In the abstract, employee compensation based on pay-for-performance structures should work. Compensation plans are created to motivate people to maximize their output in support of achieving corporate goals. And people seem to be motivated to "make more money" to improve their personal circumstance (however defined.) The problem is, people are human and come freighted with all the "failings" of our species. Psychological factors that filter the worth of the compensation plan through each person's own value system can sidetrack even the best-crafted plan

A recent working paper called "The Psychological Costs of Pay-for-Performance" by three business school professors (Ian Larkin, Lamar Pierce of Harvard and Francesca Gino of Washington University) summarizes the thinking on the limits of pay-for-performance as a motivator, and should be bookmarked by HR compensation managers as a resource for to improving compensation planning.

I wrote a more complete article here on the details of the paper, but to give you a quick taste of their conclusions, here are the three psychological factors they claim are the main hurdles to effective compensation plan results:

Social Comparison: People compare their pay/effort ratio to their peers, and expect perceived compensation to be "fair," based on these assumed ratios.

Overconfidence: People overestimate their own skill set, which leads to accepting tasks above their ability, and an inflated sense of what their work is worth.

Loss Aversion: People have "income targets." They are deeply concerned about staying afloat financially, and will work hard to earn enough to cover their obligations. Once those obligations are met, however, their positive reaction to monetary incentives diminishes dramatically.

I would add a subtext to all these factors, especially overconfidence: Bumps in pay are one-offs. Each pay packet received sets the floor for future pay expectations, and thus loses value the second time around, blunting the impact of performance pay.

I have long held that pay-for-performance is a flawed approach to compensation, with some (not all) sales positions excepted. It completely ignores the subjective needs of individuals to be valued for their skills and contributions by other people, and not just by an inflated paycheck. 

Engagement is the key. If you invest more in employee engagement and less in complicated compensation plans, you may get the improved productivity your company seeks. (See a past blog post on "changing mindsets.")

Managing the employee "experience" includes, but goes far beyond a simple focus on pay.

David Tighe has been helping companies change mindsets for twenty-three years as a principal for Bovo-Tighe, LLC. Bovo-Tighe helps organizations solve leadership, productivity, and hiring challenges using its MINDCHANGE™ and Organizational Transformation processes, which have been market- tested in hundreds of real-world business situations. Contact Dave at dave@bovo-tighe.com.