As pay for performance — linking employee compensation to effort or productivity — is increasingly accepted as a way to ensure employees are maximizing output amid a competitive economy, one study reveals the model is actually detrimental to another highly sought-after organizational goal: innovation.
Pay for performance is effective for employees in operational roles, such as a painter painting houses or a salesman hitting quotas. But when it comes to employees responsible for finding creative solutions to problems, the model is ineffective, said Gustavo Manso, co-author of a 2012 study published in the July issue of Management Science.
This is because a straight pay-for-performance model does not have a tolerance for early failure, a component essential to innovation, said Manso, an associate professor of finance at the University of California at Berkeley. Innovation is a “trial and error process,” Manso said. “You have to try things that you don’t know if they’re going to work.”
Manso and the study’s co-author, Florian Ederer of the University of California at Los Angeles, argue that the perfect compensation structure for innovation is one that provides security of early failures while rewarding for long-term success.
To prove this, the authors used a lab environment with the premise of managers conceiving a lemonade stand. The study tasked three groups with coming up with all the strategic components of setting up a stand — price, location, mix of sugar and lemon. Each group was compensated under separate models: The first group would receive a fixed wage, the second group a pay-for-performance model, and the third group a hybrid “exploration” model.
The authors’ hypothesis: The group operating under the hybrid model would explore more and be more likely to find superior strategy than the subjects in the two other compensation models.
The results proved just that. The subjects in the hybrid, exploration compensation model ended the experiment with the best location for the lemonade stand 80 percent of the time. Meanwhile, the subjects in the fixed wage and pay-for-performance model ended up in the best location 60 percent and 40 percent of the time, respectively.
“The problem is the subjects in the standard pay-for-performance model [are] too worried from the beginning to get it right,” Manso said. “They don’t try to explore a lot.
“Subjects under the fixed-wage model experiment a lot because they don’t have any consequence. However, they are not keeping track of what they’re doing.”
Manso said the third compensation scheme ended up most successful because the group was not afraid to explore and fail early in the process. While the experiment moves along they became motivated by the prospect of being rewarded for long-term success, in turn narrowing the early exploration findings into new and more creative solutions.
In the real world, Manso said some of the most innovative companies have adopted similar schemes. This is seen most commonly with executives through the use of rewards systems built on managerial entrenchment, golden parachutes and option pricing — linking a company’s long-term performance directly with an executive’s compensated equity stake.
Other innovation- and creativity-driven firms have adopted similar schemes, according to the study, with some systems not only tolerating early failure but also rewarding it.
Still, the percentage of firms that properly identify and apply this kind of hybrid innovation-driven compensation structure is small, said John Bremen, managing director of talent and rewards at human resources consultancy Towers Watson.
What’s important, Bremen said, is for companies to create a culture that recognizes and rewards innovation properly through compensation. He said the hybrid model showcased in the study is valid, but not enough companies properly apply it, instead creating a one-size-fits-all model where every employee is expected to spur innovation.
“It doesn’t mean pay for performance isn’t valid,” Bremen said. “I would argue it’s a different pay for performance,” where employees in operational roles are rewarded for short-term results while those with long-term, transformation duties are rewarded in a longer view.
Frank Kalman is an associate editor for Talent Management magazine. He can be reached at email@example.com.