Welcome to the 21st Century: Why Performance-Based Compensation Doesn’t Work Today

The science is crystal clear: performance-based compensation hasn’t worked for decades. So why is business still addicted to it?

This is the second article in a 3-part series:
1. Is Your Company Operating from an Industrial-Era Playbook?
2. Why Performance-Based Compensation Doesn't Work (This article)
3. Traditional Project Management Needs and Upgrade

Almost all companies today have a compensation program for at least some employees based on performance. From CEOs who are awarded bonuses for hitting a target share price to bike messengers who are paid by the delivery, performance-based compensation is widespread today.

Clearly, given the ubiquity of performance-based compensation, one would assume that a great of deal of research has been conducted to assess the efficacy of this model. Why would all of these smart business leaders follow practices that don’t work? That would be crazy. And if you made that assumption you would at least be partially correct: decades of research have been conducted to determine if performance-based compensation works. The problem is that, according to author Alfie Kohn writing for the Harvard Business Review, the research all confirms the opposite conclusion:

As for productivity, at least two dozen studies over the last three decades have conclusively shown that people who expect to receive a reward for completing a task or for doing that task successfully simply do not perform as well as those who expect no reward at all.

Huh? Say what? That doesn’t make intuitive sense. And what about the father of scientific management, Fredrick Taylor? Was he wrong about the motivation of piece rates? Actually, as it turns out, he wasn’t. Contemporary research supports his conclusion that performance-based compensation for piecemeal work increases productivity. The problem is that the tasks performed by modern day professionals are no longer piecemeal. We’re not in the 1900s anymore. Piece rates worked for industrial era factories when employees worked on simple products as they moved down the production line. And they also work for workers like bike messengers, who fulfill simple tasks. But most businesses today aren’t dealing with simple tasks. They are responsible for managing incredibly complex systems staffed with a highly educated workforce. So why would we think the same piece rate principle applies?

In fact, performance-based compensation for complex tasks actually reduces productivity. According Dr. Bernd Irlenbusch from the London School of Economics, in a 2009 study of 51 corporate pay-for-performance plans: “We find that financial incentives…can result in a negative impact on overall performance.”

Come again? But that makes no sense. Why would people perform worse when they are paid for their performance?

Intrinsic vs. Extrinsic Motivation

The reason has to do with a common psychological trait known as “intrinsic motivation.” According to economists Bruno Frey and Margit Osterloh in their 2009 book Successful Management by Motivation, intrinsic motivation is when the activity itself or the corresponding end goal satisfies a direct need. For example, job satisfaction or achievement of personal goals. This is the opposite of extrinsic motivation, which serves to satisfy indirect needs. For example, money is a means to an end, not a reward in its own right.

Modern day workers, unlike their forlorn counterparts in the 1900s, inherently find a sense of satisfaction in the work they do. This intrinsic motivation is very powerful, and stands in stark contrast to extrinsic motivation which is very weak. Researcher and TED speaker Jane McGonigal writes in Reality Is Broken: Why Games Make Us Happy and How They Can Change the World, about this natural human characteristic:

When we try to find happiness outside of ourselves, we’re focused on what psychologists call ‘extrinsic’ rewards—money, material goods, status or praise….Unfortunately, the pleasure of found happiness doesn’t last very long. We build up a tolerance for our favorite things and start to want more….Positive psychologists call this process ‘hedonic adaptation’.

McGonigal then contrasts this with intrinsic motivation:

Research confirms what dozens of major other studies have found: happiness derived from intrinsic reward is incredibly resilient. Every time we engage in [self-rewarding] activities, the very opposite of hedonic adaptation occurs. We wean ourselves off consumption and acquisition as sources of pleasure and develop our hedonistic resilience.

The reason why performance-based compensation reduces performance for complex tasks, according to Frey and Osterloh, is that is relies on extrinsic motivation which crowds out the far more powerful intrinsic motivation: “Meticulous laboratory experiments have confirmed the crowding-out effect. In fact, so many of these experiments have now been conducted that it is difficult to see the forest through the trees.”

This crowding out affect is particularly problematic for multi-tasking jobs that have multiple goals. For example, a sales woman for a software contractor needs to make her prospects happy with a low price and lots of functionality, and she needs to make finance happy with a profitable bid, and she has to make sure engineering is happy by not agreeing to something they can’t deliver. Unfortunately, when management institutes financial incentives, people tend to focus on the tasks for which they are compensated and ignore all others—causing unintended consequences. According to Frey and Osterloh:

Research has shown that variable performance-related pay does not lead to a general increase in a company’s productivity and earnings. Improved performance only occurs in simple, easily measured activities. In other circumstances, pay for performance can even reduce a person’s willingness to perform by ‘crowding out’ the intrinsic motivation to work.

The Corporate Rain Dance

So, if performance-based compensation has been proven not to improve productivity, and in fact makes it worse, then why are so many businesses still employing this practice? Because, despite all of our scientific knowledge, we still cling to our rain dances in an attempt to control our world. Performance-based compensation gives management a great feeling of comfort and control, the same way tribal Zuni chiefs must have felt after completing their ceremonial rain dance.

Author Dan Pink summed up this disconnect between science and current practice nicely in this 2009 TED talk “The Surprising Science of Motivation:

There is a mismatch between what science knows and what business does. And what worries me, as we stand here in the rubble of the economic collapse, is that too many organizations are making their decisions, their policies about talent and people, based on assumptions that are outdated, unexamined, and rooted more in folklore than in science.

This animated version of Dan’s full TED talk is amazing. It does a wonderful job of visually illustrating the point.

So, if current business practices involving employee compensation are rooted in industrial-era thinking, are there others hidden within our organizations?

Next we’ll take a look at project management practices next to found out.