Pay-for-performance, merit pay, bonuses and worker productivity: Research roundup

 
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Workers have a wide range of reasons for heading to the office, factory or farm every day, but monetary compensation is generally at the top of the list. From an employer’s perspective, the key is to structure compensation optimally to get maximum productivity from workers, acknowledging that talented employees must be rewarded and retained in competitive job markets. At the lower end of the wage scale, however, there may be fewer incentives to raise wages. Unskilled workers are more easily replaced, theoretically giving them less leverage, especially as organized labor has declined.

For much of U.S. history, productivity and wages rose in tandem, but recently the relationship appears to have weakened. Indeed, analysts from across the political spectrum claim that the connection has fundamentally broken down. The precise reasons remain unclear given the large number of societal and economic changes since the 1970s. Many jobs have become automated, and while that can increase productivity, workers’ wages do not necessarily follow. A 2013 study from researchers at the Federal Reserve Bank of Kansas City notes that “job polarization” — the tendency for work to cluster around low-end and high-end functions, with a hollowing out of “middle” functions such as installation, maintenance, sales, office and administrative — is structural and uniform across the economy: America’s job polarization trend is explained by much more than just the loss of U.S. manufacturing. A host of tumultuous changes, from stagnating wages and technology to globalization and the offshoring of jobs, have had an effect on U.S. compensation and productivity.

Pay rates and structure

A 2013 study in the Journal of the European Economic Association explored the effect of pay cuts, and found they had a detrimental and persistent impact on productivity, reducing average output by 20%. But what is the best way to structure potential pay increases to ensure optimal outcomes? For decades now, economists have looked at questions of wages and performance — motivational research — producing a variety of findings, many of them contradictory.

Anthony J. Nyberg of the University of South Carolina, Jenna R. Pieper of University of Nebraska-Lincoln and Charlie O. Trevor of University of Wisconsin-Madison have published one of the larger and more nuanced studies to date on pay-for-performance (PFP) issues. They examine data relating to nearly 12,000 workers over a 5-year period. Their December 2013 study in the Journal of Management, “Pay-for-Performance’s Effect on Future Employee Performance Integrating Psychological and Economic Principles Toward a Contingency Perspective,” takes a comprehensive measurement approach in an attempt to improve on prior studies that may analyze the issue too narrowly. The authors furnish the following definitions: “Merit pay is an incremental increase in base salary used to recognize past performance … and bonus pay is a lump sum cash payment used to recognize past performance.”

The study’s findings include:

  • The data show that “both merit and bonus pay are positively associated with future performance.”
  • The researchers also find that “bonus pay appears to be more influential than merit pay and compensatory effects exist between PFP components. Specifically, when one PFP type (e.g., merit pay) is low, the other (e.g., bonus pay) becomes a more potent predictor of future performance.”
  • The findings are consistent with long-standing research-based ideas that “employees do not always have time or all of the information to determine the ‘appropriate’ effort to exert,” meaning that productivity and wages do not always move perfectly as a function of one another.
  • The study’s results suggest that the way employees relate to pay can evolve over time. This overturns “traditional pay and economic paradigms.”
  • Some relationships such as job tenure and pay are difficult to isolate precisely, as “employees who deem their merit increases and bonuses to be dissatisfying or inequitable are more likely to leave the organization … thereby gradually creating a tenured cohort that may be somewhat more optimistic about future PFP outcomes than their low-tenured colleagues.”

“Contrary to conventional wisdom and traditional economic models of rational self-interest,” the researchers conclude, “our results suggest that employees may be more motivated to improve performance when bonus pay is the carrot. Furthermore, by awarding more bonus pay, relative to merit pay, firms would have more flexibility in managing cash flow…. By moving to higher percentages of bonus pay, companies may be able to increase productivity (through better employee performance) while generating greater cash flow flexibility, which means that bonus pay can be particularly advantageous for an organization trying to mitigate expenditures during fluctuating organizational business cycles.”

Related: Some research questions the health effects of tying pay to performance, as it might ramp up stress and create a “rat race” environment. For more on the cognitive science related to bonuses, see this 2014 study published in Psychological Science. A 2012 study published in the American Economic Review found that even a simple, inexpensive gift can significantly increase worker productivity, but that an equivalent cash gift was largely ineffective. A 2013 Harvard Business School paper found that once workers have accepted a fixed-term job, paying above-average wages did not increase productivity. But when part of the wage was given as an unanticipated and unconditional gift, employees worker harder for the duration of the job. Further, a 2012 study found that awards had a positive but short-lived effect on performance that spilled over to other jobs that didn’t qualify for awards. The changes were mostly driven by employees who had previously performed poorly, but the effects quickly faded. Finally, the status of workers and their tenure is also part of the puzzle: Research published in 2013 in the Journal of Monetary Economics found that the productivity of new hires was far more responsive to wages levels than that of existing employees.

 

Keywords: wages, reciprocity, productivity, economy, compensation

Last updated: April 3, 2014

 

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