Science shows pay for performance works, if used properly

Hong Kong included in new study of financial incentives

PUBLISHED : Friday, 26 February, 2016, 10:01am
UPDATED : Friday, 26 February, 2016, 10:01am

Most companies say they pay for performance. Even in cultures and societies where financial incentives are not used regularly, it is difficult to find situations where managers insist that performance levels have nothing to do with pay.

In the United States and most of Western Europe, pay-for-performance plans are nearly universally used. In Hong Kong, outside of the finance sector, pay for performance has not been the norm historically, but is increasing in popularity in the private and public sectors.

Pay for performance is certainly popular; but it is also polarising. Several speech givers and book writers – for example, Daniel Pink and Alfie Kohn – have become extremely popular (and, incidentally, have generated millions of dollars in personal earnings from book sales and speaking fees) preaching a doctrine that using money to motivate is not only ineffective, but somehow harms people and the companies they work for.

But what does science have to say on this issue? Should managers use pay for performance to increase individual performance levels? Are they helpful or harmful? As it turns out, science, in general, is fairly clear in answering questions such as these. There are five “stylised facts” about the science of pay for performance.

The problem is that the negative reactions tend to last longer

Fact 1: financial incentives are effective. The most general conclusion about pay for performance is that its use increases work performance. Most people don’t like to admit that they are motivated by money. The scientific evidence, in general, is very clear on this issue: When people are providing incentives for doing more or better quality work, they do more or with better quality. I have conducted a number of summaries of the scientific literature over the past 15 years using a researcher’s judgement but also using sophisticated techniques. The evidence from my studies and others are overwhelming. Financial incentives are effective. This does not mean that people aren’t motivated by many other factors as well; they are. But when designed appropriately, pay for performance leads to better work.

Fact 2: financial incentives do not decrease intrinsic motivation. There is a popular belief that if you pay someone for doing something that they like to do, they will end up liking it less. This idea is intriguing; it is also completely false. Recent summary studies show just the opposite. Financial incentives and intrinsic motivation go hand in hand. If we are motivated by our interest or fascination with a subject or a type of work and we are paid for our performance, then we perform even better. The positive effects of intrinsic motivation are even more positive in the presence of incentives.

Fact 3: there is a pay for performance sweet spot. Research shows that when people receive small pay-for-performance increases they do not react negatively, they simply do not react. This idea of minimum threshold is growing both in terms of its scientific validity, but also its use in practice. The most recent research shows that it takes an incentive of 5 per cent to 7 per cent to cause a behavioural reaction in workers. This does not mean that managers should not give incentives below 5 per cent as economic conditions and other factors often lead to small budget pools. Rather, it means that managers should not expect any changes in employee behaviour when small incentives are given. At the same time, very large incentives are unlikely to produce increasingly large reactions. A pay increase of 20 per cent will not generate twice the positive reaction as a 10 per cent increase. The latest evidence suggests that pay for performance may “work best” within a reasonable range, perhaps between 5 per cent and 15 per cent.

Fact 4: avoid surprises. We set expectations for many reasons – we might set high expectations to anticipate a good feeling or low expectations to avoid being disappointed. Science says that complicated reactions occur when people receive more or less pay for performance than they expect. People may be devastated to receive a small incentive, if they believe they deserve or are confident that they were going to receive a larger one. They may react very positively to a large increase if they didn’t deserve one; sort of like winning the lottery. The problem is that the negative reactions tend to last longer. The euphoria from getting an unexpected pay-for-performance windfall tends to fade quickly. The clear takeaway from science is to manage to expectations. Managers should be very clear with employees about what they are likely to receive in order to avoid the complicated reactions to under- and over-met expectations.

Fact 5: justice reigns supreme. If there is one clear factor in managing pay for performance, it is that justice is hugely important. Do employees believe that decisions are consistent? Do they believe that the process was transparent? Were the decisions based on unbiased, accurate information? These attitudes trump all other factors; they are the most important for pay-for-performance system health, success, and survival. For managers, design a fair system and then explain, explain, explain. Doing so will increase employee satisfaction with the system and raise performance levels too.

Paying for performance does not solve all problems and, clearly, it can be implemented poorly and in these cases can motivate undesirable behaviours. The fallouts from recent financial and housing market crises worldwide revealed this quite clearly. The science of performance-based pay is not simple, but it is relatively clear. The evidence shows that pay for performance (1) increases performance quality and quantity, (2) has no negative effect on employees’ love of their work, (3) works best in a range from about 5 per cent to 15 per cent and when (4) meeting expectations, and (5) when employees believe the system is fair. Taken together, science is rather positive on the use of pay for performance.

It is worth noting, however, that none of the existing studies of financial incentives were conducted in Hong Kong. We know a lot about how incentives function in the West and in other parts of Asia, but we have very little direct evidence about our own context.

It is critical that we bridge this gap. I am conducting a new global study called IMPACT (Investigating Merit Pay Across Countries and Territories) with funding from the Hong Kong Research Grants Council and support from the Centre for Leadership and Innovation (CLI) at Hong Kong Polytechnic University. The study aims to collect data from as many as 50 markets worldwide, including Hong Kong. Local companies are most welcome to participate in this research. For more information and details, please email [email protected] .

Jason Shaw is chair professor of management, associate dean for research and postgraduate studies and co-director of Polytechnic University’s Centre for Leadership and Innovation