no link between pay and performance for executives.

At Obermatt , we correlated CEO pay and company performance for the US, the UK, and for Switzerland for multi-year periods. There was no correlation:

LinkedIn: The pay-for-performance problem

All this research that is trying to prove the pay-to-motivation connection misses one key point. There are two sides of the "motivation" coin; motivation can mean two entirely different things:

1. the act or process of motivating
2. the condition of being motivated (Webster)

You may not increase employee motivation with pay, but you can make sure that people are motivated to work (even if they are not motivated).

Would you call a waiter motivated by your tip? I would call it compensated: I compensate the waiter for the work of waiting on me. In most cases, I wouldn't get served without paying for it.

That's the same with all paid work. We don't motivate the butcher and the baker to give us the food we need. We pay them to do it. If they are motivated or not depends on other things. Paying them makes sure they are motivated enough to give us the meat and bread we carve - it doesn't even need an invisible hand. :)

Motivation and executive compensation

When executive pay is made variable, we pay for the things we want from executives, motivated or not. We may or may not increase their motivation with pay but we certainly can pay for what we want from them.

If we pay employees for the time they spend working for us, we compensate them for the time they give us. If we pay executives for revenues, profits, execution on strategic projects, managing stakeholder risks (often referred to under the term "ESG") or increasing stock returns, we don't do it to further motivate them, we do it to pay them for what we want form them.

It makes sense that top executives are not compensated only for the time they give us, as pure fixed pay would do, but rather for operational and strategic objectives that we want them to achieve.

How board should talk about motivation and pay

If you are on a company board and you need to discuss variable pay, don't let yourself be tricked into the pay-for-motivation confusion. See the things as they are:

1. Pay-for-performance is not about motivation, it's about compensation. Your executives don't need to get additionally motivated by pay. They are already sufficiently motivated because they wouldn't be your executives if they were not.
2. Distinguish between motivating people, and people being motivated. The former is a leadership question, the later a compensation question.
3. Don't call it "incentive pay" or "incentive compensation". Strictly speaking, it's not about incentives, it's about compensation. "Pay-for-performance" and "variable compensation" are better terms.
4. Your executives shouldn't be paid fixed because that would imply, you only want their time. If you want more than just time from your management, think about what you want from them and link pay to your objectives.
5. To the sceptics, ask them simple questions: "Should the executives of a company that goes bankrupt get the same compensation as those that work for a company that does well?" "Should the executives of a company that spends resources carelessly get the same compensation as those that use resources efficiently?" "Should executives of a company that encounters a bribery controversy get the same compensation as those that maintain proper business practices?" If you answer any of these questions with a "yes", you are an advocate for pay-for-performance. You are for variable, and against fixed pay.