Incentives and Pay for Performance in the Workplace

CHAPTER THREE

Incentives and Pay for Performance in the Workplace Barry Gerhart University of WisconsineMadison, Madison, WI, United States E-mail: [email protected]

Contents 1. 2. 3. 4.

Introduction The Important Implications of How Incentive Pay Is Defined PFP in the Broader Compensation and People Management Context Economic and Psychological Perspectives on PFP 4.1 Economics: A Focus on Pay (Level) and the Disutility of Work 4.2 Pay Level: Only Part of the StorydShifting the Focus to PFP 4.2.1 What Is a Strategic Compensation Decision? 4.2.2 PFP Strategy: What Organizations Say and What They Do 4.2.3 How Much Versus How You Pay

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4.3 Psychology: A Focus on Cognitive Mechanisms and Concerns With the Use of 104 Monetary Incentives 4.3.1 PFP and Incentives as Irrelevant or Harmful 4.3.2 Example: Cognitive Evaluation Theory 4.3.3 Crowding Out Theory: CET’s Influence Extends to Economics

5. The Importance of Money and PFP in the Workplace 5.1 Employees and the (Unique) Importance of Pay to Them 5.2 Monetary Rewards Are the Norm in the Workplace 5.3 Research Evidence on Pay Importance to Employees 6. Use of Incentives and PFP in the Workplace 6.1 The Value of Use and Adoption Data on PFP 6.2 Use and Adoption of PFP 6.2.1 6.2.2 6.2.3 6.2.4

Merit Pay Merit Pay Effects via Promotion Merit Pay and Related PFP: Magnitude (or How Much PFP Is There?) Variable Pay: Short-Term and Long-Term Incentives

7. Effects of PFP 7.1 Incentive Effects 7.2 Sorting Effects

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7.2.1 Some Implications of Nonrandom Assignment (Sorting)

7.3 Effects of PFP in Higher Level Jobs

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7.4 Merit Pay 7.5 Variable Pay Plans at the Group/Organization Level 8. Risk and Pitfalls of PFP 9. Conclusion References

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Abstract I provide an overview of key developments in the literature on incentive pay and, more broadly, pay for performance (PFP) in workplace settings. These include the shift from a focus on pay level to an increased interest in PFP in economics and management, versus a decreasing interest in PFP and/or increased skepticism about the effectiveness of PFP in psychology. One part of the explanation for differing views on PFP may be that PFP, as actually used in workplace settings, differs from the type of PFP still mostly studied (individual incentive plans that use a formula to determine incentive payouts based on individual physical output) in psychology and, to a lesser extent, in economics. In work organizations, subjective assessments (ratings) and (often multiple) organization level measures of performance (e.g., revenues, profits) are commonly used as the basis for PFP payouts. We describe research on the use and effectiveness of both types of PFP plans with a particular emphasis on merit pay plans, which rely on subjective assessments of performance, given their wide use. We suggest that the types of PFP programs that are more common in US workplaces are less likely to suffer from the drawbacks of incentive pay (defined as individual incentive plans) often identified. Finally, we suggest how future research might better inform our understanding of PFP as used in the workplace.

1. INTRODUCTION In his book, The Principles of Scientific Management, Frederick Winslow Taylor (1911/1967) related his experience c.1900 introducing an incentive plan to improve productivity at Bethlehem Steel. When he arrived on the scene, workmen were moving 12.5 long tons of pig iron per day. Taylor declared “after studying the matter” that each workman “ought” to be moving 48 long tons per day. Why would a workman agree to move 384% more pig iron? Scientific management’s answer to that was incentive pay. Taylor emphasized that both the company and the worker needed to benefit for scientific management to work. Workers were informed that if they met the new target of 48 long tons per day they would be paid $1.85/day, a 61% increase over the $1.15/day they received previously for moving 12.5 long tons per day. Taylor reports that is what

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happened. So, both workers and the company did benefit (though it must be said that the company benefited considerably more.) It has been argued that “modern management came into being on the basis of (scientific management) principles” (Braverman, 1974, p. 120). Similarly, it has been argued that many of the principles of human resource management used today (Locke, 1982), especially those having to do with the use of incentives (Caudill & Porter, 2014) in compensation management (e.g., Newman, Gerhart, & Milkovich, 2017), can be traced back to the ideas and practices of scientific management. Although there is consensus that scientific management, including its emphasis on incentives, has been a major influence on management, it would be a mistake to say that there is a consensus regarding whether its influence, even at the time (see, for example, the report by Hoxie, 1916), was necessarily positive (Braverman, 1974; Gerhart, 1984). Interestingly, much the same can be said today on the topic of incentives. There is little consensus in the research literature regarding whether the effects of incentive pay are mostly positive (e.g., Jenkins, Mitra, Gupta, & Shaw, 1998; Locke, Feren, McCaleb, Shaw, & Denny, 1980; Oyser & Schaefer, 2011) or mostly negative (e.g., Deci, Koestner, & Ryan, 1999; Frey & Jegen, 2001; Kerr, 1975; Kohn, 1993; Pfeffer, 1998; Pink, 2009; Sanders & Hambrick, 2007) . There is also a view that, depending on what is defined as incentive pay, some forms of incentive pay (e.g., merit pay, Heneman & Werner, 2005) are of little consequence because they have little motivational effect as typically used (Sammer, 2011; Silverman, 2016). In addition, as we will discuss more later, how incentive pay is defined and studied in both psychology and economics remains similar to the incentive pay used at Bethlehem Steel c.1900. Importantly, however, this form of incentive pay is not what we typically see in the current workplace. This disconnect may help explain the differing views on the effectiveness of incentive pay and its relevance in today’s workplace. My goal in this article is to improve our understanding of the effects of incentive pay in workplace settings and to describe how this field of study has developed and evolved over time.1 This article is organized as follows. First, we begin by considering different definitions of “incentive” and how different definitions might lead us to different conclusions about issues 1

In this article, I draw on my previous reviews of incentives and pay for performance, including Gerhart (2001), Gerhart and Fang (2014, 2015, 2017), Gerhart and Milkovich (1992), Gerhart and Rynes (2003), Gerhart et al. (2009), and Rynes et al. (2005).

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such as the use, effectiveness, relevance, and risks of “incentive” pay. We will see that certain forms of incentive pay, although receiving much academic attention, are actually rarely used in the workplace. Accordingly, we will introduce a broad definition of incentive pay and use the broader term, pay for performance (PFP), which allows us to include more of what is actually happening in the workplace. Second, we place PFP decisions in the broader context of compensation management and people management. Third, we describe the perspectives of the disciplines of psychology and economics on the study of PFP and how these perspectives have in some ways evolved and in other ways remain much the same. For example, in the case of economics, we describe how developments there helped shift attention beyond pay level to PFP. Fourth, we evaluate ideas and evidence regarding the importance of pay in motivation and performance. Fifth, we provide an overview of the use of PFP in the United States. We include here an effort to provide estimates of the magnitude of the relationship between pay and performance (especially in the context of merit pay where performance is assessed subjectively with ratings) over time. Sixth, we provide an overview of the potential for PFP to have a positive influence on performance, but also its potential to have unanticipated negative consequences and/or to generate risks. Seventh, we provide suggestions for future research directions. The approach of this article may be different than what readers ordinarily encounter in the psychology literature (or in Advances in Motivation Science for that matter). My focus is very applied with a primary focus on policy and practice in work organizations. In explaining how the study of compensation relates to the study of motivation, Gerhart and Milkovich (1992) observed that in the study of compensation, “the focus is on compensation itself rather than on compensation as a means of testing particular psychological theories of motivation” (see also Dyer & Schwab, 1982). Thus, the focus is on understanding how organizations pay and what works, using theories to inform and understand, but not necessarily to determine, what is studied.

2. THE IMPORTANT IMPLICATIONS OF HOW INCENTIVE PAY IS DEFINED How we define “incentive” may influence our conclusions regarding the relevance, effectiveness, and risks of incentives. The term incentive is used and defined in one of two ways. First, the term incentive can be defined as “a promise of pay for some objective, pre-established level of

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performance,” which is often physical output (Newman et al., 2017, p. 353: sales commission plans have a similar design, except that sales volume replaces physical output).2 This narrow definition fits the incentive example from Bethlehem Steel and equates the term incentive with an individual incentive (or piece rate) program where a worker gets paid on the basis of individual objective performance (e.g., physical output in terms of number of pieces produced). However, as Newman et al. (2017, p. 353) note, “Because it’s often difficult to find good, objective individual measures, individual incentive plans don’t work for every job.” For example, they ask how “would you come up with an [individual] incentive plan for construction laborers? Maybe [an incentive plan would work] if they did the same thing all day [such as] dig 5 feet of trench, 2 feet wide by 18 inches deep” over and over and the more trenches dug, the more they would get paid. But, Newman et al. note that construction laborers perform a variety of tasks such as pouring concrete and assisting carpenters and masons in framing buildings. The Newman et al. example suggests that even for jobs where physical labor is still important, an individual incentive plan is a challenge to use. So, how common are such individual incentive plans in the US workplace overall? Not very. Perhaps the most accurate estimate comes from a study that used US Department of Labor Bureau of Labor Statistics data. Barkume and Moehrle (2001) examine incentive pay, defined as “payment that is linked by a formula to production or sales” (p. 14). Using that definition, they found that “less than 7 percent” (p. 14) of US private sector employees worked in incentive pay jobs. Further, 46.2% of those covered worked in sales occupations. That suggests that outside of sales, less than 4% (1  0.462  0.07 ¼ 0.038, or 3.8%) of private sector employees work in incentive pay jobs.3 That low percentage may be due partly to other issues raised in the many critiques of incentive pay cited earlier (see also Roy, 1952; Gerhart & Milkovich, 1992 for more detail on these points). It may also be because jobs increasingly require more use of knowledge, less use

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WorldatWork (2012, p. 85dSalary Budget Survey 2012e13) gives the following definition. “Incentive: any form of variable payment tied to performance. The payment is a monetary award. Incentives are contrasted with bonuses in that performance goals for incentives are predetermined.” Bonars and Moore (1995), using data from the National Longitudinal Surveys (NLS), estimate that 5.6% of employees work in incentive pay jobs, when defined as jobs that use either piece rates or commissions. Adding employees who work for tips (which could perhaps be seen as formula-based to an important degree) raises coverage to 8.2%. It should be noted that in the NLS data used in this study, the mean age was 27 years.

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of physical labor, and because employers have moved away from such incentive plans either because they can’t make them work for such jobs or because they have decided they are not optimal for such jobs. And yet, despite the fact that use of incentive pay under this definition is decidedly rare, this definition of incentive pay seems to be the one that most scholars have in mind when they catalog the effects, both positive (Jenkins et al., 1998; Oyser & Schaefer, 2011) and negative (Deci et al., 1999; Frey & Jegen, 2001; Kerr, 1975; Kohn, 1993; Pfeffer, 1998; Pink, 2009) of incentive pay. Consider, for example, how incentives are defined and operationalized in the cognitive evaluation theory (CET) research program on whether (extrinsic) rewards undermine intrinsic motivation. In the metaanalysis by Deci et al. (1999) on the “effects of extrinsic rewards on intrinsic motivation,” the most frequent form of extrinsic reward included was “tangible, expected rewards” and those, in turn, were primarily in the form of completion-contingent, performance-contingent, and engagement-contingent rewards. As an example of completion-contingent rewards, subjects in that condition in Deci (1971) were “told.that they would receive $1 for each puzzle they solved within the 13-minute time limit” (p. 109). As in the Bethlehem Steel example, if they completed more work, they would be paid more based on a formula (i.e., as an individual incentive or piece rate). Research in psychology on the effects of incentives on creativity also defines and uses incentives of this sort (Byron & Khazanchi, 2012). Research in applied psychology had also focused on such plans (Jenkins et al., 1998). In economics too, reviews of incentive pay often seem to focus exclusively on c.1900 Bethlehem Steel style plans. For example, although Oyser and Schaefer (2011), in the Handbook of Labor Economics, recognize that PFP can take a variety of forms, the actual evidence they review pertains (only) to how incentives worked for car windshield installers, tree planters, and fruitpickers. These are not “new economy” jobs (nor is it clear that many workers even in “old economy” jobs work under such plans). Also, as we will see, such formula-based (i.e., there is no judgment/discretion) incentives, where payment is based on a single, objective, individual-level performance measure, often seem to be the type of incentive that critics focus on (Kerr, 1975; Kohn, 1993; Pfeffer, 1998; Pink, 2009). The second, and our chosen way, to define incentives is in broader terms as an “inducement offered in advance to influence future performance” (Newman et al., 2017, p. 709). Like the narrower definition of incentives, it highlights the fact that an incentive is future oriented. However, this

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second, broader definition, unlike the first definition, allows us to include a broader range of PFP programs (merit pay, merit bonus, and related programs) that rely on subjective assessments of employee performance and/or group/organization PFP plans, which also typically measure performance using something other than individual-based, preestablished (i.e., formula-based) payout schedules. As we will see, this broader definition of incentives to include all PFP programs allows us to examine the PFP programs that are most used in organizations today. In this vein, we will see that merit pay, where adjustments to base salary are made annually on the basis of subjective performance assessments by one’s supervisor (and sometimes other sources also), is used by 94% of all US organizations and probably virtually 100% of private sector companies (in sharp contrast to the 3.8% we estimate are covered by Bethlehem Steel type incentives). There is another important point about refocusing the discussion on PFP programs such as merit pay: it is my impression that the types of serious problems raised with incentives of the sort used at Bethlehem Steel (as, for example, in CET research, Deci et al., 1999) are not considered to be likely problems with merit pay. If that is so, it changes the entire discussion about the potential advantages and disadvantages of using PFP. Accordingly, as noted, my focus is on the broader definition of incentive and includes PFP programs generally.4 As such, I define PFP as the degree to which, over time, employee pay covaries positively with performance, measured as some combination of individual and/or group/organization measures of performance. As we will see later, the “over time” aspect is important when it comes to PFP programs such as merit pay. In work organizations, the relationship between pay and performance is stronger over longer time intervals (e.g., Gerhart & Milkovich, 1989; Trevor, Gerhart, & Boudreau, 1997). There are a variety of reasons, including the smaller role of measurement error and relatedly, the focus on sustained performance, which may require (multiple) observations of performance not only over time, but across a variety of situations as well. A longer time interval also allows one to capture the cumulative impact of higher performance on pay over time, especially through the large positive impact of promotion on pay that comes from moving to higher job/pay levels (Gerhart & Milkovich, 1989). 4

Lawler (1971, chap. 2) reviews theory and evidence from the literatures on secondary reinforcement and conditioned incentives on money as “stimulus which gains value by being paired with primary rewards” (p. 21).

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3. PFP IN THE BROADER COMPENSATION AND PEOPLE MANAGEMENT CONTEXT Compensation can be defined to include “all forms of financial returns and tangible services and benefits employees receive as part of an employment relationship” (Newman et al., 2017, p. 13). Compensation can be broken into multiple dimensions or decision areas (Newman et al., 2017). Here, I focus on two. One is PFP/incentives, the topic of my paper. The second is pay level (which might be termed pay level incentives), defined as the average total compensation (including not only salary, but also other direct payments such as bonuses, incentives, commissions, stock-based compensation, as well as indirect payments in the form of benefits such as retirement and health care) per employee. Although our focus is not on pay level, it will enter our discussion at times for a number reasons: it can be intertwined with PFP decisions, it is relevant to discussing evidence on how important pay is to employees (i.e., in looking at how pay level might push them from/pull them to jobs), and because, historically, compensation research in areas such as economics long focused on pay level. Finally, experience indicates that companies that have high pay levels in the absence of PFP (e.g., the US automobile companies), when exposed to competitive market forces, find it difficult to compete using such a strategy (Gerhart & Rynes, 2003; Newman et al., 2017). So, it is important to note that a high pay level combined with the use of PFP seems to be a much more viable strategy than a high pay level in the absence of PFP. As workplace performance is typically viewed as having motivation and ability as its most proximal determinants (Campbell, 1990; Vroom, 1964), our discussion of PFP and incentives will necessarily make use of and have implications for motivation theory. However, as noted, in the management and economics literatures, the study of PFP and incentives often has a very applied focus, which can be seen in part by the preference for studying observable performance behaviors in workplace settings or, often, organization (e.g., profitability, shareholder returns) and/or unit (productivity) outcomes that are presumed to be influenced by workplace motivation and workplace behaviors.5

5

Both PFP and pay level can be defined at multiple levels, ranging from individual to organization level. In the compensation literature, they are most often defined as an organization level attribute.

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In the management and industrial relations literatures, in addition to ability (A) and motivation (M), the AMO model specifies that individual, unit, and organization performance is also a function of employee opportunity (O) to contribute to performance (Appelbaum, Bailey, Berg, & Kalleberg, 2000; Gerhart, 2007; Jiang, Lepak, Hu, & Baer, 2012; Katz, Kochan, & Weber, 1985; MacDuffie, 1995; Rabl, Jayasinghe, Gerhart, & K€ uhlmann, 2014). The focus of my article is on the motivation (M) dimension, especially as it is influenced by PFP. However, because the effects of M may statistically interact with those of A and O, a brief description of them is useful. There is extensive evidence on the (positive) relationship of job performance with cognitive abilities (Judge, Rodell, Klinger, Simon, & Crawford, 2013; Ployhart & Moliterno, 2011; Schmidt & Hunter, 1998) and with personality traits (e.g., Barrick & Mount, 1991). In addition to this main effect, there may be an interaction effect such that using PFP to motivate an employee without the abilities to perform a job may be less successful. Note that the A component is primarily determined by how recruitment, selection, and training/development are carried out in an organization. How work is designed and the constraints (e.g., Campbell, 1990; Peters & O’Connor, 1980) it places on and/or the opportunities (Blumberg & Pringle, 1982) it creates for employees to leverage their motivation and ability into high performance can also moderate the effects of motivation. Of course, in its history, psychology has devoted considerable attention to the motivating potential of designing jobs that are challenging, interesting, enjoyable, and fulfilling (e.g., Deci & Ryan, 1985; Hackman & Lawler, 1971; Hackman & Oldham, 1976; Herzberg, 1966, 1987; Maslow, 1943; Turner & Lawrence, 1965).

4. ECONOMIC AND PSYCHOLOGICAL PERSPECTIVES ON PFP 4.1 Economics: A Focus on Pay (Level) and the Disutility of Work In economics, the traditional focus in studying compensation had long been on pay level, not PFP. In economic theory, under competitive markets, the forces of supply and demand determine the price of the commodity being sold. In the case of a labor market, the commodity being sold is labor and the price is the market wage (pay level) paid by employers. In this model, there is a single going rate (price/wage) for labor. In addition, no

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single employer can influence the market wage and, as such, employers are described as price-takers, meaning that they must pay the market wage (Gerhart & Rynes, 2003, chap. 2) or else suffer negative consequences. Specifically, paying more than the market wage will increase total costs, which will either directly reduce profits or indirectly reduce profits when those higher labor costs are passed on to customers in the form of higher product (e.g., automobile, mobile phone, dining) prices, which is expected to reduce demand for the product. Paying less than the market wage will make it difficult to attract and retain a sufficient quantity and quality of employees needed to produce competitive products. Rather, they will work for employers that pay the market (higher) wage. In summary, under this classical view, employers are price-takers who must pay the market wage because product market constraints place a ceiling on wages and labor market constraints place a floor on wages. However, data on wages did not appear to conform to this basic form of economic theory (Dunlop, 1957; Lester, 1946; Reynolds, 1946; see Segal, 1986 for a review) in that it appeared that (1) the wage rate for the same job differed between employers and (2) the wage rate paid to different employees within the same job at the same employer differed (Groshen, 1988). Eventually, economic theory evolved in an attempt to reconcile these empirical facts. Human capital theory (Becker, 1962; Mincer, 1974) explained that employee differences in wages stem from different levels of productivity, which, in turn, result from different levels of human capital investment. Efficiency wage theory (EWT) models (e.g., Akerlof, 1982; Yellen, 1984) from economics eventually began in the mid-1980s to recognize that different employers might choose different pay level policies for a variety of economically rational reasons. One reason is that a higher pay level allows an organization to be more selective in hiring/retention, resulting in a higher ability workforce, which would be economically rational in organizations where the technology or work organization requires higher ability workers (Lazear, 1986). In addition, EWT sees pay level as an influence on motivation. For example, it argues that employees are motivated to the degree they fear job loss (which might be measured using the unemployment rate) and by their pay premium, defined as the difference between the pay level of their current job and their next best paying alternative job (see Gerhart & Rynes, 2003, chaps. 2 and 3, for a summary and review). In the absence of a high pay level to align interests and reduce problems of goal incongruence (or monitoring in the form of supervision to reduce

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information asymmetry), EWT anticipates that there will be a moral hazard problem and that workers will “shirk,” which means they will not be motivated to put forth effort. Thus, the impression is conveyed that a worker’s natural tendency is to avoid work. Although economic theory (e.g., Rottenberg, 1956) does not exclude nonmonetary rewards as relevant to the utility (value) an employee derives from work, there is no direct acknowledgment of factors other than pay level acting as motivators. Other aspects of economic theory also convey the sense that pay levels are crucial in decisions. Consumption of goods and leisure (nonwork time that can include a variety of activities) is limited by income and workers choose to work to generate income to allow more consumption. Models of labor market participation frame an increase in wage level as having offsetting effects: a substitution effect that leads to working more hours (in place of leisure) due to the higher wage versus an income effect, which is the tendency to use the higher income from the higher wage to increase consumption, including of leisure, which is termed a positive good (i.e., more is consumed at higher income levels). In the absence of a sufficiently high wage, workers will not enter the workforce at all, but will instead allocate their time to leisure (other activities). The idea that one would work for reasons other than income such as the fulfillment and meaning that comes from working is not excluded as a possibility under the theory, but neither is it explicitly included. Again, the impression conveyed is that one works (only) for income. Work without income, is seen as lowering utility (i.e., creating disutility).

4.2 Pay Level: Only Part of the StorydShifting the Focus to PFP Although economists, of course, recognize better than any field the importance of monetary incentives, most of the focus in the economic study of compensation had long been on pay level as the main incentive issue and, as noted, mostly on how little discretion employers had in choosing their pay levels. For many years, when it came to employee decisions/motivation, the focus was on labor supply: whether an individual would choose to enter the labor market and, if so, how many hours they would choose to work. The first systematic focus on PFP-related issues in economics might be said to have been in the stream of agency theory that began in the 1970s (Fama, 1980; Fama & Jensen, 1983; Jensen & Meckling, 1976; see Eisenhardt, 1989, p. 59), but which only began to make an impact on the management literature in the late 1980s (e.g., Eisenhardt, 1988, 1989; Oviatt, 1988; Tosi & Gomez-Mejia, 1989). As Lazear (1986, pp. 405e406) noted

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around that time: “Little attention has been paid to what may be among the most important and obvious distinction in methods of compensation, namely, the choice between a fixed salary.and paying a piece compensation that is specifically geared to output” (Note: here again, we see a focus on incentives of the type that are rare in the US economy). Under agency theory, the metaphor of a contract is central and a key focus is on what type of contract is most likely to control agency costs, which refers to the fact that an agent (e.g., a manager or employee) will not act in the best interests of the principal (e.g., an owner) because of goal incongruence and information asymmetry. A results-based (or outcome-based) contract ties incentive payouts to objective performance measures such as physical output, sales, profits, and revenue. A result-based contract is seen as having better/stronger incentive effects, but despite that, are not always optimal because such contracts shift risk to the agent in the sense that those types of outcomes may be influenced by factors other than the agent’s effort and thus the agent bears the risk that his/her payout will vary due to these factors beyond his/her control. A compensating differential must be paid to the agent to bear this risk, thus adding to the cost of using such a contract. A second type of contract, behavior-based, monitors behaviors and may use subjective assessments/judgment, which allows for consideration of how factors beyond the agent’s control might affect observed performance. There is also a risk in such contracts due to aspects of subjectivity that may penalize the agent. But, behavior-based contracts are generally seen as shifting less risk to the agent. Thus, the choice in agency theory is sometimes described as incentives versus risk/insurance (Prendergast, 1999). 4.2.1 What Is a Strategic Compensation Decision? Against this backdrop, where the importance of pay is taken as given and where the main focus (with exceptions beginning to appear) was on pay level, Gerhart and Milkovich (1990) set out to better understand which compensation decisions were most strategic. Drawing on Pearce and Robinson (1982), they defined strategic as decisions that “require top management involvement, entail allocation of large amounts of company resources, have major consequences for multiple businesses or functions, are future-oriented, require consideration of external environment factors, and affect the long-term performance of the organization.” Gerhart and Milkovich (1990, p. 668) reasoned that because compensation “typically accounts for 20 to 50 percent of total operating expenses.and has implications for attraction, retention, and performance motivation across business

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units and functional areas, and thus perhaps for organizational performance,” pay level and PFP decision were likely to be strategic. They also drew on an earlier, but empirically neglected idea. Even if an employer was constrained in its choice of pay level, there was no necessary constraint on how that amount of pay was paid: “It [is] clear that a variety of psychologically meaningful parameters of pay can be varied by a company without increasing the total salary expense over time, yet the motivational leverage of alternative forms at constant cost has had remarkably little empirical investigation” (Haire, Ghiselli, & Gordon, 1967, pp. 9e10). 4.2.2 PFP Strategy: What Organizations Say and What They Do As the literature on organization differences in pay strategy, including PFP, began to develop, the initial approach to measurement was to ask organizations what their PFP strategy was. Typically, a single respondent, sometimes referred to as a “key informant,” was the source of such data (e.g., Balkin & Gomez-Mejia, 1987).6 Early on, Gerhart and Milkovich (1990, p. 668) argued for using data on what organizations actually paid their employees as a measure of pay (pay level and PPF) strategy: In measuring strategy, both intentions and actions are relevant, but the correspondence between the two is not necessarily high.Actions, not intentions or plans, are likely to have the greater consequences for the costs and behaviors related to compensation. Thus.we focused on “realized” pay strategies, those in which “a sequence of decisions in some area exhibits consistency over time” (Mintzberg, 1978, p. 935; cf. Miles & Snow, 1978). In other words, for organizational effects to have strategic properties, they should be stable over time.

4.2.3 How Much Versus How You Pay Gerhart and Milkovich (1990) tested the above theoretical logic that suggested the main strategic “action” might be with respect to PFP (“how” you pay) rather than pay level (“how much” you pay), and did so using data on actual pay and observations on approximately 16,000 top and middle level employees in 200 organizations over 5 years. They observed that “Despite the heavy focus on pay level in previous field research.our findings suggest that [PFP] deserves at least as much 6

We also later raised issues and limitations of using single respondents in the literature dealing with the broader question of how overall human resource strategy (including pay strategy) influences performance outcomes (Gerhart, 2000; Gerhart, Wright, McMahan, & Snell, 2000) and a debate followed (Gerhart, Wright, & McMahan, 2000; Huselid & Becker, 2000).

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attention.” Indeed, they went on to report that they observed larger organization differences (both raw and partial, after including explanatory variables) in PFP strategy than in pay level strategy, and that organizations’ use/intensity of PFP was (strongly and positively) related to subsequent organizational performance, whereas pay level differences were not. Table 1 shows how predicted return on assets, a measure of profitability, varied according to the use of PFP, as measured by two variables: the ratio of bonus pay to base pay in each organization and by the percentage of employees in each organization eligible for long-term incentives. Importantly, neither of these “incentive” (or PFP) variables were defined in the narrow Bethlehem Steel manner. Long-term incentives pay out to the employee when total shareholder return increases. Bonus plans are typically a form of short-term incentive where payouts are based on some combination of revenue, profits, individual performance, and increasingly, nonfinancial performance measures such as customer service (these plans are discussed more later). Also of note is that the jobs in the Gerhart and Milkovich (1990) study were very different from the manual labor jobs often examined in incentive pay studies, instead consisting of top executives, profit center heads, and employees in legal, employee relations, manufacturing, marketing, finance, government relations, information systems, research and development, and engineering.

4.3 Psychology: A Focus on Cognitive Mechanisms and Concerns With the Use of Monetary Incentives Motivation in the workplace is a major focus of psychology, including applied psychology and a number of reviews are available (e.g., Ambrose & Kulik, 1999; Campbell & Pritchard, 1976; Elliot & Dweck, 2005; Gagné & Deci, 2005; Grant & Shin, 2012; Kanfer, 1990; Kanfer & Chen, 2016; Latham, 2007; Latham & Pinder, 2005; Pinder, 2014; Ryan & Deci, 2000; Schmidt, Beck, & Gillespie, 2013). In addition, annuals such as Table 1 Return on assets as a function of two dimensions of organization PFP strategy Predicted return on assets Short-term incentive Long-term incentive (bonus/base ratio) (%) (% of employees eligible) % $

10 20 10 20

28 28 48 48

5.2 5.6 5.9 7.1

250 million 269 million 283 million 341 million

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Advances in Work Motivation and volumes such as the Handbook of Competence and Motivation, 2nd Edition: Theory and Application provide in depth and recent examinations of programs of study of motivation in a variety of achievement settings. In contrast to the focus of economics and compensation literatures, where it is given that PFP/incentives motivate and the focus is on the optimal design of such programs, one would be challenged in combing through the motivation literature reviews cited above to find much attention given to monetary incentives. Rather, the motivation literature, even that with a specific focus on work motivation, as noted by Rynes, Gerhart, and Parks (2005), primarily focuses on psychological mechanisms and processes and individual differences. For example, a recent review of the broad topic of work motivation (Schmidt et al., 2013) was organized around the following major topics: overview of goals and goal processes; expectancies, self-efficacy, and related concepts; affect; individual differences related to the self and personality; temporal dynamics; and multiple goals and decision making. The role of compensation decisions related to incentives and PFP is a topic that was not included. When the psychology literature does give attention to what motivates, its focus is usually on job attributes other than pay (e.g., autonomy). Where attention is given to incentives, it may be to argue their detrimental effects (e.g., CET, Deci et al., 1999). Yet, looking back in the history of psychology, one would be hard pressed to argue that contingent rewards had been overlooked. Reinforcement (Skinner, 1953; Thorndike, 1911) and organizational behavior modification theories (e.g., Luthans & Kreitner, 1975) certainly placed a great deal of focus on how reinforcers and reinforcement schedules could be used to shape behavior. However, at least some forms of this behaviorism approach to motivation were seen as being deterministic, denying free will, emphasizing the causal role of environmental factors in driving behavior, and also in some cases denying the theoretical value of cognitions, including thoughts, perceptions, goals, and values and in reaction what is sometimes referred to as a “cognitive revolution” resulted (Chomsky, 1971; Dember, 1974; Greenwood, 1999; Locke, 1977; Locke & Latham, 2015; Ryan & Deci, 2006). One can speculate that something as central to the behaviorist paradigm as the use of extrinsic rewards to shape and control behavior might still carry a stigma. That would be especially true from the standpoint of those who helped bring a focus on free will, autonomy, self-determination, personality traits, affect, and cognitions to the study

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of motivation. Although recognizing that point, it must also be recognized that there is no need to choose between cognitions and incentives in explaining behavior (Locke, 1977; Locke & Latham, 2015; Rynes et al., 2005). Integrating both into our theories and empirical investigations is valuable for understanding how motivation works and for having the greater confidence in the types of causal inferences that are essential for making valid and credible policy recommendations (Gerhart & Milkovich, 1992). “Unless one knows why and how something ‘works’, one does not know when it will work or even that it will work in a given circumstance” (Locke, 1977, p. 550). 4.3.1 PFP and Incentives as Irrelevant or Harmful Gerhart and Rynes (2003) and Rynes et al. (2005) also observe that when money’s role in motivation is discussed in psychology, it often seems to be in a negative light. Again, that may be partly a remnant of the earlier pushback in the field against the strands of environmental determinism and control of behaviorism. Whatever the reason, Maslow’s (1943) need hierarchy theory and Herzberg’s (Herzberg, 1966, 1987) motivator-hygiene theory share the view that pay is largely irrelevant to motivation in the workplace, with Maslow deeming it relevant only to lower order needs and Herzberg placing pay in his hygiene factor category, not his motivator category. Herzberg sees factors such as achievement, as well as challenging, meaningful work as sources of motivation. Maslow emphasized achievement also, as well as independence and freedom. Although the scholarly literature has, for the most part, come to the conclusion that some key propositions of the Maslow and Herzberg models are not empirically supported, these models appear to continue to assert considerable influence on how people view pay (see Gerhart & Rynes, 2003). 4.3.2 Example: Cognitive Evaluation Theory As noted, one psychological theory of motivation, and a particularly influential one, that takes a mostly negative view of extrinsic rewards such as monetary incentives is CET (Deci et al., 1999; for an interpretation of CET that acknowledges potential positive effects of PFP, see Gagné & Deci, 2005). The argument is that monetary incentives/PFP can actually be harmful to what is viewed as a superior, higher quality form of motivation: intrinsic motivation (see Deci, 1975; Deci & Ryan, 1985; Deci et al., 1999; Ryan, Mims, & Koestner, 1983; in the management literature see

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Kohn, 1993; Pfeffer, 1998; Pink, 2009).7 We have reviewed this theory and empirical evidence in some depth elsewhere (Gerhart & Fang, 2015) and we refer interested readers to that work. Here, we make a few brief observations. First, none of the studies included in the Deci et al. (1999) metaanalysis appear to have been conducted in workplace settings. Payment is the norm in the workplace (unlike in other settings) and equity theory (Adams, 1963) tells us that in the workplace, equity is a strongly held value. Equity means being paid in proportion to the value of one’s inputs such as performance. Thus, not using PFP in workplace settings is likely to cause perceptions of inequity, which is a source of a variety of negative behavioral consequences (e.g., lower effort, higher turnover; Gerhart & Rynes, 2003). So, even if PFP/incentives do diminish intrinsic motivation, not using it is likely to result in other, possibly more serious problems with perceived inequity. Extrinsic motivation would also be expected to suffer in the absence of PFP/incentives. Second, the Deci et al. meta-analysis (1999) does not report any analyses that use performance as a dependent variable. Thus, from this work we do not know the net effect on performance of these different effects of PFP/incentives. Third, as noted earlier, the definition and operationalization of incentive in this line of research is very rare in today’s workplace. A study (Fang & Gerhart, 2012) conducted in the workplace and that defined and operationalized PFP more as merit pay found no negative effect of PFP on intrinsic interest, but rather a positive effect. 4.3.3 Crowding Out Theory: CET’s Influence Extends to Economics There is now also a body of theory and research in economics (e.g., Frey & Jegen, 2001; Gneezy, Meier, & Rey-Biel, 2011) on the ineffectiveness and/ or harmful effects of incentives. Examples include studying incentives intended to motivate students to attend school, people to contribute to the public good (e.g., donating blood), and people to improve their wellness (e.g., smoking cessation, exercise, weight control). The theoretical explanation is that “crowding out” takes place, which means that when people are given a monetary incentive to engage in a behavior, what had previously been their source of motivation (e.g., being helpful) diminishes. Thus, 7

Returning to the question of how one defines “incentive” may help explain the often negative view of monetary incentives in psychology. For example, in the program of research on intrinsic motivation and the undermining effect of incentives, incentives take the form of what we saw in Taylor’s work at Bethlehem Steel c.1900. However, as we have seen, incentives of this sort probably cover fewer than 4% of US employees outside of sales jobs.

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monetary incentives and other sources of motivation sometimes have nonadditive effects in such settings. It is very important to emphasize, however, that this crowding out effect has, to my knowledge, only been demonstrated in nonwork settings, where payment (unlike in the workplace) is not the norm. And, as we have seen, even if such studies of incentives (narrowly defined) were extended to workplace settings, they would be relevant to less than 4% of nonsales jobs.

5. THE IMPORTANCE OF MONEY AND PFP IN THE WORKPLACE Despite the dim view taken of incentives (as typically defined in the research that holds this view) and the role of money in the workplace overall, when we look at organizations and employees, we see that money in the form of wages, salaries, and incentives (broadly defined to include all PFP programs) is, of course, ubiquitous. The US Bureau of Labor Statistics reports that the mean annual wage (not including benefits, which would add another 40% on average) for among 138 million full-time workers across occupations and industries is $48,320. That adds up to $6.7 trillion. That amount reinforces the need to understand how and why organizations spend that money and what they receive in return for it. To begin, we now turn to understanding the importance of pay to employees.

5.1 Employees and the (Unique) Importance of Pay to Them Why is money uniquely important to employees? Although 50 years ago, Opsahl and Dunnette (1966, p. 108), as quoted in Lawler (1971, p. 16) put it in a way that may still resonate: “Executives strive mightily to advance to higher-paying jobs, entertainers work toward more and more lucrative arrangements; bankers embezzle; robbers rob; university professors publish to win increased salary and to enjoy royalty checks.” Gerhart and Milkovich (1992), in less colorful language, pointed to the important consequences for employees of compensation decisions, as wages and salaries are the main source of income for most employees and “may also be taken as indicators of a person’s social standing or success in life” (p. 483). Applied psychologists have similarly noted that pay is uniquely important because it is instrumental for satisfying so many other kinds of needs and/or goals (e.g., security, status, esteem, achievement; Lawler, 1971; Locke et al., 1980). For example, Lawler (1971) presented a model showing that pay is important because it is instrumental in meeting these many needs, both tangible (e.g., Maslow’s,

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1943 frequently mentioned “lower-order” needs such as food and shelter) and less tangible (Maslow’s “higher order” needs such as security, status, esteem, and achievement).8 Today, of course, we continue to see examples of how important pay is, whether it be social movements to protest income inequalitydsee equity theory later (e.g., “Occupy Wall Street,” an occupation of Zuccotti Park in New York City’s financial district to protest the unfairness of a system viewed as unfair and that benefits primarily “the top 1%,” see Berrett, 2011; Levitin, 2015) and/or to raise wages for low-paid workers, such as the “Fight for $15” (an effort to obtain a minimum wage of $15 city by city and state by state, which compares to a current federal minimum wage of $7.25; see Greenhouse, 2016 and Rolf, 2016). These social movements suggest that monetary rewards are uniquely important among the spectrum of rewards that make up the employment relationship.

5.2 Monetary Rewards Are the Norm in the Workplace Unlike in many other types of organizations and/or other types of social exchange relationships, in an employment setting, the norm is that a central inducement/reward employees receive in return/exchange for their contributions such as effort and performance is money. “Compensation is a defining feature of employment” (Rousseau & Ho, 2000, p. 73). The exchange of inducements and contributions forms a contract, implicit or explicit, between employers and employees (Adams, 1963; Barnard, 1938; March & Simon, 1958; Rousseau, 1989; Tsui, Pearce, Porter, & Tripoli, 1997). Compensation can be viewed as part of the broader construct of total rewards or equivalently, inducements, that employees receive from organizations in return for their contributions to the goals of an organization. In addition to monetary rewards, inducements more broadly include whatever it is that some employees value about job/organization attributes. One example is the nature of the work in terms of how interesting, challenging, developmental, and meaningful it is (e.g., Hackman & Lawler, 1971; Hackman & Oldham, 1976; Hertzberg, 1966, 1987; Maslow, 1943; 8

Additionally, economists (e.g., Rottenberg, 1956) have pointed out that money has the advantage of not only being more easily quantified than other rewards, in part because it is a ratio level scale (i.e., has a meaningful zero point), but also the unique quality among rewards that more of it is almost always preferred to less of it (cf., responsibility, social interaction, and other job attributes, which may differ in their attractiveness to different individuals).

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Ryan & Deci, 2000; Turner & Lawrence, 1965). The job satisfaction (Harrison, Newman, & Roth, 2006; Judge, Thoresen, Bono, & Patton, 2001; Locke, 1976; Smith, Kendall, & Hulin, 1969), organizational commitment (e.g., Meyer, Allen, & Smith, 1993), and other literatures additionally identify the importance to some employees of, for example, good coworkers and leaders (Chiaburu & Harrison, 2008; Judge & Piccolo, 2004), and organizational values that align with their own (O’Reilly & Chatman, 1986; O’Reilly, Chatman, & Caldwell, 1991). Being treated fairly and with dignity and respect are some of the things “best employers” are known for (Fulmer, Gerhart, & Scott, 2003).

5.3 Research Evidence on Pay Importance to Employees Based on research evidence too, pay is very important to employees. One type of evidence is based on what people “say” and another type is based on what they “do” (Rynes, Gerhart, & Minette, 2004). Based on their review of what people say, Rynes et al. (2004) observe that when asked directly, people may under-report the importance of pay, relative to other rewards, perhaps because of social desirability (e.g., saying you would like to earn money is less noble than saying you want to do meaningful work or make the world a better place). Nevertheless, even when asked directly about which rewards they value most, employees often indicate that pay is most important. As an example, consider the results of the Society for Human Resource Management’s (2014) surveys of employees over the course of 10 years (2004 through 2013) regarding which of 21 job attributes (including “opportunities to use skills/abilities,” “relationship with immediate supervisor,” “communication between employees and senior management”) are most important to them (in deciding whether to stay with the organization). The three job attributes most often rated as “very important” by employees were in order: job security, benefits, and compensation/pay, all of which relate to compensation. Rynes et al. (2004) also reviewed evidence from research where employee preferences are estimated more indirectly (e.g., policy-capturing). That research, on average, tends to find stronger evidence for the importance of pay. Second, we can look at evidence on what people do (i.e., their behaviors) in response to pay, here pay level. There is solid evidence that higher pay levels significantly reduce employee turnover. For example, Newman et al. (2017) summarize five studies showing that a 10% higher pay level is associated with employee turnover that is 8.5%e35% lower. Gerhart and Rynes (2003) and Newman et al. (2017) reviewed studies on how employee

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pay level changes when they quit and move to another job. This evidence indicates that moving to take another job was associated with a pay level increase ranging from 14% to 25%, with estimates being more toward the higher end for those who first lined up the new job prior to quitting (Dreher & Cox, 2000; Gomez-Mejia & Balkin, 1992; Keith & McWilliams, 1999). In terms of attitudes, which predict behaviors, a meta-analysis by Williams, McDaniel, and Nguyen (2006) shows that employee perceived pay discrepancy, which is the discrepancy between an employee’s perception of what pay should be and what pay currently is, correlates at a substantial level (corrected r ¼ 0.54) with pay satisfaction. One additional piece of evidence comes from a University of Wisconsin-Madison report on outside offers received by its faculty members. In cases where salary information was available for the outside offer, it was a median of 30% higher than the University of Wisconsin-Madison salary.9 The University also reported that it spent a total of $23.56 million to retain 232 faculties, some in the form of salary, most in the form of funds to support their research, which works out to $101,552 per faculty member retained. As such, faculty with outside opportunities, whether they left or stayed, received substantial returns to their (presumably high) performance, not all in the form of direct compensation, but the increased research support would arguably be expected to increase their future performance above what it would have been in the absence of this level of support, which would, in turn, increase their future pay over what it would have otherwise been.

6. USE OF INCENTIVES AND PFP IN THE WORKPLACE 6.1 The Value of Use and Adoption Data on PFP Earlier, we saw that using a narrow definition of incentive consistent with the type of incentive plan we saw at Bethlehem Steel c.1900 would result in us concluding that less than 4% of today’s US workforce is covered by an incentive plan. We argued that defining incentive more broadly would give a more accurate picture of the role of PFP in the workplace. Understanding the degree of use of PFP and what such plans look like is important for a few reasons. First, it demonstrates that PFP as typically practiced today has little to do with the type of incentive plan used at Bethlehem 9

Summary of Outside Offers and Retention Efforts, 2015e16, University of Wisconsin-Madison.

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Steel. To the degree that concerns about incentive and PFP plans pertain to that sort of plan, such concerns may be less consequential than often believed. Second, although it would be a mistake to equate plan use with plan effectiveness, we do believe that plans that continue to be used over time can be said to have perhaps met a market test of sorts. The logic here is that plans that add value are more likely to survive in a competitive market. We have seen that PFP is widely used in organizations, especially in the private sector, where market forces are strongest, arguably requiring, at least to some significant degree, the use of practices that contribute to efficiency and effectiveness. In contrast, in the public sector, where competition and market forces play less of a role than in the private sector, PFP is used less. We also know that PFP is used less in the union sector and that the union sector has declined precipitously in size over time, due, some would argue, to the lower efficiency (output/cost) of union production. Finally, there are no longer any major economies that fully use central planning, one reason presumably being that such economic systems did not provide the incentives necessary to achieve the efficiency and standard of living found in more market-oriented economies. The efficiency of an economy depends on efficiently managed firms and there is a literature documenting that firms having higher management quality practices have higher productivity (Bloom & Van Reenen, 2007). One dimension of management quality is the (higher) use of PFP (Bloom & Van Reenen, 2007). The data we are about to see on the extensive use of PFP in US companies might also be considered in light of international comparative data on productivity from the World Bank. Among the major economies, the United States is the most productive in terms of output per worker (gross domestic product/number of employed persons, adjusted for purchasing power) at $68,374, compared to China at $15,250, Japan at $44,851, Germany at $43,243, the United Kingdom at $49,428, and France at $52,535. As such, the economy of the United States is 30% more productive than that of the next most productive major economy. Thus, although it is possible that US companies are more productive despite their heavy use of PFP, it is perhaps more plausible instead that the positive effects of PFP on motivation are a key part of what drives its high productivity.10 Again, the literature on management quality (Bloom & Van Reenen, 2007) supports 10

As we have seen, PFP is used widely in the United States, especially in the private sector. It is also used in much of the rest of the world, including in the largest economies (e.g., Newman et al., 2017, chap. 16).

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the latter interpretation in that the United States also has the highest average management quality.

6.2 Use and Adoption of PFP WorldatWork, the professional association for compensation professionals, as one of its activities, conducts surveys of compensation practices in organizations. It reports that 94% have merit pay programs (WorldatWork, 2016), 99% have short-term incentive plans (payment based on attainment of financial, operational, and individual goals during a period of 12 months or less), and 88% have long-term incentive plans (payment based on attainment of goals over a period of longer than 12 months; usually related to stock-based performance). Actually, these percentages underestimate the use of PFP in the private sector, given that 22% of responding organizations were in the nonprofit, not-for-profit, or public sectors where we know that the use of PFP (as well as its intensity when it is used) is considerably lower (WorldatWork, 2012). And, of course, long-term incentive plans, given that they typically rely on stock performance, are not readily feasible where there is no stock. Thus, the modal US private sector company relies heavily on PFP and, the percentage of private sector organizations using two or more of the above PFP plans is probably close to 100%. I will say more on this subject later. 6.2.1 Merit Pay Under a merit increase plan, salary increases (i.e., they become part of base salary) are given (typically) on an annual basis and are based on performance (as measured by a subjective assessment, or judgment, typically a rating by the supervisor). When organizations are asked how much they differentiate merit increases based on individual performance, the modal response (45% of responding companies) is that “top performers” receive salary increases 1.5 times as large as those received by average performers (WorldatWork, 2016). Recall that 22% of the sample used in this study are not for-profit companies, which likely makes 1.5 times a lower bound. In any case, recently, the average merit increase pool has been about 3%. As such, an employee who consistently receives 3% would see their salary grow by a factor of 1(1 þ 0.03)20 ¼ 181% (not adjusting for inflation) over 20 years via merit increases alone, whereas an employee with a 4.5% annual salary growth would see their salary grow by 1(1 þ 0.045)20 ¼ 241% (not adjusting for inflation) over 20 years via merit increases alone. About 20% of organizations (again, including not-for-profit organizations) report that

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top performers receive two times as much as an average performer. That would translate into 1(1.06)20 ¼ 321% growth. Low performers would receive less than 3%. At a consistent growth rate of say 2%, their pay would grow 49% over 20 years. Two employees, both starting at $100,000 (roughly the going rate for a new US MBA), would then have anticipated salaries after 20 years of $321,000 versus $149,000, as a function of their over time performance differences. It is also possible that the lower performing employee would not remain in the labor force. As a coarse way to pull out the effects of inflation, we can assume an inflation rate of 2% and then accordingly estimate the difference in real growth rates between low and high performers as 4.5%  2% ¼ 2.5%. Over 20 years then, the low performer would experience 0.0% real salary growth, compared to 1(1 þ 0.025)20 ¼ 164% real salary growth for the high performer. Some caveats are required. The assumption that some employees receive above (below) average performance ratings and thus above (below) average merit increases every year is probably not realistic given variations in performance over time, as well as the limited reliability (Viswesvaran, Ones, & Schmidt, 1996) of supervisory ratings, meaning that the base salary differences over 20 years based on different performance levels may be overstated. Also, in most companies, “merit increase grids” assign lower percentage merit increases to those whose salary is above average for their job, thus slowing salary growth over time, unless, that is, one gets promoted. 6.2.2 Merit Pay Effects via Promotion It is important to recognize, however, that merit increases, which are within-salary grade increases, are not likely to be the main source of salary growth for high-performing employees. Higher performance ratings pay off through additional mechanisms. In particular, PFP operates to a large degree through the process by which employees maximize their career earnings by moving to higher level, more impactful, higher paying jobs. That can occur either through promotion in one’s current organization or by moving to another organization (i.e., turnover) for a promotion and/or higher paying job opportunities (e.g., Gerhart & Fang, 2014; Gerhart & Milkovich, 1992). In private sector (and arguably in many public sector) workplaces, individual performance is the main determinant of promotion. For example, Gerhart and Milkovich (1989) reported that, in the case of men, those one point above the mean on a four-point performance scale received 48% more promotions over a six-year period than those with performance at the mean.

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In another WorldatWork survey (2016b), companies report that 9.3% of employees get promoted each year and that the average pay increase for each promotion ranges from 8.1% to 9.6% with the larger percentage being at higher job levels. That is an underestimate of the payoff in the sense that a promotion typically moves someone from high in one salary grade to low in the higher salary grade, and the lower one is in a salary grade, the larger the merit increase one typically receives for a certain level of performance in most companies, based on their merit increase grids (Newman et al., 2017; WorldatWork, 2016). We know that the modal midpoint progression (the differential between the midpoint of the salary grade level prior to promotion and the midpoint of the salary grade of the grade following promotion) is roughly 15%. Any employee with average or better performance will steadily move higher in their new salary grade following a promotion, meaning that promotion alone will essentially translate into a 15% increase for that group within a few years (we also saw earlier that when employees voluntarily leave one organization to join another, they receive a substantial salary increase on average).11 Thus, for example, after three promotions, we might project pay to be 1.15  1.15  1.15 ¼ 1.52 times higher. We also know that the typical company designs its salary grades such that the salary grade maximum is roughly 20% above the midpoint (and the minimum is roughly 20% below the midpoint).12 As such, if an employee receives no further promotions, it would be possible to still increase pay by an additional 20%. So, in our example, with three promotions and high performance ratings in the final/highest salary grade, pay would have grown by 1.52  1.20 ¼ 1.84, or 84% in what could be a relatively short time. Of course, additional promotions (whether at the current or a different employer) would be received by some. Thus, one of the most important ways that organizations pay for or incentivize performance is through their use of promotion. For example, based on results reported by Trevor et al. (1997), who looked at the relationship over a three-year period between average salary growth (including that due to promotions) and average performance

11

Most organizations use a merit increase matrix to determine the size of the merit pay increase received by each employee. Typically, the matrix is designed such that larger percentage merit increases are given to high performers, but also to employees whose pay is below their salary grade midpoint/average. 12 Range spread is defined as salary maximum/salary minimum: 1. The typical range spread is roughly 50%, which translates roughly into the midpoint  20%.

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(rating), employees with mean performance one standard deviation above the mean experienced 58% higher salary growth than those having performance one standard deviation below the mean (Gerhart, Rynes, & Fulmer, 2009). 6.2.3 Merit Pay and Related PFP: Magnitude (or How Much PFP Is There?) A company may report that it uses PFP. However, that does not tell us the magnitude of the relationship between pay and performance. One reason is that some companies reporting that they have merit pay do not meet our earlier definition that PFP exists when pay and performance are positively and meaningfully related over time. One cause is when a company does not give meaningfully different merit increases to employees having different performance levels. A second cause is when the company has little variance in its distribution of merit (performance) ratings. Either or both will weaken actual PFP. A different possibility is that PFP will be underestimated by incorrectly ignoring the effect of performance on pay via promotion. For example, Konrad and Pfeffer (1990) reported that a one standard deviation increase in research performance among university faculty was associated with only a $400 increase in faculty pay (the mean faculty pay in their study, which used data collected in 1969, was $11,782 with a standard deviation ¼ $4533). However, they controlled faculty rank (assistant, association, full professor). As noted by Gerhart et al. (2009), such a model estimates only the direct effect of research performance, excluding its (indirect) effect on pay that stems from more productive faculty being more likely to be promoted to higher faculty ranks. Gerhart et al. (2009) reanalyzed Konrad and Pfeffer’s data to show that a faculty member one standard deviation above the mean on research performance (without controlling for rank or other variables) had $2234 higher pay, an effect that is more than four times as large as the $400 estimate emphasized by Konrad and Pfeffer. Likewise, Gerhart et al. (2009) observed that a faculty member one standard deviation above the mean on research performance would have an expected salary of $14,016, compared to $9548 for a faculty member one standard deviation below the mean, a difference of 47%. In a study of white-collar jobs at a petrochemical company, Trevor et al. (1997) found that at one standard deviation below mean performance (mean ¼ 2.74, SD ¼ 0.66), mean salary growth over a three-year period was $1705, compared to $2695 for performance at one standard deviation

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above the mean, a difference as noted earlier of 58%. Gerhart (1990), in another study of white-collar positions, in this case at a large, diversified company, reported that over a 5-year period, each one-point increase in performance was associated with a 16.1% higher salary. The magnitude of PFP can also be examined where PFP has fewer merit pay features. In a study of National Hockey League players, using 7 years/ seasons of data, 175 team-years, and 4465 player-years, Trevor, Reilly, and Gerhart (2012) found that a majority of the variance (R2 ¼ 52%) in player compensation level could be explained by seven performance measures: goals, assists, plus/minus (the differential between goals scored and allowed when the individual being rated is on the ice and the team scoring is not on a power play), power play goals, shorthanded goals, penalty minutes, shots on goal, and defensive goals and assists. Finally, we consider an area of compensation that is often the subject of criticism: the compensation of CEOs in US companies. One frequently made criticism is that CEO pay is not meaningfully related to company performance (Dalton, Daily, Certo, & Roengpitya, 2003; Tosi, Werner, Katz, & Gomez-Mejia, 2000). However, we (Nyberg, Fulmer, Gerhart, & Carpenter, 2010) argued that previous research in the management literature had not specified the relationship correctly. To do so, it is necessary to capture all key aspects of CEO compensation (e.g., in large companies, a minority portion is in the form of base salary with the largest component usually being in the form of long-term, stock-based pay, followed by short-term bonus-based pay) and to study the relationship over several years because payouts from some major sources of CEO pay such as stock options may not occur for several years after they are received and after sufficiently high firm performance (e.g., total shareholder return) drives up their value. Based on this approach to model specification, we found a strong positive relationship between CEO return (i.e., change in CEO’s employmentbased wealth) and the total shareholder return (i.e., the change in shareholder wealth). Specifically, the addition of shareholder return to the model, after controlling for other determinants of CEO return, resulted in an increase in the (adjusted) R2 from 22% to 67%. Further, we found that a CEO at a firm with shareholder return in the 75th percentile had a CEO return of $21.6 million, compared to a CEO return of $9.5 million in a firm with shareholder return at the median (50th percentile). A related observation is that, despite much criticism of executive pay, the majority of shareholders support the way their executives are paid. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, an advisory (i.e., nonbinding) “say on pay” vote by shareholders on whether

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to approve executive pay has been required since 2011 to be held at least every 3 years at all companies subject to Securities and Exchange Commission (SEC) proxy reporting rules (which includes, among others, all publicly traded companies listed on an exchange). Equilar (https://sayonpay.equilar. com/sayonpay/home) has tracked say on pay votes at over 2600 companies in each of the past 3 years (2014, 2015, 2016) and reports that in 97%e98% of the votes (depending on the year), shareholders have approved executive compensation, with over 90% of shareholders voting for approval in a strong majority (71%e72%) of the votes. To summarize, one criticism of PFP is that overly strong connections, such as those found using individual incentive pay, can cause problems. A very different criticism we have considered here is the claim that in some cases pay and performance are not connected strongly enough, which is more typically a concern in the case of merit pay, mainly due to the use of subjective performance measures and/or in the case of top executives (e.g., where there is a concern that board of directors, the representatives of shareholders, are not sufficiently independent to strongly connect executive pay to performance). However, the evidence reviewed above suggests that in both cases, the connection between pay and performance is positive and practically significant. 6.2.4 Variable Pay: Short-Term and Long-Term Incentives Although it is sometimes argued that the use of subjective measures of performance (e.g., see agency theory) limits the strength of the PFP relationship under merit pay because subjectivity means uncertainty and risk in pay for employees, we have seen that once the role of promotion in PFP is incorporated and once the cumulative effects over time of PFP are also incorporated, the relationship between salary and performance over time due to merit pay alone can be (and often is) substantial. Yet, there are further dimensions of PFP still to be included in our discussion. We now turn to what are often called variable pay programs, which refers to the fact that payouts do not become part of base salary. Also, especially at higher job/pay levels, the share of compensation that is paid in the form of variable pay exceeds that paid in the form of salary. Thus, at high job/pay levels, variable pay programs result in the strength of PFP being dramatically stronger (e.g., as in the study by Nyberg et al., 2010 discussed above) than what we have already seen in our discussion of PFP in base salary determination. We will look at several sources of evidence.

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Table 2 Base salary increases and merit bonus/variable pay awards, as a percentage of payroll, salaried exempt employees, by year 1990 (%) 2015 (%)

Base salary increase budget Merit bonus/variable pay budget (where used)

5.5 4.2

3.0 12.7

Abosch, K. (June, 2015). The quiet revolution of variable pay. Compensation Focus. https://www. worldatwork.org/adimComment?id¼78809&utm_source¼Direct&utm_medium¼eNewsletter &utm_term¼cf_editorial1&utm_content¼Articles&utm_campaign¼ED_CF2515

First, data from Aon Hewitt show that while merit increase budgets have declined over time, in contrast, what they refer to as merit bonuses (Abosch, 2012, 2015), have increased substantially over time. For example, the merit increase budget was 5.5% in 1990 versus 3.0% in 2015 (Abosch, 2015; that decline is due in part to a decline in inflation).13 By contrast, the merit bonus budget went from 4.2% in 1990 to 12.7% in 2015 (see Table 2). Merit bonuses here appear to be what are alternatively called variable pay or short-term incentives in other surveys. As such, they include payouts that may be based at least in part on individual performance or they may include across-the-board payouts resulting from profit-sharing, which are often a fixed percentage of each employee’s salary. So, in terms of PFP based on individual performance, the plans vary. However, consistent with our earlier discussion, we will see that such plans rarely use individual level, objective measures of performance. A key reason for the growth in merit bonuses is cost control, especially the desire to reduce fixed labor costs (in the form of salaries and benefits), which are a difficult challenge when revenues fall for a company. Unlike salary increases, which once awarded, are part of salary “forever,” merit bonuses must be earned anew each year. Developing theory and research suggests merit bonuses and merit pay may have different effects, depending on the context (Nyberg, Pieper, & Trevor, 2016). One important note is that the 12.9% merit bonus budget pertains only to companies that use merit bonuses and then, within those companies, only to certain groups of employees. In the case of merit bonuses, the percentage of salary would also be higher among higher level employees. That is, in contrast to merit budgets, which typically apply to all or nearly all employees, and the percentage increase does not vary by employee group. Gerhart and Fang (2014) estimate, after taking into account the fact that not all employees are covered by merit bonus programs, that in the US 13

Abosch (2015), based on Aon Hewitt annual survey data on US merit increases.

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economy overall, merit bonus payments represent about 3.3% of base pay for nonexempt hourly employees, 4.1% for nonexempt salaried employees, 6.9% for exempt salaried, and 26.5% for officers/executives. A second survey, from WorldatWork (2014), looks in greater detail (than the WorldatWork, 2016a survey data earlier) at both short-term incentive programs, which would cover some of the same territory as the “merit bonuses” data just examined above, as well as at an additional separate form of variable pay: long-term incentive programs. Recall that short-term incentives are based on a performance time period of 12 months or less and long-term incentives are based on longer periods. In this second survey, which was limited to publicly traded (i.e., for-profit) companies, 99% used short-term incentive plans and 88% used long-term incentive plans. Further information was gathered on how the most widely used shortterm incentive plans worked. This shows that 97% of these plans use some type of financial (organization, not individual level) performance measure, most commonly revenue (43%), followed closely by various (organization level) profit measures. Looking across financial, operational, and individual performance measures, “overall individual performance (e.g., performance evaluation or rating)” was used by 48%. So, the individual level performance measures appear to typically be subjective, unlike the objective performance measures used in the Bethlehem Steel and much of the academic psychology, economics, and, to some extent, management literatures.14 Many operational measures were also used, most frequently customer satisfaction (28%). Table 3 further indicates that higher level jobs (officers/executives, exempt salaried) are more likely to be eligible for short-term incentive payouts and that their target payout levels are higher. If one multiplies eligibility (roughly 53%e55%) and payout target (5%) among lower-level employees, the expected payout in the sample for them is less than 3% versus almost 15%e40% for higher level employees. Across employee groups, the typical basis for payouts is some combination of corporate, business unit, and individual performance. Table 4 provides information on allocation of long-term incentives (which are stock or derivatives including stock options whose value depends on stock price/return).

14

It should be observed that the management literature also includes much research on PFP among the five highest paid executives in US publicly held firms. One reason is that firms are required to publicly disclose such data. In this research, performance is not measured as physical output. A mix of short-term and long-term incentives are typically used with a combination of subjective and objective performance measures like those described in the WorldatWork (2014) survey.

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Table 3 Short-term incentive plans: eligibility, payout target and performance basis, by employee group Performance basis mean Median payout % Companies target as % of Business where eligible base pay Corporate unit Individual

Officers/ Executives Exempt salaried Nonexempt salaried Nonexempt hourly nonunion

96

40

61

23

17

97 55

15 5

40 46

33 30

28 25

53

5

39

33

28

WorldatWork. (2014). Incentive Pay Practices Survey: Publicly Traded Companies.

Table 4 Mean percentage of long-term incentive grant allocated, by employee group

CEO Officers/Executives (excluding CEO) Exempt salaried Nonexempt salaried Nonexempt hourly nonunion

14% 55% 29% 1% 1%

WorldatWork. (2014). Incentive Pay Practices Survey: Publicly Traded Companies.

Here, we see an even more dramatic difference in allocation by job level, with the lowest two employee groups each receiving 1% of the value of the total allocation. Thus, we see that variable pay in the form of shortterm and long-term incentives is mostly relevant to higher level jobs, but that in about one-half of companies, lower-level employees receive variable pay equivalent to about 5% of their pay (when performance targets are met).

7. EFFECTS OF PFP There are two general mechanisms by which PFP influences performance: incentive effects and sorting effects (Gerhart & Milkovich, 1992; Gerhart & Rynes, 2003; Lazear, 1986). First, the incentive effect describes how the current workforce reacts to PFP. It may be thought of as the effect on performance estimated from a between-subjects design implementing

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PFP for one set of employees, but not for another (e.g., using fixed salary instead) equivalent set of employees or as the effect from a within-subjects design when shifting from fixed salary to PFP (or the reverse). Second, PFP can influence performance via what Lazear (1986) described as a “sorting” effect (Gerhart & Milkovich, 1992; Gerhart & Rynes, 2003; Lazear, 1986, 2000; Rynes, 1987). Here, a change in PFP influences employee performance not by changing how the current workforce reacts, but rather by changing workforce composition (Gerhart & Milkovich, 1992), specifically causing lower performers (who earn less under PFP) to leave and replacing them with higher performers (who earn more under PFP). Perhaps the best illustration of the distinction between incentive and sorting effects is Lazear’s (2000) study of how worker productivity at an automobile windshield glass installation company changed when it replaced a fixed salary system where salary was independent of individual worker productivity, with a system where worker pay was a formulaic function of productivity (the number of windshields installed), similar to the Bethlehem Steel type of incentive. Lazear observed a 44% increase in productivity when the company implemented PFP. In looking at the productivity of individual workers present both before and after the pay system change, Lazear found that their average productivity increased by 22%. So, that accounted for one-half of the total 44% increase. What accounted for the remaining 22% productivity change? Lazear found that this other one-half of the total 44% productivity improvement was due to a sorting effect, whereby lowproductivity workers were more likely to leave under the new incentive systems and be replaced by higher productivity workers. We now look at incentive effects and sorting effects in more depth.

7.1 Incentive Effects Theories of PFP (e.g., reinforcement, expectancy, efficiency wage, agency; see Gerhart & Rynes, 2003) largely agree that incentives and reinforcement (central to any PFP plan), when sufficiently strong, can have a substantial influence on important workplace behaviors such as employee performance and employee attraction/retention. Some of the clearest evidence comes from meta-analytic summaries of research that uses objective measures of individual output/productivity as the dependent variable, which we now review. In evaluating these results, the reader should once again bear in mind that our earlier estimates suggest that less than 4% of workers in nonsales jobs are covered by this type of c.1900 Bethlehem Steel form of an incentive plan.

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Locke et al. (1980) summarized evidence on the impact of four motivational techniques: monetary incentives, goal setting, participation, and job enrichment. They included studies that were conducted in the field, used either control groups or before-after designs, and used objective performance measures (e.g., physical output). They found that the use of monetary incentives resulted in the largest median performance improvement (30%), followed by goal setting (16%), job enrichment (9%e17%), and participation (less than 1%). Based on these results, Locke et al. concluded that “Money is the crucial incentive.No other incentive or motivational technique comes even close.” (p. 379). Guzzo, Jette, and Katzell (1985) examined the effects of several types of human resource interventions, including financial incentives and work redesign. In studies that used physical output as the dependent variable, they found that financial incentives had a mean effect of d ¼ 2.12. Work redesign had a mean effect of d ¼ 0.52 (where d is the difference in group means expressed in SD units). Jenkins et al. (1998) conducted a meta-analysis of the relationship between financial incentives and performance quantity and quality in studies where objective performance measures were used and where the incentives were at the individual (as opposed to group) level. To be included, a study had to “have a control group or a premeasure with an explicit manipulation of the performance contingency of the incentive.” In addition, only studies using adult samples were examined. Based on 41 effect sizes covering 2773 employees, the mean correlation between use of financial incentives and performance quantity was r ¼ 0.32, which converts to d ¼ 0.68. Jenkins et al. also reported that the mean effect size based on field/workplace settings (r ¼ 0.46, d ¼ 1.04) was roughly twice as large as the mean effect size from laboratory studies (r ¼ 0.23, d ¼ 0.47). Finally, based on a k ¼ 6 effect sizes, no statistically significant correlation was found between incentive use and performance quality, suggesting that positive effect of incentives on performance quantity do not come at the expense of performance quality. As noted, an important limitation of the findings from these meta-analyses is that the types of jobs studied may not be very representative of those in today’s workplace. For example, in the case of the Jenkins et al. (1998) meta-analysis, only eight of the total of 47 studies were conducted in a field setting, Examples of the performance measures used in these eight studies include number of trees planted and number of animals trapped. The studies reviewed by Jenkins et al. (1998) although not representative, do provide some of the most important evidence on the potentially powerful effects of monetary incentives on behavior in workplace (or workplace-like) settings.

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Interestingly, Oyser and Schaefer (2011) argue that “simple jobs are preferred because employees’ actions can easily be measured, and the experimental design eliminates issues surrounding the endogenous choice of compensation plans.” They accordingly focused their review on such studies (individual incentives in simple/manual labor jobs) from the economics literature and reached a conclusion similar to that of the meta-analytic evidence reviewed above (Jenkins et al., 1998) from applied psychology: “Pay-for-performance incentives surely change behavior in organizations,” at least “measured performance” (emphasis in original). They go on to say that “Broadly speaking.the available empirical evidence suggests that pay-forperformance incentives are associated with improvements in organizational performance” (p. 1774). Thus, reviews from applied psychology and economics agree that the research shows substantial positive effects of such incentives on performance, at least the aspects of performance that are measured and included in the incentive plan. As we continue to emphasize, less than 4% of US workers are in jobs where such incentives are used.

7.2 Sorting Effects Beginning with Gerhart and Milkovich (1992) and continuing with Trevor et al. (1997, 2012), we began to shift attention from a sole focus on how PFP affects what current workers do (the incentive effect) to how PFP influences who those workers are (a sorting effect). Early conceptual work on sorting was conducted by Brown (1990), Lazear (1986), and Rynes (1987). Lazear (1986, p. 427), for example, argued that under a fixed salary system, “workers are not sorted efficiently.the least able workers are always in the salary firm.” Gerhart and Milkovich (1992), in their review devoted a section to the question, “What impact do pay plans have on composition of the work force?,” which they described as “the notion that there is selfselection by individuals and selection by organizations to find people that fit the pay system” (p. 520). The attraction-selection-attrition framework (Schneider, 1987) provided another intellectual basis for the idea that different human resource policies could shape the composition of the workforce. Eventually, empirical work, primarily in applied psychology and management, documented that different degrees of emphasis on PFP in pay systems attracts different types of individuals (Cable & Judge, 1994; Fang & Gerhart, 2012; Trank, Rynes, & Bretz, 2002), and specifically that high performers are much more likely to choose PFP over fixed pay (Cadsby, Song, & Tapon, 2007). In addition, field work shows that

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high-performing employees are more likely than low-performing employees to quit in response to a lack of PFP (Harrison, Virick, & William, 1996; Lazear, 2000; Nyberg, 2010; Salamin & Hom, 2005; Shaw, Dineen, Fang, & Vellella, 2009; Trevor et al. 1997) and specifically, move to employers that use stronger PFP (Trevor et al., 2012). As we saw earlier, Lazear’s (2000) study provided an especially good illustration of incentive and sorting effects of PFP. Another study from economics to document sorting effects such that high performers choose to work under strong PFP were conducted by Dohmen and Falk (2011); see Gerhart and Fang, 2014, for a broader review of this sorting literature. 7.2.1 Some Implications of Nonrandom Assignment (Sorting) In a laboratory experiment, subjects are randomly assigned to incentive conditions. However, as we saw above, employees are, in contrast, nonrandomly “assigned” to jobs in the workplace. This difference is important because it means that random assignment of subjects to incentive/PFP conditions in the laboratory almost assuredly results in stronger mismatches than are likely to be observed in organizations (Fang & Gerhart, 2012), given that there is no opportunity in a typical laboratory experiment (unless it treats incentive/PFP condition as a within-subjects factor) to improve on what are likely to be the many poor matches resulting from expressly assigning subjects to conditions independent of their attributes (e.g., performance, preferences for PFP). One implication is that the effectiveness of PFP may be understated in experiments (consistent with the difference in effect sizes reported by Jenkins et al., 1998) because random assignment prevents the matching of employee attributes to pay system attributes (e.g., PFP versus fixed pay). Stated differently, the existence of nonrandom assignment (sorting, matching) in the workplace may make negative effects of PFP less likely and positive effects of PFP more likely (Fang & Gerhart, 2012), at least to the degree that there is sufficient employee mobility for matching/sorting processes to operate (Feng & Gerhart, 2016).

7.3 Effects of PFP in Higher Level Jobs We have seen strong evidence of incentive and sorting effects of PFP, but mostly in simple, often manual labor jobs. We also saw that some (Oyser & Schaefer, 2011) have argued that studying PFP in such jobs is preferred because it is easier to isolate the effects of PFP. However, there is reason to question how well findings from simple jobs generalize to more complex jobs. At a very basic level, the PFP plans used for higher level jobs are

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different. So, it is probably unwise to assume that they necessarily have the same effects. There are also specific theoretical issues. For example, CET (Deci et al., 1999) argues that PFP will work better in routine jobs having little intrinsic interest because extrinsic motivation is the main potential source of motivation. However, in intrinsically motivating jobs (which tend to be higher level, more complex), CET (Deci et al., 1999) argues that PFP may have a detrimental effect on intrinsic motivation, which CET sees as a higher quality form of motivation. Evidence of PFP (positive) effects in higher level jobs from Gerhart and Milkovich (1990) was reviewed earlier. In addition, a review by Gerhart (2000) found, using diverse samples, including high-level jobs, generally positive effects of PFP (see Table 5.2, Gerhart, 2000), although in some cases, whether the effects were positive depended on contingency factors (moderators) such as business strategy. Reviews by Gomez-Mejia, Berrone, and Franco-Santos (2014) and Gomez-Mejia and Balkin (1992) provide further evidence of such effects in higher level jobs. Gerhart (2000, see Table 5.3) also reviewed evidence across samples of mostly higher level jobs showing that different types of PFP plans can have an influence on specific executive behaviors such as risk-taking and level of investment in research and development.

7.4 Merit Pay Earlier, we saw that merit pay, which refers to changes in base salary as a function of performance (usually a rating by the immediate supervisor) is the most common form of PFP in the sense that it is used by virtually all organizations and applies to all levels of employees in private sector organizations. (As we have seen, merit bonuses, which do not become part of base pay, are now also widely used.) The main exception would be that private sector workers who are members of labor unions would often not be covered by such plans, as “equal pay for equal work” is a common goal of unions and, as well, there is generally a preference against the use of supervisory ratings as the basis of base pay differences between workers. We note, however, that only just over 7% of US private sector employees are now represented by labor unions. The evidence on the effects of merit pay has been reviewed a number of times (e.g., Heneman, 1992; Heneman & Werner, 2005; Milkovich, Wigdor, Broderick, & Mavor, 1991; Rynes et al., 2005). The Milkovich et al. report (1991) was prepared under the auspices of the National Academy of Sciences to help the federal government evaluate “research on performance appraisal and on its use in linking pay to performance” to

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assist it in revising its own use of merit pay among its mid-level managers. Milkovich et al. (1991), however, were forced to acknowledge that “we found virtually no research on the effects of merit pay systems” (p. 3). Gerhart et al. (2009) similarly concluded that “There has been surprisingly little empirical research on the influence of merit pay on worker performance.” Given the prevalence of merit pay, more work is clearly needed.

7.5 Variable Pay Plans at the Group/Organization Level There is abundant research that examines the relationship between effectiveness and specific PFP programs such as gainsharing and profit sharing (for reviews, see Gerhart & Milkovich, 1992; Gerhart & Rynes, 2003; Gerhart et al., 2009). Gainsharing plans (e.g., Matsumura & Shin, 2006; Schuster, 1984) are used in one part of an organization such as a plant or facility and are very widely applicable in that they can be used, for example, in a manufacturing plant, a bank, a hospital, a store, and so forth. One form of gainsharing computes a baseline ratio of labor costs/revenues using recent years and if labor costs are kept below that ratio in future years, there is a gain that is shared by workers and the company. But, a gainsharing plan can include additional metrics, such as store profit, safety, quality, and customer (or patient) satisfaction. Profit sharing can be as simple as sharing a percentage of organization profits, but as we saw in our earlier summary of variable pay program use, there are many different varieties of plans, some at the organization level, some at the business unit level. Many organization and business unit plans use multiple measures of performance. As such, many PFP plans do not fit easily into a single plan type category. For the most part, the evidence consistently documents a positive relationship between gainsharing (e.g., Kaufman, 1992) and productivity and between profit sharing (e.g., Doucouliagos, 1995; Kruse, 1993; Weitzman & Kruse, 1990) and profits. There is also evidence to suggest that employee stock ownership, which can be accomplished in different ways, is also positively related to firm performance (Blasi, Freeman, Mackin, & Kruse, 2010). Again, inferring causality in the designs typically used in this line of research has its challenges. Of course, causality matters a great deal in deciding whether to use such programs. In the case of profit sharing, for example, if the program causes no change in employee behaviors that contribute to higher profits, then the organization faces the possibility that when its profits increase, they do so for other reasons, meaning that profit sharing payments to employees are a simple reallocation of profits away from owners to employees.

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8. RISK AND PITFALLS OF PFP The evidence reviewed above suggests that PFP use is substantial. Additional evidence indicates that PFP can have substantial positive effects on performance. That, of course, does not mean that PFP always works as intended. Indeed, as Gerhart et al. (2009) put it: “PFP is of special interest because when it ‘works’, it seems capable of producing spectacularly good results and when it does not work, it can likewise produce spectacularly bad results.” Indeed, PFP has been described as a “high risk and high return” strategy (Gerhart, Trevor, & Graham, 1996, p. 145) or similarly as “a high risk, high reward strategy” (Gerhart, 2001, p. 222). Many (e.g., Kerr, 1975; Kohn, 1993; Lawler, 1971; Milgrom & Roberts, 1992; Pfeffer, 1998; Roy, 1952; Sanders & Hambrick, 2007) have documented what can go wrong when using PFP, which includes (Gerhart & Fang, 2015) “excessive risk taking, excessive competition within the firm, focusing too little on performance measures (e.g., quality, customer service, longterm performance) not explicitly included in the PFP plan, and focusing too much on (including gaming or manipulating) performance measures (e.g., sales, stock returns) that are included in the plan.” We do think it is important to note, however, that the most notable negative effects of PFP tend to occur with individual incentive plans of the variety used at Bethlehem Steel, where pay is a direct formulaic function of individual output, measured objectively, without any judgment involved and often without any other measures of performance includes. Such plans tend to use powerful incentives that do not fall short in motivating high levels of effort, but do run the serious risk of not getting the direction of the effort right and/or not ensuring that the performance goal is achieved in an acceptable and legitimate manner. Sales commission plans, which share a similar design (pay is linked to an objective performance measure, sales volume, often at the individual level), like individual incentive plans, have been shown to positively influence performance (e.g., Banker, Lee, Potter, & Srinivasan, 1996), but are likewise subject to similar potential problems, as we will see below. Importantly, as we have noted repeatedly, individual incentive plans are uncommon in the US economy, covering less than 4% of private sector workers in nonsales jobs. Based on our earlier estimates, perhaps another 3% of private sector workers work under sales commission plans. One way to frame the problem is in terms of which performance goals employees emphasize and which ones they deemphasize or ignore because

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of incentive design. According to Oyser and Schaefer (2011, p. 1774), incentives “induce employees to take actions that improve measured performance, but.there may be important-but-harder-to-measure aspects of performance that are ignored as employees work to hit measured-performance benchmarks.” As Gerhart and Fang (2017) observe, goals play a major role in not only motivating the intensity of motivation, but also in directing that motivation toward some behaviors and away from others by virtue of choice and prioritization of goals (e.g., Bandura, 1997; Elliot, 2006; Locke & Latham, 2002; Lawler, 1971; Lord, Diefendorff, Schmidt, & Hall, 2010; Schmidt & DeShon, 2007; Wright, George, Farnsworth, & McMahan, 1993; see Gerhart & Rynes, 2003 for a review) and those priorities are likely to depend on how strongly different goals are incentivized, especially given that employees have finite time and cognitive resources (Kanfer & Ackerman, 1989). In this vein, Milgrom and Roberts (p. 228) define “the equal compensation principle” as follows: If an employee’s allocation of time or attention between two different activities cannot be monitored by the employer, then either the marginal rate of return to the employee from time or attention spent in each of the two activities must be equal, or the activity with the lower marginal rate of return receives no time or attention.

Here, “rate of return” refers to which activities (goals) are most strongly incentivized (a closely related concept to the equal compensation principle in the economics literature is “multitasking,” Prendergast, 1999). The stronger the incentive intensity (Gerhart & Rynes, 2003; Milgrom & Roberts, 1992), the greater the risk to the company of serious problems. Ellig (2014) refers to what happened in the financial services sector and to the economy as a whole (The Financial Crisis of 2008) as an example of the “devastation” that excessive risk-taking due to incentive plan design can cause. The problem has been described by Baily, Litan, and Johnson (2008, p. 20) : The most perverse incentive in the mortgage origination market.is the ability of originators to immediately sell a completed loan off their books to another financial institution. Currently, most mortgage loans are originated by specialists and brokers who do not provide the funding directly. One institution provides the initial funding of the mortgage but then quickly sells it off to another financial institution.The key issue here is that the institution that originates the loan has little or no financial incentive to make sure the loan is a good one. Most brokers and specialists are paid based on the volume of loans they process. They have an incentive to keep the pace of borrowing rolling along, even if that meant making riskier and riskier loans.

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So, here we see, consistent with the equal compensation principle, when brokers were paid (solely) on the basis of sales volume, not on the basis of whether the loan was “a good one,” they maximized their loan sales volume and ignored the quality/risk of the loans. The former Director of Corporate Finance Policy at the US Treasury wrote that such “misaligned incentive programs are at the core of what brought our financial system to its knees” (Jacobs, 2009, p. 13) and the former Vice-Chairman of the US Federal Reserve has made similar comments (Blinder, 2009). There was also a concern that this mindset started at the top. Thus, a main feature of the subsequent Troubled Asset Relief Program legislation was to discourage executives from taking “unnecessary and excessive risks” by placing restrictions on how their compensation/incentive plans were designed. More recently, US Federal Reserve officials continued to advise firms to be aware of “warning signs of excessive risk taking and other cultural breakdowns” (Glazer & Rexrode, 2015, p. A1). Part of the solution may be to introduce judgment into the determination of PFP/incentive plan payouts. One argument, based on agency theory, against is that this introduces a different kind of risk, which is borne by those covered by such an incentive plan. The concern is that judgment is subjective and possibly arbitrary and unfair. Without trying to resolve this issue fully here, let us just note that judgment can be made less subjective in a number of ways, including by increasing the number of informed judges (i.e., raters) providing performance evaluations. Let us also note that an objective measure is not necessarily better (i.e., more accurate/valid, less subject to moral hazard/gaming) than a subjective/judgment measure. Indeed, the most important decisions still rely on human judgment. Thus, removing judgment from the decision of how PFP payouts will be determined is perhaps a factor contributing to incentive plan problems such as excessive risk taking and achieving results in the wrong way. There are many other potential pitfalls of incentive plans, which we do not attempt to address here. Examples include the problem of rate-cutting (Gerhart & Rynes, 2003; Roy, 1952) and concerns regarding the use of PFP plans that reward individual performance in contexts where teamwork, cooperation, and/or interdependence are high or in countries having national cultures that are sometimes viewed as being too collectivistic for such plans to work. I refer the reader to our work (Gerhart & Fang, 2014; Trevor et al., 2012) on these topics and simply note that theory and evidence do not always conform to these particular logics. Finally, another concern, that PFP undermines intrinsic motivation, is one that we addressed

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briefly earlier, and is addressed in more detail in Gerhart and Fang (2015). On that subject, our review concluded that neither theory nor empirical research support the existence of such detrimental effects on total motivation and/or performance in workplace settings.

9. CONCLUSION In this article, I have described how incentive pay, or what I prefer to define more broadly as PFP, is used in (primarily private sector) work organizations and some evidence on its effectiveness. A basic conclusion is that PFP, when sufficiently strong, does change behavior, often in a way that increases effectiveness. The stronger PFP is, the greater the opportunity for large performance gains. At the same time, evidence and experience indicates that PFP also carries risks and that these risks are more likely to become a problem when incentive intensity/PFP strength is greater. Thus, as we have noted, PFP has been referred to as a high-risk, high-return strategy. Going forward, several areas need of further research attention. First, evidence indicates that the individual incentives of the type used at Bethlehem Steel c.1900 are rare in today’s US workforce. Yet, such incentives appear to continue to be widely studied in academic research on extrinsic rewards and incentives in psychology and economics. It would be useful to expand the types of incentive pay studied to better capture the types of PFP more widely used in work organizations. Second, when such studies are conducted in laboratory settings, some thought needs to be given to whether to always automatically use random assignment, at least throughout an entire study, given that the matching of employees to jobs/ organizations is decidedly nonrandom. One approach is to use random assignment initially, but then allow matching of subjects to pay conditions to occur through choices (e.g., by subjects; see Cadsby et al., 2007). Third, although there is better evidence on profit sharing, gainsharing, and other PFP programs, the conclusion reached by Milkovich et al. (1991, p. 3) that there is “virtually no research on the effects of merit pay systems” remains nearly as true today, 25 years later, as it was then. Some progress has been made on better understanding the magnitude of merit pay (i.e., how strongly are performance ratings and salary linked over time). However, it continues to prove difficult to isolate the effects of merit pay in organizations where so many other aspects of people management are

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at work and where so many other factors influence dependent variables such as performance.

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