Effective Pay for Performance: The Devil is in the Detail

With companies increasingly using pay-for-performance (PFP) plans to drive competitive advantage a study of the US travel industry examined the relative effects of three commonly used PFP plans (merit pay, individual bonuses, and long term incentives) on employee performance and employee turnover. The findings of the study indicate that, in an environment where all three types of PFP plans are operating simultaneously, merit pay has a greater effect on both performance and turnover than bonuses and long term incentives.

Key Topics: Pay for performance; Merit pay; Bonus; Long term incentives; Turnover

Title of Reviewed Article: Evaluating Form and Functionality of Pay-for-Performance Plans: The Relative Incentive and Sorting Effects of Merit Pay, Bonuses, and Long-Term Incentives
 
Researchers: Sanghee Park (Rutgers University) and Michael C. Sturman (Cornell University).
 
Publication: Human Resource Management, 2016, Vol. 55 No. 4, pp. 697–719.

_____________________________________​_____________________________________

Setting the Scene
 
Research indicates that, in general, PFP plans increase the performance levels of employees (e.g., Gerhart & Fang, 2014). Such plans are typically defined as those that include pay that varies depending on individual or company performance (Milkovich, Newman, & Gerhart, 2013).
 
Research suggests that PFP plans have two primary effects, namely sorting effects and incentive effects (Cadsby, Song, & Tapon, 2007; Gerhart & Fang, 2014). Sorting effects relate to the composition of the company’s workforce and the influence of PFP plans over those who seek to join the company and those employees who stay with the company (Rynes et al., 2005). Incentive effects, on the other hand, relate to PFP plans’ effect on employee motivation and effort.
 
Although research on PFP is considerable (e.g.  Gerhart & Fang, 2014), much of this research has focused on single PFP plan environments (e.g., Kwong & Wong, 2014). However, companies often use multiple types of individual-based rewards (e.g., merit pay, long and short term incentives) and/or group rewards, such as profit sharing plans (Gerhart et al., 2009; Milkovich et al., 2013). Given that companies often simultaneously use multiple PFP plans (Cohen, 2011; Gerhart & Fang, 2014), this study looks to examine such multiple PFP plan environments.
 
In the current study the researchers focused on three commonly used PFP types, merit pay, individual bonuses, and long term incentives. With merit pay, employees receive a permanent pay increase, which is typically based on their individual performance (Heneman & Werner, 2005). Bonuses are typically monetary rewards given over and above fixed compensation and generally based on individual performance (Milkovich et al., 2013). Long term incentives (LTIs) are typically tied to the company’s long term growth and employee retention, and are commonly awarded based on some element of individual performance (Rousseau & Ho, 2000).
 
The researcher outlined a number of research questions to investigate:
 
Hypothesis 1 - “When considering the incentive effects of multiple pay plans simultaneously, the strength of the connection between individual performance and associated rewards, after separating the PFP effects (i.e. controlling for effects) associated with other pay plans, will be positively related to future employee performance.”
 
Hypothesis 2 - “If the separated PFP relationship (i.e., the effects for each plan, after controlling for the PFP effects of the other plans) for each plan has effects (is greater than zero), the incentive effect for merit pay on individual job performance should be greater than the incentive effect for bonuses, which should be greater than the incentive effect for LTI.”
 
Hypothesis 3 - “For any plan type where the separated PFP relationship (i.e., the effect of the plan, after controlling for the PFP effects of the other plans) has no effects (is not significantly different from zero), the incentive effect of the connection between pay and performance for that plan on individual job performance should be zero.”
 
Hypothesis 4 - “When considering merit pay, bonuses, and LTI plans simultaneously, the PFP for merit pay will negatively moderate the performance-turnover relationship.”
 
Hypothesis 5 - “When considering merit pay, bonuses, and LTI plans simultaneously, the PFP for LTI will negatively moderate the performance-turnover relationship.”
 
Hypothesis 6 - “When considering merit pay, bonuses, and LTI plans simultaneously, the effect of PFP on the performance-turnover relationship will be stronger (i.e., more negative) for merit pay than for LTI.”
 
How the research was conducted
 
This study used data from a two-year period between 2001-2002 from a large US based travel service related company. Data was collected in relation to performance ratings, gender, tenure, and compensation (salary, merit pay, bonuses, and LTIs). The data included information relating to 720 employees reporting to 88 supervisors.
 
The company participating in this study applied a four-point performance rating scale during the years related to this study, and this was used by the researchers to define performance. In order to measure the pay for performance relationship, the researchers examined this at an employee-supervisor level. Voluntary turnover was assessed using leaver data from the company in 2002.
 
The researchers examined this information in the context of their hypotheses.
 
Key Research Findings
 
For the population reviewed, annual merit percentage increases were on average 3.1%, while average bonuses were 7% of salary, and LTI was 1.2% of salary on average. As such, the average additional compensation received by employees was 11.3%. On average, those with higher performance ratings were found to receive higher performance compensation, although there were some exceptions found to this trend.
 
Hypotheses 1-3 related to the simultaneous assessment of all three compensation plan types. The results supported these three hypotheses. To support the assumptions of Hypothesis 1 it was expected that there should be a positive effect of merit and bonuses but no effect for LTI, and this is what the results indicated. Hypothesis 2 predicted that merit would have a greater effect on performance than bonus, which in turn would have a greater effect than LTI, and this was supported by the results. The effect of PFP-LTI was not found to be significant, which support Hypothesis 3.
 
Hypotheses 4-6 related to the relative sorting effects of PFP plans and how they impact on the performance-turnover relationship. Again, the results supported all three hypotheses. The results showed that merit pay had the strongest effect on retention of employees, which supports Hypothesis 4. A retention effect was also found for LTI, albeit a weaker effect than for merit, thus supporting Hypotheses 5 and 6.
 
Results Commentary
 
Previous PFP research has broadly found there to be positive sorting and incentive effects, although the focus has primarily been on the effect of single PFP plan. The current study results validate these single plan effects in a more complex multiple PFP plan environment, which is typical in many companies.
 
Through this study’s examination of a multiple PFP plan environment the researchers provide further insight into the interplay between various PFP plans. For example, the value of merit pay on performance has often been questioned (e.g. Heneman & Werner, 2005), with one argument being that there is often little difference between the merit award given to top and bottom performers (Gomez-Mejia & Balkin, 1989), however the current study found merit to have the greatest effect on performance and turnover. What this study further indicates is that PFP plans do not by default have a positive effect, but rather the effectiveness of a PFP plan depends on the strength of the link between pay and performance, and on the other PFP plans offered simultaneously.
 
Organizational and Reward Implications
 
One of the key practical implications is this study is the finding that the strength of a PFP plan largely rests in the strength of the performance-reward link. Simply implementing a plan and calling it PFP is not sufficient, and companies must think carefully about how to best implement strong links between these factors. At the forefront of this is having adequate budget available in order to provide meaningful levels of performance related pay and also to allow for a range of awards tied to varying performance levels. If companies fail to create these strong performance-reward links then they should anticipate limited effectiveness of the PFP plan.
 
Companies, particularly in more economically difficult times, may be inclined to avoid awarding merit increases as they increase fixed employee costs, however what this study highlights is that doing so has the intangible cost of taking away a powerful PFP mechanism. Given that merit increases were shown to have greater incentive and sorting effects than bonuses and LTI, this is a decision that companies should not take lightly.
 
Final Thoughts
 
This study adds to prior PFP research, which primarily focused on single PFP plan environments, by examining a multiple PFP plan environment, and in so doing provides valuable insight into the interplay and effectiveness of merit pay, bonuses, and LTI, as they relate to performance and turnover. It would be of benefit for future research to continue this examination of multiple PFP plan environments, as these are prevalent across many companies.

_____________________________________​_____________________________________

Source Article: Park, S., & Sturman, M. C. (2016). Evaluating Form and Functionality of Pay-for-Performance Plans: The Relative Incentive and Sorting Effects of Merit Pay, Bonuses, and Long-Term Incentives. Human Resource Management, 55(4), 697-719.
 
Published by: Wiley Periodicals, Inc.
 
For further details and access to the full journal article Click Here (subscription or payment may be required).

_____________________________________​_____________________________________

References:
 
Cadsby, B., Song, F., & Tapon, F. (2007). Sorting and incentive effects of pay for performance: An experimental investigation. Academy of Management Journal, 50(2), 387–405.
 
Cohen, K. (2011). Salary budget increases going for a slow ride: WorldatWork 2011–2012 budget survey results. Workspan, 54(Sept), 30–37.
 
Gerhart, B., & Fang, M. (2014). Pay for (individual) performance: Issues, claims, evidence and the role of sorting effects. Human Resource Management Review, 24(1), 41–52.
 
Gerhart, B., Rynes, S. L., & Fulmer, I. S. (2009). Pay and performance: Individuals, groups, and executives. Academy of Management Annals, 3, 251–315.
 
Gomez-Mejia, L. R., & Balkin, D. B. (1989). Effectiveness of individual and aggregate compensation strategies. Industrial Relations, 28(3), 431–445.
 
Heneman, R. L., & Werner, J. M. (2005). Merit pay— linking pay to performance in a changing world(2nd ed.). Greenwich, CT: IAP.
 
Kwong, J. Y., & Wong, K. F. (2014). Fair or not fair? The effects of numerical framing on the perceived justice of outcomes. Journal of Management, 40(6), 1558–1582.
 
Milkovich, G. T., Newman, J. M., & Gerhart, B. (2013). Compensation (11th ed.). New York, NY: McGraw-Hill, Irwin.
 
Rousseau, D. M., & Ho, V. T. (2000). Psychological contract issues in compensation. In S. L. Rynes & B. A. Gerhart, (Eds.), Compensation in organizations: Current research and practice (pp. 273–310). San Francisco, CA: Jossey- Bass.
 
Rynes, S. L., Gerhart, B., & Parks, L. (2005). Personnel psychology: Performance evaluation and pay for performance. Annual Review of Psychology, 56, 571–600.