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6 Pay and Performance: Individuals, Groups, and Executives Barry Gerhart a; Sara L. Rynes b; Ingrid Smithey Fulmer c a School of Business, University of Wisconsin-Madison, b Tippie College of Business, University of Iowa, c College of Management, Georgia Institute of Technology, First Published on: 01 June 2009

To cite this Article Gerhart, Barry, Rynes, Sara L. and Fulmer, Ingrid Smithey(2009)'6 Pay and Performance: Individuals, Groups, and

Executives',The Academy of Management Annals,3:1,251 — 315 To link to this Article: DOI: 10.1080/19416520903047269 URL: http://dx.doi.org/10.1080/19416520903047269

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The Academy of Management Annals Vol. 3, No. 1, 2009, 251–315

6 Pay and Performance:

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Individuals, Groups, and Executives

BARRY GERHART* School of Business, University of Wisconsin-Madison

SARA L. RYNES Tippie College of Business, University of Iowa

INGRID SMITHEY FULMER College of Management, Georgia Institute of Technology

Abstract Academy 10.1080/19416520903047269 RAMA_A_404899.sgm 1941-6520 Original Taylor 3102009 bgerhart@bus.wisc.edu BarryGerhart 000002009 and & Article Francis of(print)/1941-6067(online) Francis Management Annals

In this chapter, we address three pay for performance (PFP) questions. First, what are the conceptual mechanisms by which PFP influences performance?

Second, what programs do organizations use to implement PFP and what is the empirical evidence on their effectiveness? Third, what perils and pitfalls arise on the way from PFP theory to its execution in organizations? We address these questions in general terms, but also highlight unique issues that arise in PFP for teams and for executives. We highlight the fact that research and practice in the area of PFP requires one to deal with a number of tradeoffs. For example, strengthening PFP links can generate powerful motivation *Corresponding author. Email: bgerhart@bus.wisc.edu ISSN 1941-6520 print/ISSN 1941-6067 online Š 2009 Academy of Management DOI: 10.1080/19416520903047269 http://www.informaworld.com

251

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252 • The Academy of Management Annals effects, but sometimes these are in unintended and unanticipated directions, resulting in undesirable effects. In addition, there are also trade-offs in deciding the degree of emphasis to give to individual versus team performance and to results versus behaviors in PFP plans. What all this means is that, as in other areas of management, “one best way” advice (e.g., do or do not use individual PFP plans) or “sound-bite” conclusions (e.g., PFP does not exist; PFP does or does not motivate) are rarely valid, but rather depend on the circumstances and the organization. In the realm of executive pay, we question the current conventional wisdom in the management literature that there is little or no PFP. We close the chapter with a discussion of our key conclusions and suggestions for what we think would be the most interesting and useful future research areas. We encourage the management literature, which has increasingly become interested in the concept of evidence-based management, to execute this concept more effectively in its research and when talking or writing about pay.

Introduction Literally hundreds of studies and scores of systematic reviews of incentive studies consistently document the ineffectiveness of external rewards. (Pfeffer, 1998, pp. 214–215) Money is the crucial incentive because, as a medium of exchange, it is the most instrumental… No other incentive or motivational technique comes even close to money with respect to its incremental value.

(Locke, Feren, McCaleb, Shaw, & Denny, 1980) The link between pay and performance [of executives] has increased nearly tenfold since 1980. (Hall, 2000) Research shows only a small relationship between executive compensation in any form and firm performance. (Hitt, 2005).

On average, the single largest operating cost for an organization is employee compensation (Blinder, 1990; European Parliament, 1999; Bureau of Labor Statistics, 2001). An organization’s success depends not only on the magnitude of this cost, but also on what it gets in return for its investment.1 Yet, as the opening quotes suggest, there is considerable disagreement about both the existence, and the effects, of pay for performance (PFP) among employees and executives. In this chapter, we hope to shed some light on which claims are best supported by research evidence.

Compensation (also called pay or remuneration) can be defined to include “all forms of financial returns and tangible services and benefits employees receive as part of an employment relationship” (Milkovich & Newman, 2008, p. 9).2 However, in this chapter, we focus on one dimension

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Pay and Performance • 253 of compensation—PFP. Although there are multiple dimensions of compensation (e.g., pay level, pay structure, benefits), our decision to focus primarily on PFP stems from its potential both as a basis for organization differentiation from competitors and as a potentially powerful driver of performance.

In addition, PFP is a strategic compensation decision where organizations appear to have more discretion than in other areas such as pay level, which is more constrained by labor and product market parameters (Gerhart & Milkovich, 1990; Haire, Ghiselli, & Gordon, 1967). Also, PFP is of special interest because when it “works”, it seems capable of producing spectacularly good results and when it does not work, it can likewise produce spectacularly bad results (Gerhart, 2001). Thus, it seems to be an area where organizations can choose to be different in an effort to achieve high performance, but in doing so, also run higher risks (Gerhart, Trevor, & Graham, 1996). PFP is also of interest because such plans (in one form or another) not only continue to be prevalent in the private sector, but also seem to be making inroads into sectors of the economy where they have not historically been prevalent (e.g., the public sector, health care, education). Apparently, there is a growing belief that PFP can be used to improve effectiveness in these sectors as well.

In this chapter, we focus first on three general issues related to PFP. First, what are the conceptual mechanisms by which PFP influences performance?

Second, what programs do organizations use to implement PFP and what is the empirical evidence on their effectiveness? Third, what perils and pitfalls arise on the way from PFP theory to its execution in organizations? Finally, we devote a separate section to PFP for executives. The issues in executive PFP are similar in some ways to the three general issues covered in our broader discussion of employee PFP. At the same time, however, executive compensation is unique in important ways (its magnitude, the key role of stock plans, the amount of public interest and regulatory scrutiny), suggesting the value of a separate discussion. We close the chapter with a discussion of our key conclusions and suggestions for what we think would be the most interesting and useful future research areas.

We highlight in this chapter the fact that research and practice in the area of PFP requires one to deal with a number of trade-offs and conundrums.

Strengthening PFP links can generate powerful motivation effects, but sometimes these are in unanticipated and undesirable directions. Similarly, the relative emphasis given to results-based and behavior-based measures of performance may contribute to too much or too little focus on certain performance objectives. In like fashion, the relative emphasis given to individual and group/organization performance in PFP plans may be beneficial for some objectives, but detrimental to others. What all this means is that, as in other areas of management, “one best way” advice (e.g., do or do not use individual PFP plans) or “sound-bite” conclusions (e.g., pay does or does not motivate)

254 • The Academy of Management Annals are rarely valid, but rather depend on the circumstances. This, of course, is what makes the field so interesting. In the case of executive compensation, the large sums of money involved, questions about its appropriateness and disagreement regarding the degree to which it is determined by performance versus less legitimate factors only adds to that interest.

Conceptual Issues

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Incentive and Sorting Effects Several social sciences, but particularly psychology and economics, have offered a variety of theories to explain the impact of pay in organizations.

These include reinforcement, expectancy, equity, utility, agency, efficiency wage, and tournament theories (for reviews, see Bartol and Locke (2000) and Gerhart and Rynes (2003)). To simplify greatly, these theories suggest that pay operates on motivation and performance via two different mechanisms— incentive effects and sorting (Gerhart & Milkovich, 1992; Gerhart & Rynes, 2003; Lazear, 1986).

First, there is the potential for an incentive effect, which is the impact of PFP on performance via its impact on current employees’ motivational states.

In other words, the incentive effect is how pay influences the level or intensity of individual and aggregate motivation, holding attributes of the workforce constant. More so than sorting effects, incentive effects have been the focus of the great majority of theory and research in compensation.

The most direct evidence of the power of incentive effects comes from meta-analytic summaries of empirical work on individual incentive programs.

This research aims to isolate the impact of individual contributions an objective measures of performance. For example, in a meta-analysis of potential productivity-enhancing interventions in actual work settings, Locke et al.

(1980) found that the introduction of individual pay incentives increased productivity by an average of 30%. These results are particularly compelling because the authors only included studies that were conducted in ongoing organizations (as opposed to laboratories), that used either control groups or before–after designs, and that used objective performance measures (e.g., physical output). A second meta-analysis by Guzzo, Jette, and Katzell (1985) likewise found that financial incentives had a large mean effect on productivity (d=2.12).3 More recent meta-analyses (Jenkins, Mitra, Gupta, & Shaw, 1998; Judiesch, 1994; Stajkovic & Luthans, 1997) also provide similarly strong support for the impact of PFP incentives. In short, in contrast to Pfeffer’s (1998) assertion, there is strong evidence that PFP produces incentive effects that are very strong under certain conditions (e.g., individually-based with objectively measureable outcomes).4 Second, PFP may also produce higher performance through sorting effects, which reflect the impact of pay on performance via its impact on the

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Pay and Performance • 255 composition of the workforce (Gerhart & Milkovich, 1992). That is, different types of pay systems may cause different types of people to apply to and stay with (i.e., self-select into) an organization. For example, individuals attracted to different types of pay systems may vary on the basis of ability (Trank, Rynes, & Bretz, 2002), responsiveness to PFP (Stewart, 1996), risk seeking (Cable & Judge, 1994), trait-like motivation (Amabile, Hill, Hennesey, & Tighe, 1994; Judge & Ilies, 2002), or other productivity-related attributes.

Organizations too may differentially select and retain employees, depending on the nature of their pay level and/or PFP strategies. The self-selection aspect of sorting and its application to the effects of pay is based primarily on work in economics (Lazear, 1986), but the idea is also consistent with Schneider’s (1987) attraction–selection–attrition (ASA) model in the applied psychology literature (Bretz, Ash, & Dreher, 1989). Critics of PFP, including Pfeffer (1998), tend to ignore this effect.

As with incentive effects, there also is rather compelling evidence of sorting effects associated with PFP. For example, Lazear (2000) reported a 44% increase in productivity when a glass installation company switched from salaries to individual incentives. Of this increase, roughly 50% was due to existing workers increasing their productivity (an incentive effect), while the other 50% was attributable to less productive workers quitting and being replaced by more productive workers over time (a sorting effect). Another study, a field experiment by Bandiera, Barankay and Rasul (2007), demonstrated that when managers were switched from straight salaries to a PFP system where their pay depended on the productivity of workers they managed, the managers increased worker productivity both by hiring more productive workers (sorting) and by pushing existing workers (incentive) to be more productive.

Cadsby, Song, and Tapon (2007) likewise found that both incentive and sorting effects explain the positive impact of PFP on productivity. Their study, set in the laboratory, was designed so that subjects went through multiple rounds of a task. In some rounds, they were assigned to a PFP plan, in others, to a fixed salary plan. In yet other rounds, they were asked to choose between fixed salary or PFP. By the last rounds in three experiments, the PFP condition generated 38% higher performance than the fixed salary condition, and the sorting effect (less risk averse and more productive subjects being more likely to select the PFP condition) was approximately twice as large as the incentive effect in accounting for the performance difference.

Further evidence suggests that PFP is more attractive to higher performers than to lower performers. For example, Trank et al. (2002) found that the highest-achieving college students place considerably more importance on being paid for performance than do their lesser-achieving counterparts.

Likewise, people with higher need for achievement (Bretz et al., 1989; Turban & Keon, 1993) and lower risk aversion (Cadsby et al., 2007; Cable & Judge, 1994) also prefer jobs where pay is linked more closely to performance.

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256 • The Academy of Management Annals Other research shows that high performers are not only more likely to seek out PFP, but they are also more likely to quit and seek other employment if their performance is not sufficiently recognized with financial rewards (Nyberg, 2008; Salamin & Hom, 2005; Trevor, Gerhart, & Boudreau, 1997).

Conversely, low performers are more likely to stay with an employer when pay– performance relationships are weaker (Harrison, Virick, & William, 1996).

Finally, we should note that to the degree sorting effects operate, it may appear as though the PFP relationship is weak because selectivity in hiring by employers (and/or self-selection by applicants), combined with the use of selection procedures having predictive validity, will result in not only higher mean performance, but also restricted within-organization variance in performance (Brogden, 1949). Under such range restriction, the observed PFP relationship will be attenuated, but it would be a mistake to conclude that PFP is unrelated to performance. In any event, prior research has convincingly shown that PFP can have substantial positive effects on performance, and that these effects occur through both incentive and sorting mechanisms.

Defining and Measuring Performance A major decision in the design and success of PFP programs is likely to be the choice of how to define and measure performance. We focus on two key choices here. First, how much emphasis is placed on results-oriented/objective performance measures (e.g., number of units produced, profitability) relative to behavior-based ones (e.g., supervisory/merit evaluations of effort or quality)? Second, how much emphasis is placed on individual contributions relative to collective contributions?

Behavior-based (subjective) versus results-based (objective) measures.

Behavior-oriented measures (such as traditional merit ratings) offer a number of potential advantages relative to results-based measures (Eisenhardt, 1985a, 1989; Gerhart, 2000; Holmstrom, 1982; Lawler, 1971; Ouchi, 1979). First, they can be used for any type of job. Second, they permit the rater to factor in variables that are not under the employee’s control, but that nevertheless influence performance. Third, they permit a focus on whether results are achieved using acceptable means and behaviors. Fourth, they generally carry less risk of measurement deficiency, or the possibility that employees will focus only on explicitly measured tasks or results at the expense of broader pro-social behaviors, organizational citizenship behaviors, or contextual performance (Arvey & Murphy, 1998; Lawler, 1971; Milgrom & Roberts, 1992; Wright, George, Farnsworth, & McMahan, 1993).

On the other hand, the subjectivity of behavior-oriented measures can limit their ability to differentiate employees (Milkovich & Wigdor, 1991). Metaanalytic evidence has found a mean inter-rater reliability of only 0.52 for performance ratings (Viswesvaran, Ones, & Schmidt, 1996), making it difficult

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Pay and Performance • 257 for organizations to justify differentiating employees based on such errorladen performance measures, especially if a single rater (usually the immediate supervisor) is the source. Moreover, even if subjectivity could be sufficiently controlled and performance reliably and credibly differentiated, managers may be reluctant to differentiate because of concerns about adverse consequences for workgroup cohesion, pro-social behaviors, and management– employee relations (Heneman & Judge, 2000; Longenecker, Sims, & Gioia, 1987). Finally, behavior-based measures are not applicable in situations where either the opportunity to observe behaviors or the ability to judge behaviors is not feasible.

At first blush, objective measures of performance, such as productivity, sales volume, shareholder return, and profitability, would seem to provide the solution to the aforementioned problems. However, relevant objective measures are not available for most jobs, especially at the individual level.

Moreover, agency theory (which we discuss more fully in our section on executive compensation) emphasizes that results-based plans—at least those that seek to replace some part of fixed salary with an incentive component— increase risk-bearing among employees (Gibbons, 1998). Because most employees derive the bulk of their income from employment, they cannot diversify their employment-related earnings risk, making them more riskaverse than others (e.g., investors) who can diversify their investments. Thus, employees prefer fixed pay to incentives, unless there is a compensating differential (Cable & Judge, 1994; Weitzman & Kruse, 1990). This, then, is the classic trade-off between designing plans that maximize incentives while keeping the negative effects of risk (in the form of negative employee reactions) under control.

Risk aversion is less of a problem where objective measures are seen as credible and performance on such measures is high, providing significant payouts to employees. However, poor performance on such measures (and thus decreasing or disappearing payouts)—especially if attributed to factors employees see as beyond their own control (e.g., poor decisions by top executives or a sinking economy)—often results in negative employee reactions (Gerhart & Milkovich, 1992). In such cases, there will almost inevitably be pressure to revise (e.g., the experience at GM’s Saturn division (Gerhart, 2001)) or abandon the plan (DuPont (Gerhart & Rynes, 2003)).

Another issue is that even though objective measures are possibly more reliable, they may also be more deficient. Lawler (1971) warned that “it is quite difficult to establish criteria that are both measurable quantitatively and inclusive of all the important job behaviors”, and “if an employee is not evaluated in terms of an activity, he will not be motivated to perform it” (p. 171).

This is similar to the equal compensation principle from economics, which states that if an employee’s allocation of time or attention cannot be monitored by the employer, then marginal rates of return to employees for desired

258 • The Academy of Management Annals

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activities must be at least equal to or greater than rates of return to activities that are not desired, or they will receive little or no time or attention (Milgrom & Roberts, 1992).

Finally, results-oriented measures often have a higher degree of incentive intensity (Gerhart, 2001). Two potential consequences, one good, one bad, of higher incentive intensity are: (a) higher motivational intensity; and (b) a higher risk that this intensity will cause unintended consequences as these highly motivated employees use their “ingenuity” to find new ways to earn large payouts. We return to this concern later.

Individual and group (or collective) performance measures. Criticisms have been leveled at organizations for focusing too much on individual performance and rewards (Deming, 1986; Pfeffer, 1998; Pfeffer & Sutton, 2006). For example, Deming (1986) argued that management’s “excessive” focus on individual performance ignores the fact that differences in individual performance often “arise almost entirely from the system that (people) work in, rather than the people themselves” (p. 110). Regarding teamwork, Deming cautioned that under individual PFP, “Everyone propels himself forward, or tries to, for his own good… The organization is the loser” (Deming 1986, p. 110).

While the potential pitfalls of individually-based PFP are important, the literature is quite clear that group-based plans also have their own potential drawbacks. One is that most employees (at least in the US) prefer that their pay be based on individual rather than group performance (Cable & Judge, 1994; LeBlanc & Mulvey, 1998). Another is that, as noted earlier in the section on sorting, this preference appears to be stronger among more productive applicants and employees, suggesting that group-based PFP might, on average, be prone to unfavorable sorting effects.

Another concern has to do with the weakening of incentive effects (or “line of sight”) under group plans (Schwab, 1973), particularly as group size increases. Individuals are less likely to see a clear link between their effort and their pay when the PFP plan uses group or organization-level performance measures, which are influenced by a host of factors other than employee effort and many of which are beyond workers’ immediate control. In addition, there is a concern that co-workers will not contribute equally to group performance, but nevertheless will receive the same level of rewards. Although Pfeffer (1998, p. 219) claims that evidence regarding the importance of the “so-called freeriding problem” is “surprisingly meager”, major reviews of team incentives conclude that the free-rider problem is indeed an important phenomenon requiring considerable attention if it is to be mitigated (Albanese & Van Fleet, 1985; Cooper, Dyck, & Frohlich, 1992; Shepperd, 1993).

Summary. A major issue in designing PFP plans is how to define and measure performance. Two principal decisions are the relative emphasis to be

Pay and Performance • 259 placed on results- versus behavior-based measures and on individual versus group/collective performance. As we have seen, there are trade-offs involved in each decision. In practice, many organizations fashion PFP plans that combine different types of performance measures, perhaps in the hope of obtaining positive motivation intensity (and sorting) effects, while at the same time focusing employee motivation on multiple objectives (Gerhart et al., 1996; Gerhart & Rynes, 2003). However, too much complexity in a PFP plan can also be a drawback by undermining line of sight.

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Risk/Return and Fit/Misfit The preceding discussion, especially that dealing with potential incentive and sorting effects, focuses primarily on the mean (i.e., average) and main (i.e., noninteractive) effects of PFP programs. Of course, to focus only on average and main effects is to oversimplify reality. Even if PFP has a positive effect on average, any organization considering a particular PFP program should also be interested in the variance of the effect across organizations, which can be interpreted as a measure of risk (Gerhart et al., 1996). In addition, perspectives on fit, alignment, and contingency seek to understand contextual factors (e.g., business strategy, national culture, organization size, and HR practices other than compensation) that may further influence (strengthen or weaken) the success of PFP plans (for reviews, see Gerhart (2000, 2007), Gomez-Mejia and Balkin (1992) and Milkovich (1988)).

Empirical Evidence on Individual and Group PFP Plans In practice, organizations use specific PFP programs at the individual and/or group level (e.g., merit pay, profit-sharing, and so forth) in an attempt to enhance and support organization effectiveness. Thus, we organize our review of the evidence on specific PFP plans by whether the plans are individual-based or group/organization-based. Within each of these sections, we also segment research according to results-based versus behavior-based performance (Table 5.1). Although not explicitly included in Table 5.1, a third factor, incentive intensity, is implicitly included in that it tends to be stronger for resultsbased plans. We conclude with a discussion of risk/return and fit issues.

Table 5.1 Pay for Performance (PFP) Programs, by Level and Type of Performance Measure Level of performance measure Type of performance measure

Individual

Behavior-based

Merit pay

Results-based

Individual incentives sales commission

Facility/plant

Organization Merit pay for executives

Gain-sharing

Profit-sharing stock plans

260 • The Academy of Management Annals Despite the fact that we describe each PFP program separately, it should be kept in mind that people are often paid using a combination of programs.

Moreover, successful PFP programs (such as those at Lincoln Electric, Nucor Steel, Whole Foods, Southwest Airlines, and General Electric, to name just a few) come in many different formats, with varying degrees of relative emphasis on individual, group/unit, and/or organization level performance.

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Individual-Based PFP Plans Individual incentives. Individual incentives provide results-based (rather than behavior-based) rewards. These can, for example, be in the form of piece rates (where production workers get paid on the basis of the number of pieces produced) or sales commissions, where pay is based on revenue produced. As shown earlier, much of the meta-analytic evidence on PFP comes from studies of individual incentive plans. This research has shown substantial positive effects for PFP (Locke et al., 1980; Guzzo et al., 1985; Jenkins et al., 1998). However, because incentive systems cannot be applied in the absence of valid measures of objective performance, their feasibility is limited for most job categories.

In addition, if used exclusively, individual incentive plans can cause unintended consequences (overly narrow motivational focus, ethical shortcuts to achieve results). Lawler (1971), for example, warned that “it is quite difficult to establish criteria that are both measurable quantitatively and inclusive of all the important job behaviors” and that “if an employee is not evaluated in terms of an activity, he will not be motivated to perform it” (p. 171). Similar concerns are raised by Milgrom and Roberts (1992). Even where individual incentives start out working well, problems often eventually arise if management begins to feel that the production standard is set too low and, as a result, increases the amount of production needed to earn the same incentive payout.

If such rate-cutting is perceived to be unfair, workers may restrict their output and management’s credibility may be irreparably harmed (Lawler, 1971; Roy, 1952). Finally, individual incentive plans alone will not motivate cooperative behaviors. As a consequence of such challenges, merit pay is a more common PFP system.

Merit pay. Merit pay is by far the most common PFP program, being used in roughly 90% of US organizations (with managerial and professional employees most likely to be covered; Cohen, 2006), as well as in many other countries (Heneman & Werner, 2000). Merit pay is typically defined as an increase to base salary (often on an annual basis) that is based on (subjective) performance appraisal ratings, usually by an employee’s supervisor.5 Merit pay can be said to exist objectively when performance ratings validly differentiate employees on the basis of performance and these differences are positively and meaningfully correlated with salary increases in a particular year (and, over time, with salary levels).

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Pay and Performance • 261 Although merit pay policies are very common, both employers and employees are often less than satisfied with their results. One problem encountered in many organizations is that merit ratings have a high mean and little variance (Heneman, 1992). Without sufficient differentiation in merit ratings (and thus, merit increases), it is easy to understand why many employees are skeptical about the existence of genuine PFP in merit pay systems. In a HayGroup (2002) survey conducted in 335 companies, employees were asked whether they agreed with the statement, “If my performance improves, I will receive better compensation”. Only 35% agreed, while 27% neither agreed nor disagreed, and 38% disagreed with this statement.

Given these challenges with merit rating programs, an entire literature arose that sought to estimate the extent of rating “errors”. These errors include leniency (overly favorable ratings) and central tendency (not using the low and high ends of the scale), both of which result in a lack of differentiation in merit ratings. Researchers have also studied the effectiveness of potential solutions to these errors, such as rater training and re-design of performance appraisal instruments to reflect behaviors rather than traits. However, Murphy and Cleveland (1995) argue that this approach views performance appraisal too narrowly—“as a measurement process” (p. 30)—and thus has not been very fruitful because many so-called rater errors “are consciously made and that failure to discriminate among persons…is often a highly adaptive behavior” (p. 28). For example, very high ratings are likely to require greater justification because they result in higher salary costs, while low ratings may require difficult conversations with the ratee or even more difficult decisions, such as termination. Arvey and Murphy (1998) conclude that rating errors such as central tendency, halo, and leniency, “which occupied so much research space, are [now] thought to be relatively unimportant, trivial, and due to understandable factors” (p. 163). They also “find a trend in increased optimism regarding the use of supervisory ratings”.

Rather than studying and controlling rating “errors”, a more straightforward and aggressive approach to achieving greater differentiation is to use a forced distribution policy, such that a certain percentage of employees must fall into each of the performance rating categories. For example, rather than having a distribution (using a four-point scale with 4 being high) that often comes out to be in the neighborhood of 5% rating a “1”, 25% “2s”, 55% “3s”, and 15% “4s”, a forced distribution policy might require a distribution more like 20% “1s”, 30% “2s”, 40% “3s”, and 10% “4s”. A number of companies have instituted these forced distribution systems (Scullen, Bergey, & Aiman-Smith, 2005). Some (e.g., General Electric) have continued to use them over time, while others have encountered problems having to do with employee morale and/or equal employment opportunity, leading them to discontinue or modify their systems (e.g., Ford and Pfizer; even GE seems to have tempered their system recently). In addition, there are concerns about perceived unfairness and effects

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262 • The Academy of Management Annals on cooperation among employees. However, to the degree that such systems are used to identify and discharge low performers (and reward high performers), there are, as might be anticipated, potentially important sorting effects (Scullen et al., 2005).

Moreover, even where PFP does exist in an objective sense in merit pay systems, process issues may serve to either clarify or obscure this fact. GomezMejia and Balkin (1992), for example, highlight the role of policy choices such as pay disclosure versus pay secrecy (Colella, Paetzold, Zardkoohi, & Wesson, 2007) and participative versus authoritarian pay system design. Where there is PFP, anything that increases employee awareness and understanding should increase line of sight (and thus, motivation). For example, Shaw and Gupta (2007) reported that PFP was more strongly associated with lower turnover among higher performers to the extent that there was strong pay system communication, thus enhancing sorting effects.

Without in any way minimizing the challenges to PFP administration, it can be argued that merit pay is stronger than usually believed for a number of reasons (Gerhart & Rynes, 2003), a few of which we highlight here. First, as discussed, merit pay can have important sorting effects, even where the within-organization incentive effects of PFP appear to be small due to possible range restriction. Second, “merit pay” is often defined too narrowly. Merit ratings influence not only annual salary increases, but also promotions (Gerhart & Milkovich, 1989). The average pay increase due to promotion is in the range of 8–12% (Milkovich & Newman, 2008, p. 363), which is considerably larger than the average within-grade merit increase (roughly 3% in recent years in the US). Moreover, the pay increase due to promotion is considerably larger at top management levels, often more than 70% (Gerhart & Milkovich, 1990).

Consider one example of how different the PFP estimate can be, depending on how promotion is treated. Konrad and Pfeffer (1990) concluded that, across 200 colleges and universities, the relationship between research productivity and faculty pay was “small”. Specifically, they reported that a one standard deviation increase in research productivity was associated with only a $400 increase in faculty pay. (The mean faculty pay in their study, which used data collected in 1969, was $11,782 with a standard deviation=$4533.)

However, their model included controls for faculty rank/level, meaning that they estimated the within-rank, PFP relationship, or the direct effect of research productivity, excluding the (indirect) effect of research productivity on faculty salary via more productive faculty being more likely to be promoted. Konrad and Pfeffer’s (1990) Appendix Table A.2 shows that the correlation between research productivity and faculty salary was 0.493, which provides an estimate of the total (direct + indirect) effect of research productivity on salary. This 0.493 correlation indicates that a one standard deviation increase in productivity (without controlling for rank or other variables) was associated with pay that was higher by 0.493 salary standard deviations, which

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Pay and Performance • 263 works out to an increase of $2234, an effect that is more than four times as large as the $400 estimate emphasized by Konrad and Pfeffer (1990). Consider then that a faculty member one standard deviation above the mean of performance would have an expected salary of $14,016, compared to $9548 for a faculty member one standard deviation below the mean, a difference of 47%.

This does not strike us as a “small” PFP relationship.

Other studies, all using data on exempt employees in a wide range of jobs, also show that recognizing the promotion-related aspect of PFP results in larger estimates of total PFP in merit pay systems. For example, Trevor et al.

(1997) found that at one standard deviation below mean performance (mean=2.74, SD =0.66), mean salary growth over a 3-year period was $1705, compared with $2695 for performance at one standard deviation above the mean, a difference of 58%. Gerhart (1990) reported that over a 5-year period, each one point increase in performance was associated with a 16.1% higher salary. Gerhart and Milkovich (1989) found that promotions, which play a major role in salary growth (Milkovich & Newman, 2008), were influenced importantly by performance. In the case of men, for example, those 1 point above the mean on a 4-point performance scale received 48% more promotions over a 6-year period than those with performance at the mean.

There has been surprisingly little empirical research on the influence of merit pay on worker performance, particularly in recent years. However, what research does exist is primarily positive. For example, in a review of merit pay research, Heneman (1992) found that reported relationships between merit pay and performance ratings are almost always positive, though not always statistically significant. Kopelman and Reinharth (1982) conducted a 3-year study of 10 branch offices of a financial services organization. They examined the average size of the performance rating/merit pay increase relationship in each branch and then correlated the size of these PFP relationships with average performance ratings in each unit, both concurrently and lagged by 1 and 2 years. They found that “the stronger the performance–reward tie, the higher the level of subsequent performance” (p. 34). Greene and Podsakoff (1978) examined changes in production workers’ individual performance ratings and satisfaction after removal of a merit pay system from a unionized paper plant.

Relative to a control plant, average performance ratings dropped dramatically after the removal of merit pay, as did satisfaction with pay and supervision for those who had been rated as high performers.

In a contrary finding, Pearce, Stevenson and Perry (1985) reported that performance in 20 Social Security branch offices did not significantly improve after the switch to a (nominally) merit pay system. However, there were a variety of problems with the study that made it a test of the effects of merit pay. For example, 8 of the 12 before-and-after tests were conducted at the start of the program, before any merit increases had actually been distributed. In addition, there was “evidence that the implementation of this federal merit

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264 • The Academy of Management Annals pay program was flawed in several ways” (Pearce et al., 1985, p. 271), and the amount of money tied to merit was very small. As such, to the extent that a “merit system” was implemented at all, it appears to have been done in a very weak fashion.

In summary, despite considerable skepticism about merit pay (Konrad & Pfeffer, 1990; Pfeffer, 1998), the actual evidence on merit pay is primarily positive. Specifically, performance ratings are nearly always statistically significantly related to merit raises (Heneman, 1990), units with stronger merit pay programs have higher subsequent performance (Kopelman & Reinharth, 1982), and removal of merit pay can result in lower subsequent performance, as well as lower satisfaction among top performers (Greene & Podsakoff, 1978). High performers are less likely to leave (Trevor et al., 1997) and highachievers are more attracted (Trank et al., 2002) to organizations where PFP is strong. Thus, as with individual incentive systems, there appear to be both incentive and sorting effects associated with merit pay. In addition, merit ratings are clearly associated with probabilities of promotion, which in turn are associated with considerably higher rewards than “regular” merit increases and result in significant accumulations over time. Although more research would certainly be welcome, a comprehensive look at the existing research suggests that merit pay exists in many organizations, and that it can positively influence performance.

Rewards at the Supra-individual Level: Group- and Organization-level PFP Plans Over the past two decades, organizations have increasingly moved toward evaluating and rewarding performance at plant, division, and corporate levels.

There are a variety of reasons for this trend. One is that more jobs and projects are being designed in such a way that success is dependent on the cooperation of multiple employees (Hollenbeck, DeRue, & Guzzo, 2004). Another is that when jobs are designed independently and employees rewarded only on the basis of their individual performance, aggregated individual performance may not add up to optimal organizational performance (Schuster, 1984). Yet another reason, as previously noted, is that influential management gurus (Deming, see Gabor (1992) and Pfeffer (1998)) have touted the superiority of team- or group-based systems, arguing that individual reward systems cause employees to compete with one another, attaining personal success at the expense of other employees or the larger organization.

In this review, we examine the evidence with respect to group-based plans.

We begin with plans focused on relatively large units of analysis such as gainsharing, profit-sharing, and employee stock ownership plans. We begin there because these plans have a longer history and a much stronger research base, particularly in ongoing employment settings. We then turn to reward systems for small work groups or teams, where evidence (particularly outside of the laboratory) is scarce, and the results much less clear.

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Pay and Performance • 265 Gain-sharing. Gain-sharing is a results-based program that generally links pay to performance at the facility level. Theoretically, gain-sharing programs are expected to be less motivational than individual incentive programs, given that outcomes are dependent on other workers as well as broader environmental factors (e.g., economic downturns or entry of new competitors). However, they also have a number of expected advantages. For example, they can be customized to target multiple objectives in addition to productivity, such as schedule attainment, safety, or customer satisfaction. In addition, goals are generally both objective and based on historical standards—factors that are likely to facilitate employees’ goal acceptance (Case, 1998). The various potential advantages of gain-sharing led Milkovich and Wigdor (1991, p. 86) to suggest that it might: provide a way to accommodate the complexity and interdependence of jobs, the need for work group cooperation, and the existence of work group performance norms and still offer the motivational potential of clear goals, clear pay-to-performance links, and relatively large pay increases.

Indeed, the empirical evidence on gain-sharing appears to be quite favorable (Gerhart & Milkovich, 1992; Lawler, 1990; Welbourne & Gomez-Mejia, 1995). For example, one 5-year study of 28 sites found positive effects of a variety of gain-sharing plans on productivity (Schuster, 1984). Another study (Hatcher & Ross, 1991) found that changing from individual incentives to gain-sharing resulted in a decrease in grievances and a fairly dramatic increase in product quality (defects per 1000 products shipped declined from 20.93 to 2.31). Arthur and Jelf (1999) examined gains (in labor costs, costs of maintenance materials, perishable tools, scrap, rework, and supplies) from a 5-year gain-sharing plan in an auto parts manufacturing company with 1600 employees. They found a total of $15 million in savings over the 5-year period, as well as a decrease of 20% in absenteeism and 50% in grievances. In a follow-up study, Arthur and Aiman-Smith (2001) reported an increase (from 40% to 60%) in the ratio of “double-loop” to “single-loop” suggestions6 from workers over a 4-year period—a phenomenon that they interpreted as evidence of increased organizational learning.

In another study with positive results, Wagner, Rubin, and Callahan (1988) found a substantial increase in productivity (103.7%) under a foundry gain-sharing plan, as well as statistically significant decreases in labor costs and grievances. An interesting feature of this particular study is that in contrast to most gain-sharing plans (McAdams, 1995), the evaluated plan did not have a strong worker participation feature. Despite this, the authors also reported greater employee concern for cooperative behaviors as well as co-worker “policing” of quantity and quality to assure equitable contributions.

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266 • The Academy of Management Annals Similarly, Banker, Lee, Potter, and Srinivasan (1996) compared results from 15 stores of a major retailer with store-level incentives against results from another 19 stores without incentives. Time-series analyses showed that stores with the incentive plan had 4.9% higher sales, 3.4% higher customer satisfaction, and 4.4% higher profit than stores without the incentive plan. In addition, there were three contextual variables that proved to be important (positive) moderators: tough market competition, upscale customer profiles, and low ratios of supervisors to sales associates.

Petty, Singleton, and Connell (1992) compared one division of an electric utility company that implemented a gain-sharing plan to another division that did not. The gain-sharing division performed better on 11 of 12 objective performance measures, providing an estimated savings of somewhere between $857,000 and $2 million. In addition, there were also positive differences in employee perceptions of teamwork, fairness, employee involvement, and other attitudes.

Despite this generally positive evidence, gain-sharing plans are not without their problems. For example, the program studied by Petty et al. (1992) was subsequently discontinued due to a breakdown in union negotiations over how to distribute the gain-sharing pie among employees. Based on the initial success of the gain-sharing unit, unionized employees in other divisions pressed to be covered by the plan and to share in the payouts. However, management wanted the bonus to be distributed as a percentage of worker salaries while the union wanted identical (flat) bonuses for all employees. The impasse over this issue resulted in the entire plan being discontinued.

Gain-sharing programs can also come under pressure in years when there is no bonus payout. For example, a plan at DuPont’s Fibers Division was discontinued, and one at Saturn substantially watered down in terms of the variable pay component (Bohl, 1997) over this issue. In fact, program discontinuation seems to be relatively common. For example, Kaufman (1992) found that of 104 companies that had implemented a particular kind of gain-sharing program (Improshare) between 1981 and 1988, 23% had discontinued the plan by the time of his study. In addition, another 163 companies that were known to have implemented Improshare plans during the period did not return the survey, so it is likely that the discontinuation rate was higher than the one measured.

As discussed earlier, another potential concern is a negative sorting effect.

For example, a study by Weiss (1987) at AT&T found that extreme performers (at both the top and bottom) were more likely to leave under a gain-sharing plan. More generally, as we have noted, high performers have been found to be highly sensitive to relative rewards and more favorably inclined toward individual (versus group) PFP (Trevor et al., 1997; Trank et al., 2002).

Finally, the returns from gain-sharing programs appear to dwindle with increasing plan size. For example, Kaufman (1992) reported that doubling the

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Pay and Performance • 267 number of employees covered by Improshare from around 200 to 400 was associated with a reduction in the average productivity gain of nearly 50%. In addition, Zenger and Marshall (2000) found that incentive intensity in group and organization plans was negatively associated with the administrative unit level of the plan (e.g., department or work team versus entire organization) and unit size. As such, it appears that organizations’ incentive design decisions are consistent with theory and research on the negative relationship between group size and incentive effects. Thus, while Pfeffer (1998) claims that the “evidence for the effectiveness of various group incentives is compelling, while the empirical evidence for free-riding is sparse” (p. 219), the evidence in fact indicates that as group or organization size increases, the effectiveness of group/organization-based PFP plans becomes weaker. (See also the studies by Kruse (1993) and Blasi, Conte and Kruse (1996) in the following two sections.)

Profit-sharing. Profit-sharing plans pay out based on meeting a profitability target (e.g., return on assets or net income). Profit-sharing can be either deferred (i.e., to fund retirement) or paid in cash, while payouts may be either formula-based (e.g., a fixed percentage of net income) or discretionary. In terms of employee attitudes, Weitzman and Kruse (1990) reported generally positive employee attitudes toward profit-sharing, although this was “tempered…by the risk of fluctuating income” (p. 123).

Several researchers have provided estimates of the effect of profit-sharing on productivity. Weitzman and Kruse (1990) estimated the mean effect at 7.4%, and the median at 4.4%. A meta-analysis by Doucouliagos (1995) of 19 studies and 32,752 firms reported a correlation between profit-sharing and productivity (generally measured as value added or sales per employee) of r=0.05.

However, the correlation was significantly higher in employee-managed firms (r=0.26) than in more traditional firms (r=0.04). We note, however, that Doucouliagos’ definition of profit-sharing included other plans such as gainsharing. Thus, it is possible that plans covering smaller numbers of employees (such as gain-sharing) may have partly driven the results.

In perhaps the most extensive study to date, Kruse (1993) surveyed 275 firms employing a total of approximately 6 million employees. Kruse found that productivity growth in profit-sharing companies was 3.5–5.0% higher than in companies not using profit-sharing. However, there were some important contingency factors. For example, cash plans exhibited substantially higher productivity growth than deferred plans, particularly in withinindustry models. Size was also an important contingency factor, with annual productivity growth of 11–17% in companies having fewer than 775 employees versus 0–6.9% growth in companies with more than 775 employees. A third contingency factor, formula versus discretionary, indicated an advantage for discretionary plans, particularly using within-industry models. Kruse

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268 • The Academy of Management Annals speculated that such plans probably require trust and a positive employee relations climate in order to be effective.

Research on profit-sharing, like research on gain-sharing, suffers from a number of limitations (Kruse, 1993). For example, both research streams are likely to suffer from selection bias (i.e., successful profit-sharing plans are more likely to be studied because unsuccessful plans are less likely to survive or be written about). Secondly, because most studies have used cross-sectional data, there is the possibility of reverse causality (i.e., gain- and profit-sharing plans may be more likely to be adopted by companies that are more productive or profitable in the first place). For example, when Kim (1998) used a simultaneous equations model to control for reverse causality and profits, the positive effect of profit-sharing on profits disappeared. Third, the effects of both gain-sharing and profit-sharing programs may be confounded with other positive management practices that are not measured or controlled.

Finally, the typical measure of productivity in profit-sharing research is value added (the extent to which the price of a product exceeds the cost of the factor inputs such as labor and capital), rather than a measure of physical productivity (e.g., units produced). Obviously, the price of a product can be influenced by many factors other than productivity, such as industry trends and marketing (Gerhart & Rynes, 2003). Thus, finding a relation between profits distributed per worker (profit-sharing) and value added does not necessarily mean that profit-sharing causes higher productivity.

For these reasons, the following factors should be kept in mind with respect to the modestly positive results summarized previously. First, profitsharing appears to be associated with higher overall labor costs (Kim, 1998; Mitchell, Lewin, & Lawler, 1990), a finding consistent with agency theory predictions that workers will require a compensating differential for accepting the risk involved in variable compensation programs. Second, even where profit-sharing has been found to have a positive relationship with productivity, it is not clear whether the relationship is causal. Third, the hoped-for advantage of making labor costs variable in relation to profitability will be realized only if profit- or gain-sharing plans survive years when no payouts are made.

Stock plans. According to the National Council on Employee Ownership website, as of February 2008, 11.2 million employees owned company stock worth more than $928 billion via employee stock ownership plans (ESOPs), stock bonus plans, or profit-sharing plans invested in stock. Another 1.5 million employees held $133 billion in stock via 401(k) plans. In addition, 9 million employees participated in broad-based stock options plans, while another 11 million participated in stock purchase plans. Thus, approximately 33 million employees, or about one-third of all private sector employees, appear to have some degree of ownership in their employing companies.

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Pay and Performance • 269 Moreover, partial employee ownership has grown from an estimated 1% of corporate equity in the 1920s to almost 5% (Blasi, Kruse, Sesil & Kroumova, 2003). However, these same authors indicate that “significant” employee ownership (20% or more of a company’s stock) is mainly associated with small and medium-sized family and independent businesses.

Another prominent feature of stock plans is that different types of plans tend to be used for different employee groups. For example, stock purchase plans and provision of company stock through 401(k) plans are roughly equally prevalent across employee categories. In contrast, stock options, outright stock grants, and phantom stock plans (where pay is linked to stock performance, but with no actual option or ownership) are still heavily weighted toward officers and executives. As such, these latter plans will be discussed primarily in our coverage of executive compensation.

With that said, it is worth noting that stock option plans have frequently been used as a major attraction and retention strategy for non-executives of high-tech companies and small start-up firms. Microsoft, for example, created more than 10,000 millionaires through its stock option program (although it has now been discontinued, in favor of stock grants instead).7 Also, in one of the few studies of stock options focused below the executive level, Gerhart and Milkovich (1990) examined the relationship between the percentage of top and middle level managers (within six levels of the Board of Directors) eligible for stock options in a firm and the firm’s return on assets. Their results suggested that a company having 20% of managers eligible for stock options had a predicted return on assets of 5.5%, as compared with a predicted return on assets of 6.8% (or roughly 25% higher) for companies having 80% of managers eligible. However, because these findings pertain to relatively high-level and highly paid managers, results might be weaker for plans covering a broader range of employees, particularly in larger firms (Oyer & Schaefer, 2005).

Turning to stock ownership plans (as opposed to options), it is generally assumed that whatever effect ESOPs might have on firm performance is likely to be mediated through employee attitudes. Klein (1987) hypothesized that ESOPs might affect employee attitudes and motivation in three ways: (1) through a “pride in ownership” effect, regardless of financial benefit; (2) through the financial benefits yielded by the plan; and (3) through improved two-way communication between employees and managers. She tested these hypotheses on data from 2804 employees in 37 ESOPs. In addition, she also obtained data from key managerial respondents in each firm pertaining to the extent to which the ESOP was a core part of management’s philosophy, as well as the resources devoted to ESOP communication.

Klein’s findings did not support the first hypothesis (mere pride of ownership), but did support the second and third. Specifically, the R2 between size of employer financial contribution and organizational commitment was 0.17, and the R2 with turnover intention was 0.25 (higher contributions were

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270 • The Academy of Management Annals associated with lower intentions). Adding the management philosophy and ESOP communication variables increased the R2 to 0.30 for organizational commitment, and 0.39 for turnover intentions. There was also support for a relationship between perceived worker influence on decisions and employee commitment, but not with turnover intentions.

In a study of “psychological ownership”, Wagner, Parker and Christiansen (2003) examined how the 401(k) participation of employees and their perceptions of organizational climate related to: (a) attitudes toward ownership (e.g., beliefs that individual employees should share both the financial successes, and setbacks, of their employer); (b) ownership behaviors (e.g., trying to cut costs, making suggestions for work improvement, and seeking information about their employer’s financials); (c) attitudes toward the organization; and (d) financial performance (sales per square foot, net sales, and ratio of net sales to planned sales). They examined these relationships at the group level of analysis, studying 204 work groups from 33 stores in a large retail organization. (Employees had the option of investing their 401(k) contributions in company stock or mutual funds, whereas company matching contributions were in the form of company stock). Their results showed that participation in 401(k) plans and working in a climate supportive of self-determination were related to attitudes toward ownership, ownership behaviors, and attitudes toward the organization. In addition, ownership behaviors were positively related to group financial performance. Thus, both Klein (1987) and Wagner et al. (2003) suggest that employee attitudes are important determinants of the effects of employee ownership.

Most other studies of ESOPs have examined their effects on productivity or financial outcomes, rather than attitudes. Overall, the results of these studies suggest very modest benefits to stock ownership. For example, Blasi et al.

(1996) examined 562 Employee Ownership Firms (EOFs) and compared their financial performance (profitability and price/earnings ratios) to 4716 firms without such plans. Overall, they found no main effect for EOF on firm performance. Instead, the relationship between EOF and performance depended to a “striking” (p. 75) degree on firm size. Specifically, Blasi et al. (1996) found that for the smallest quartile on firm size (maximum firm size=1015), EOF firms were 1.3 percentage points higher on ROA, and 1.5 percentage points higher on price/earnings (P/E) ratio. In contrast, in the quartile where firm size ranged between 3014–12,700 employees, EOF firms had ROAs that were 1.9 percentage points lower, and P/E ratios that were 1.6 percentage points lower. Thus, the coefficients generally revealed a declining pattern of returns by firm size. Similarly, Doucouliagos (1995) conducted a meta-analysis based on 17 studies and 31,323 firms and found a weighted mean correlation between employee ownership and productivity of only r=0.03. Thus, this study also suggests that the typical effects of ESOPs on firm productivity are very modest.

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Pay and Performance • 271 More recently, Blasi et al. (2003) report that, based on seven large-sample studies, “we observe at least neutral and generally positive effects of employee ownership on firm performance” (p. 908). However, they indicate that few employers (probably less than 1%) use stock ownership in a way that would be expected to generate large incentive effects (i.e., in combination with high goal-setting, active employee participation, and strong two-way communications between workers and management). Rather, most companies adopt such plans for their financial, tax, or takeover defense advantages—or as substitutes for defined benefit pension plans—rather than as motivational plans designed to induce employees to “act like owners”. Nevertheless, results from Klein (1987), Blasi, Conte et al. (1996) and Blasi, Kruse et al. (2003) and Wagner et al. (2003) suggest that ESOPs can have a positive impact on firm performance under the right conditions (e.g., in smaller firms, in firms where ownership improves communication and employee attitudes, and in firms having greater financial success).

Compensation for small groups and teams. In small group or team-based systems,8 conflicting reward objectives come to the forefront. “One objective is to foster member cooperation and cohesiveness in executing team projects and assignments. The other is to recognize individual differences in the contribution members make toward team accomplishments. While the first objective is compatible with extending reward payouts to members as equal shares, the second objective argues for members receiving equitable reward payouts in proportion to their relative contribution” (Weinberger, 1998, p. 18). Or, as Hollenbeck et al. (2004, p. 362) put it: “The degree to which teams should operate and be rewarded for behaving as cooperative or competitive systems is at the heart of the debate on reward structures for teams”.

Unfortunately, extant research does not provide a great deal of advice to managers on how to deal with this conflict. Although there have been a large number of studies of group rewards (not always pay) in laboratory settings, findings from field settings are very scarce. In addition, existing laboratory studies often employ subjects and manipulations that are considerably different from those observed in employment settings. Perhaps not surprisingly, then, an extensive review of this literature by DeMatteo, Eby and Sundstrom (1998) presented few clear conclusions about the likely effects of different ways of compensating teams in ongoing organizations. We turn now to providing our own updated review.

In one of the few field studies of small-group reward systems, Wageman (1995) examined the effects of implementing individual, group-based, and “hybrid” (mixed individual and group) rewards on intact groups of technicians at Xerox’s Customer Service Division. Wageman sought to identify managers who would be highly motivated to implement alternative reward structures (which in the past had been primarily individually-based). Specifically, she

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272 • The Academy of Management Annals identified five district managers “who expressed strong interest in participating and were willing to alter the ways in which rewards were distributed in their districts” (p. 155). In addition, she recruited two additional district managers who agreed to continue rewarding employees on an individual basis (i.e., the status quo). Participation of these 7 districts yielded 60 groups (353 technicians) in the group outcome condition, 77 groups (398 technicians) in the hybrid outcome condition, and 55 groups (369 technicians) in the individual outcome condition.

All groups in a given district implemented the same type of reward condition. Prior to implementation, all first-line managers received a one-day training session in “planned spontaneous” reward practices. In addition, managers developed monthly plans for delivering rewards to groups and/or their members. Furthermore, as the study progressed, managers recorded all rewards delivered each month and sent the list to the author. Three types of outcomes were measured: (1) archival data on group performance; (2) survey and archival measures of group interactions; and (3) survey measures of individual motivation and satisfaction. In addition, an extensive measure of preimplementation group interdependence (assessed via such things as the extent to which groups actively coordinated the queuing of service calls or managed their expenses collectively) was developed. This served as a “before” measure for assessing change in group interdependence as a result of the reward implementation.

Although Wageman (1995) reported a variety of results, the most notable was that pure group or pure individual systems were associated with better performance than hybrid systems: Findings showed that the work performed by the technicians in this study can be done well in two different ways: independently and interdependently…. By contrast, a look at the dynamics of hybrid groups shows that both the independent and the interdependent processes were barely half-fueled in the hybrid-task/hybrid-outcome condition.

Hybrid tasks required groups to act sometimes as groups, sometimes as individuals. While the individual part came naturally, acting as a group did not. Individuals perceived the introduction of group-level elements to their work and rewards as an add-on, not a fundamental change in the work, and it undermined attention to the basic aspects of the task.

(Wageman, 1995, p. 173–175) In assessing the likely generalizability of Wageman’s findings, it is important to note that beyond praise and recognition from managers, the only money managers distributed under the system came from their discretionary budgets, which were not connected to annual merit increases. In addition, only one type of job was studied. Moreover, Wageman only observed performance over a 4-month period (although some individual difference variables

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Pay and Performance • 273 were measured eight months later), and those months did not include the end-of-the-year annual salary increase. Still, Wageman reported that: “the intervention produced significant differences in the reward practices of participating districts…and it created three distinct levels of outcome interdependence—group, hybrid, and individual” (p. 160). As such, at the very least, her study suggests that the move from individual to hybrid systems may be fraught with danger—perhaps more danger than moving to a more extreme (i.e., completely interdependent) system.

The balance between group and individual rewards was also addressed in a study reported in a short research summary by Katz (2001). She was interested in how to design group incentives that might encourage high performers to help weaker members, while simultaneously increasing weak performers’ desire to improve their own performance. To do this, she tested 35 three- or four-member teams in an interactive simulation that provided opportunities for team members to both cooperate with and compete against one another.

Thus, “although the simulation did not re-create a management setting per se, it did involve many of the conditions that characterize one: dispersed information, time pressures, easily evaluated performance, and the need for collaboration” (Katz, 2001, p. 22).

Teams were compensated via one of five different structures: pay equality (all members received the same pay); pay equity (members were compensated based on individual performance) and three hybrid methods: group threshold (pay rose after the team as a whole reached a certain target); individual threshold (pay increased after every member of the team hit an established target), and relative ratio (team members were paid for individual performance, but once the highest paid earned twice as much as the lowest paid, some of the highest performer’s earnings were transferred to the poorer performers).

Results showed that the two threshold schemes were better at keeping high performers motivated than the equality scheme, and better than the equity scheme at encouraging high performers to share information with others. In addition, the individual threshold scheme created a strong drive among lower performers to improve their performance. In contrast, the relative ratio scheme was the least effective because it placed a cap on rewards and made groups members constantly concerned about how they were performing relative to others. Katz concluded that group and individual threshold systems might be most applicable, particularly in situations when group outputs are quantifiable, when members’ roles are not highly differentiated, when highly skilled workers are not enough to “carry” a whole team, and when there is sufficient time for high performers to teach less effective members.

Because small-group compensation research is not yet plentiful, it is possible that future meta-analytic studies will reveal a number of main effects or generalizable advice for compensating small groups or teams. At the present

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274 • The Academy of Management Annals time, however, the effectiveness of small-group compensation systems appears to be affected by multiple contingency variables (DeMatteo et al., 1998).

For example, one variable (in addition to group size—see our earlier discussion) that has long been hypothesized to moderate the effectiveness of incentive plans is the extent to which tasks are truly interdependent. For example, Shaw, Gupta and Delery (2002) found that in an industry where tasks are mostly independent (long-distance trucking), firm accident rates and time spent out-of-service were lowest (i.e., performance was best) when there were high individual pay incentives and high pay dispersion across drivers. In contrast, in a second study in the concrete pipe industry, they found that safety performance was poorest when high pay differentiation was coupled with high task interdependence (measured via the existence of self-managed teams).

However, some theoretical models have suggested that the relationships between task interdependence, reward systems, and performance may be even more complicated than suggested by Shaw et al. (2002). For example, Siemsen, Balasubramanian and Roth (2007) used mathematical logic to argue that the appropriate team reward system depends on the nature of the dependency (i.e., for output-, help-, or knowledge-sharing). Similarly, Siggelkow (2002) proposed that appropriate rewards depend on whether team outputs are complements, or substitutes, for one another. Chillemi and Gui (1997) suggested that employers’ optimal responses to individual salary demands by team members also depend on how much team turnover the group can afford.

Empirical laboratory studies, too, have suggested that things may be quite complicated with teams. For example, Beersma et al. (2003) engaged 75 fourperson teams in a distributed decision making computer simulation task.

Although the task was interdependent, half the teams were told that they would be rewarded based on individual performance (with the highestperforming members winning $10 each), while the other half were rewarded based on team performance ($40 to the highest-performing team). Each team participated in 1.5 hours of training appropriate to its reward condition (i.e., teams rewarded on an individual basis received individual performance feedback, while teams rewarded on a team basis received team-level feedback).

Results showed that teams rewarded on an individual basis outperformed others on speed, but under-performed on accuracy relative to those rewarded on a team basis. In addition, there was an interaction between two personality characteristics of team members and the reward system. Specifically, teams with higher levels of extroversion and agreeableness performed relatively better under the cooperative condition than did teams with lower levels of these personality traits. Finally, analyses showed that the poorest individual performers were more sensitive to the interaction of reward structure and personality than were the highest-performing individuals.

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Pay and Performance • 275 In a subsequent study, Johnson et al. (2006) extended the findings of Beersma et al. (2003) by putting 80 student teams through two rounds of a similar computer simulation, utilizing four conditions. In one condition, teams were rewarded competitively (i.e., on the basis of individual performance) in both rounds (competitive/competitive); in a second condition, they were rewarded cooperatively (based on team performance) in both rounds (cooperative/cooperative). For the other teams, the reward systems were switched between rounds, resulting in a competitive/cooperative condition and a cooperative/competitive condition.

Results from this two-phase experiment showed that teams in the cooperative/competitive condition performed similarly in the second (competitive) round to teams that were competitively rewarded all along. In contrast, competitive/cooperative teams performed quite differently from teams that were cooperatively rewarded in both rounds. Specifically, in the second (cooperative) round, instead of being higher on accuracy than on speed (as were cooperative/cooperative teams), they were higher on speed than accuracy.

Moreover, competitive/cooperative teams slowed down at Time 2 but did not improve on accuracy as compared to Time 1. In addition, cooperatively rewarded teams shared significantly more information than competitively rewarded teams, with information-sharing partially mediating the relationship between reward structure and team accuracy. The authors concluded that their results were more complicated than what would be predicted by simple contingency theories, since performance in Time 2 was dependent on how teams had been rewarded in Time 1. As such, team results appeared to be pathdependent, as suggested by the resource-based view of the firm (Barney, 1991).

Summary Every pay program has its advantages and disadvantages. Programs differ in their sorting and incentive effects, their incentive intensity and risk, their use of behaviors versus results, and their emphasis on individual versus group measures of performance. Individual-based plans are likely to fit better where work is independent and competition between individuals is encouraged, but less well where there is interdependence and a greater need for cooperation.

Group and organization-based plans would seem to provide the solution in the latter case. However, as we have seen, such plans have potentially weaker incentive effects and may also have adverse sorting effects, particularly as the number of employees covered increases. Results-based plans can achieve strong incentive intensity, but a compensating differential for the increased risk borne by workers is likely to make such plans more costly, unless expected performance improvements actually materialize. Also, objectives not explicitly included in the plan may be ignored. Behavior-based plans can be better on these dimensions, but it is typically more difficult to achieve strong incentive intensity without objective performance measures.

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276 • The Academy of Management Annals Because of the limitations of any single pay program, organizations often elect to use a portfolio of programs (e.g., merit pay combined with profitsharing) that focus on different objectives, which may provide a means of hedging the risks of particular pay strategies while still achieving most of the hopedfor benefits (Gerhart et al., 1996). Of course, as the Wageman (1995) research suggests, hybrid plans are not always superior, especially to the degree that there are mixed or conflicting messages and the relative size of incentives tied to different performance objectives is not consistent with the stated priorities.

There continues to be a need for research on PFP programs of all types, with the most valuable research including measures of mediating variables (to better understand causal processes), and longitudinal designs (to better understand survival, sorting effects, and also to satisfy time precedence standards for understanding causal processes). In addition, given that most PFP plans are combination or hybrid plans, it would be useful to see more research that studies such plans as holistic entities, rather than studying only one aspect (e.g., profit-sharing) and not measuring other co-existing PFP plans.

In the previous review, we have emphasized the fact that the empirical evidence shows that PFP programs can “work”, and work quite well.

Nevertheless, we do not want to lose sight of the equally important fact that PFP programs can also have unintended consequences that may negatively influence effectiveness. (For example, executives at Enron were found to have inflated earnings to increase the stock price and thus, their own compensation.) The recent financial industry “meltdown” is attributed by some to overly strong and risk-inducing incentive plans. Thus, there is a risk to using PFP programs, especially those with high-intensity PFP. The empirical evidence on this point is less systematic and organized, yet it is important to recognize. Often, the evidence comes from experiences of individual organizations. Typically, the problem is that PFP motivates “too well”, but in the wrong direction. Examples include mis-coding health conditions in hospitals to get higher government reimbursement rates and auto repair shops finding (non-existent) mechanical problems so they could sell more repairs (Gerhart, 2001) In both cases, the incentive plans were designed to reward employees for driving revenue. Both plans accomplished that, but employees used unacceptable means to do so. (Our later section on executive PFP provides further examples of unintended consequences.)

PFP plans, particularly to the degree they rely on results-based performance measures (e.g., profits), carry other risks as well. For example, PFP plans are expected to increase labor costs, particularly in plans that add a PFP component with no reduction in base salary. Indeed, companies with aggressive PFP programs such as Whole Foods, Lincoln Electric, and Nucor Steel, do have relatively high labor cost per worker. However, to date these higher costs have been more than offset by higher productivity (i.e., fewer workers to produce a particular level of output). So, the model is one of highly-paid,

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Pay and Performance • 277 highly-productive workers, but fewer of them. Of course, not all companies have been able to execute their PFP programs as successfully.

In plans that use the PFP component as a replacement for some portion of base pay, direct costs are more contained. However, employee relations problems are likely to arise in years when the PFP portion does not pay out, or when management retrospectively decides that the performance hurdle for payout is too low (Roy, 1952; Whyte, 1955). Consequently, in deciding on the use and design of PFP programs, “One must consider whether the potential for impressive gains in performance” from such plans is “likely to outweigh the potential problems, which can be serious” and be aware that such plans are best thought of as representing “a high risk, high reward strategy” (Gerhart, 2001, p. 222).

In other cases, the failure of PFP programs may be less dramatic, but still a problem. How long a PFP plan remains in place is sometimes used as a measure of its success. While a short-term gain in performance from a pay plan that does not last long should not be dismissed (Gerhart et al., 1996), a plan that generates longer-term performance gains is, of course, preferred. Also, changing plans too often can result in a counterproductive “flavor-of-the-month” perception among employees (Beer & Cannon, 2004). So, survival is a useful indicator. Evidence on survival is also important for estimating statistical effect sizes of PFP plans because studying only plans that survive would result in a biased sample (Gerhart et al.).

A recent paper by Beer and Cannon (2004) provides survival information on 13 PFP experiments conducted at Hewlett-Packard in the mid-1990s. In 12 of the 13 cases, the programs did not survive, in part, Beer and Cannon conclude, because of a perceived lack of fit with H-P’s high-commitment culture at the time. In the H-P case, the PFP initiatives had unintended consequences and managers eventually decided that performance could be more effectively improved “through alternative managerial tools such as good supervision, clear goals, coaching, training, and so forth” (Beer & Cannon, 2004, p. 13).

They note that: “This decision [did] not imply that managers believed that pay did not motivate or that it could not be used effectively in other settings” (Beer & Cannon, 2004, p. 13). Rather, managers decided that at H-P, there were better alternatives. As Ouchi (1979), for example, pointed out, “control systems” can take many forms other than PFP (e.g., careful selection of committed employees, socialization, as well as rituals and ceremonies to reward those who display attitudes and values seen as leading to organization success).

Moreover, to the degree that it is difficult to measure both performance outcomes and the behaviors that lead to performance outcomes, it may prove difficult to use PFP and greater emphasis on alternative control systems may be required (Ouchi, 1979; Williamson, Wachter, & Harris, 1975).

The high failure rate of this one set of PFP plans at H-P warrants a few additional comments. First, the particular PFP programs that Hewlett-Packard

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278 • The Academy of Management Annals experimented with appear to have been mostly team-based programs (Ledford, 2004). Although these did not survive, H-P has for many years used and continues to use other PFP programs such as broad-based stock options and profit-sharing (Beer & Cannon, 2004). Second, the fact that managers decided to “experiment” with PFP plans may indicate the influence of what other organizations were doing, as opposed to what would best fit H-P. Benchmarking is a standard and necessary practice in compensation, but as in any area of management, it can devolve into following fads and fashions. Certainly, we know that institutional forces play a role in compensation policies and practices (Conlon & Parks, 1990; Eisenhardt, 1985b; Gerhart et al., 1996). Third, PFP programs may generate desirable sorting effects, and it is possible that some perceived lack of fit with the pre-existing culture, resulting in dissatisfaction among some employees is a necessary part of this process (Cannon & Beer 2004; Gerhart & Rynes, 2003). Finally, whenever the risk of implementing a new PFP plan is discussed, it is also necessary to discuss the risk of not implementing such a plan (Gerhart et al., 1996), since changes in PFP strategy can sometimes pay off handsomely.

Executives and PFP To this point, our discussion has dealt with PFP issues as they affect a wide range of employee types. However, both employers and scholars recognize that, due to their strategic importance to the organization—as well as the heightened potential for conflicts of interest and associated regulatory scrutiny—certain employee groups require special attention in the design and study of their pay (Milkovich & Newman, 2008). Certainly, executives are one such group.

Executives, especially chief executives, are also unique, of course, in that their pay levels are much higher than those of nonexecutives and represent a sizeable percentage (roughly 6% according to Bebchuk & Grinstein, 2005) of net income.

According to the chief executive officer (CEO) Compensation Survey/2007 conducted by the Wall Street Journal and the Hay Group (Wall Street Journal, 2008), median CEO pay (defined as base pay, annual incentive/bonus, and the value of grants of stock options, restricted stock, and other long-term incentives) in 200 large US companies in 2007 was $8.85 million. However, the composition of executive pay is also notable. Of the $8.85 million, only about $1.1 million, or 12%, was in the form of base pay, with the remainder in the form of either short-term (21%) or long-term (67%) incentives. In the great majority of companies, the long-term incentive component is based on stock returns.

As will be seen, there is less research than might be expected on the effectiveness of PFP programs for executives. However, there is more research on the degree to which PFP exists among executives (enough to generate two meta-analyses), as well as on the degree to which PFP intensity and use vary as a function of contextual organizational factors. Other work examines how the design of executive pay packages may influence the business objectives that

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Pay and Performance • 279 executives choose, which likely has implications for performance as judged by shareholders. There is also research on the degree to which factors other than performance (e.g., sociopolitical factors) influence executive pay. (By implication, the greater the role played by these non-performance factors, the smaller the role played by PFP.) Finally, executive pay is also sometimes seen as influencing how non-executives (and other executives) in an organization feel and perform (Cowherd & Levine, 1992; Wade, O’Reilly, & Pollock, 2006). Thus, executive pay not only has potential consequences for firm performance through its effect on the performance of the executive, but also via its possible impact on the performance of other employees.

There is also great public interest in the level of executive pay. Walsh (2008, p. 30) observes that “Public concern about executive pay… is about fairness.

Taken-for-granted norms of fairness are essential to the health of the free market system”. The question here is whether anyone, regardless of their performance, deserves to be paid so much. Public interest in this question can be seen to some degree in the congressional and regulatory attention given to executive pay (see our later discussion). Most recently, it has been readily apparent as struggling private sector companies ranging from financial services institutions to auto manufacturers turn to the federal government for financial assistance. The norm to date has been that any firm expecting to receive such assistance must agree to restrictions on executive pay. (For example, see our later discussion of the Troubled Assets Relief Program.)

We begin our review of executive PFP with a discussion of agency theory, the dominant theoretical framework in the area.

Agency Theory For non-executives, motivational theories such as goal-setting, expectancy theory, reinforcement theory, and to some extent agency theory, have grounded research and practice around performance-based pay. In the case of executives, however, agency theory has overwhelmingly dominated the scene.

Agency theory starts from the observation that once an entrepreneur hires his/her first employee, there is separation of ownership and control (Jensen & Meckling, 1976). The entrepreneur (and/or others having ownership stakes, as in larger firms) retains ownership, but now must deal with an agency relationship, under which the owner (i.e., principal) contracts with one or more employees (i.e., agents) “to perform some service on their behalf which involves delegating some decision making authority to the agent” (Jensen & Meckling, 1976, p. 308).

Agency costs: executives behaving badly. Agency theory posits that selfinterested, effort-averse, and relatively risk-averse managers (i.e., agents) may sometimes fail to act in the best interests of shareholders (principals) due to divergence of interests and information asymmetry (Fama & Jensen, 1983a,

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280 • The Academy of Management Annals 1983b; Jensen & Meckling, 1976). As a result, shareholder welfare can suffer due to such factors as suboptimal executive decisions, empire building, gaming of incentive systems, shirking, sociopolitical activities, excess perquisites extracted by executives, and so on. Dalton, Hitt, Certo and Dalton (2007) provide a thorough review of the evidence on the existence of agency costs and the challenges in controlling them. They describe “the central tenet of agency theory” to be “that there is potential mischief when the interests of owners and those of managers diverge” and that this may allow executives “to extract higher rents than would otherwise be accorded to them by owners of the firm” (Dalton et al., 2007, p. 2).

Although such costs are difficult to eliminate entirely, they can, under agency theory, be reduced through contracting (i.e., PFP) schemes that are based on monitoring of executive behaviors and/or presumed outcomes (e.g., firm performance) of such behaviors. Thus, boards of directors, acting on behalf of shareholders, must decide the most efficient mechanism for aligning the interests of the executive with those of shareholders. The costs of reducing agency losses plus any remaining unmitigated agency losses are referred to collectively as agency costs (Jensen & Meckling, 1976).

Because executive behaviors are difficult to specify in advance and costly to measure due to unobservability, compensation that is contingent on firmlevel performance is commonly used to motivate executives to act in shareholders’ interests (Eisenhardt, 1989; Gomez-Mejia & Balkin, 1992; Murphy, 1999). But outcome-based contracts involve shifting risk from the principal to the agent, and the greater the uncertainty inherent in this risk-shifting, the higher the overall cost of compensation. This trade-off makes it challenging to specify the exact nature of the “optimal” compensation contract (i.e., “one that maximizes the net expected economic value to shareholders after transaction costs and payments to employees” (Core, Guay & Larcker, 2003, p. 27)). There is also evidence that there is a “dark side” (Dalton et al., 2007, p. 18) to executive PFP in that it may motivate undesired or “untoward activities” (e.g., misrepresentation of earnings (Harris & Bromiley, 2007)) despite being designed with the intent of aligning interests of executives with those of shareholders.

(As we saw earlier in this chapter, a similar challenge exists for nonexecutive PFP plans.)

As noted, compared with most nonexecutive employees, executives have a much larger percentage of their compensation is in the form of performance-contingent pay. Executives are also unique in that they are generally required to maintain a large personal equity stake in the corporation on an ongoing basis.9 This effectively increases their own personal investment risk through a lack of portfolio diversification, making the fundamental agency theory challenge (the trade-off between incentives and risk) particularly salient. These large-equity stakes usually come from stock and option holdings that have accumulated over the years. Effectively, then, executive PFP

Pay and Performance • 281 plans have long-term effects because they lead to equity accumulation, the value of which is very sensitive to the firm’s stock performance (Nyberg, Fulmer, Gerhart, & Carpenter, 2008).

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Effects of Executive PFP: Empirical Evidence Does PFP → performance?. In his review, Murphy (1999) concluded that there was surprisingly little direct evidence on the effects of executive PFP programs on firm performance. There is, however, plenty of evidence that PFP design influences the goals and actions chosen by executives (see reviews

by Gerhart (2000) and Devers, Canella, Reilly and Yoder (2007)). Examples of executive behaviors affected by PFP (usually defined in terms of the extent of equity-related incentives) reported in these reviews include extent of diversification, research/development and capital investment decisions, choice of strategy, risk-taking, earnings manipulation, reaction to takeover attempts, stock option backdating, and option grants being more likely in advance of strong earnings. Although some of these outcomes of PFP are clearly undesirable and sometimes even illegal (as in the case of backdating options, which we discuss later), in other cases, the alignment of actions with shareholder interests can only be assessed after the fact. Most importantly, these studies, by themselves, do not directly address the question of the net effect of such incentives on financial performance.

Some early research suggested positive effects of PFP (defined in terms of use of executive stock plans) on financial performance. For example, Masson (1971) found that firms with greater emphasis on stock-based compensation had higher shareholder return, while Brickley, Bhagat, and Lease (1985) found that announcement of stock-based incentives was associated with an abnormal (i.e., a deviation unpredicted by other variables) return to shareholders of 2.4% during the period between the Board of Directors’ first meeting to discuss the plan and the day that the Securities and Exchange Commission (SEC) received the proxy statement describing the plan (mean days in period=58.4). Similarly, Gerhart and Milkovich (1990) found that incentive pay for middle and top managers (defined as eligibility for stockrelated incentives, but also as bonus/base ratio) was positively associated with subsequent financial performance (Gerhart & Milkovich, 1990). Consistent with agency theory’s focus on the trade-off between incentives and risk, however, firm risk seems to be a moderator of this relationship, with high-risk firms performing more poorly when they emphasize incentive pay than when they do not (Aggarwal & Samwick, 2006; Bloom & Milkovich, 1998).

It may be that Murphy’s conclusion about the lack of research on PFP consequences reflected not only a judgment about the amount of research available on the topic at the time of his review, but also its credibility. The task of credibly isolating the impact of PFP from the other determinants of firm performance is a challenging one. Theory and research on this question is also

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282 • The Academy of Management Annals fragmented and often conflicting in its world views and inferences. For example: “[t]here is presently no theoretical or empirical consensus on how stock option and managerial equity ownership affect firm performance” (Core et al., 2003, p. 34).

A recent study by Hanlon, Rajgopal, and Shevlin (2003) shows some of the challenges in studying the PFP → performance question. They examined the degree to which the Black–Scholes value of executive stock option grants predicted future financial performance. Interestingly, rather than stock returns, they used earnings (over 5-year periods) to measure financial performance. (This was to avoid the complication of announcements of options grants influencing stock price, see Brickley et al. (1985).) As discussed later, earnings and stock returns show substantial convergence over longer time periods like the 5-year period used here (but not over shorter periods), so this is a viable study design. Hanlon et al. (2003) found that for each $1.00 increase in the value of stock option grants, earnings increased $3.71, a very strong rate of return to shareholders. However, Hanlon et al. (2003) also found that this return estimate depended on the functional form and the estimation method. Using a linear model, there was actually a negative earnings return (–$0.69) to stock option grants. Only when a nonlinear relationship was specified, did the overall return estimate turn positive. In addition, the $3.71 estimate was obtained using instrumental variables (in an effort to correct for simultaneity bias). Using ordinary least squares (with the nonlinear function form) yielded an even higher estimate. Thus, the Hanlon et al.

(2003) study shows that the estimation of the PFP effect is not as robust as one might wish across alternative specifications, limiting its ability to provide a strong conclusion.

Still, the work that does exist generally seems to find that executive PFP is associated with higher subsequent firm performance. Does this mean, then, that firms should use more equity incentives, or are firms already generally using an optimal level? Some researchers imply that firms can improve performance by simply granting more equity (Morck, Schliefer, & Vishny, 1988), while others researchers argue that since firms generally contract optimally, observed equity ownership levels are likely to be efficient given a particular firm’s own unique circumstances (Core et al., 2003), such as managerial risk aversion and firm risk (Aggarwal & Samwick, 2006).

Does PFP actually exist for executives?. Although some evidence suggests that PFP may positively influence performance, given the lack of research consensus, scholars in both finance/economics and management have sought to address the related question of whether PFP truly exists among executives.

If the answer is no, the key role of incentive alignment expected under agency theory can be questioned and a search for alternative (e.g., sociopolitical) explanations for observed CEO pay becomes more important. As we will see,

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Pay and Performance • 283 the fields of management and economics/finance have reached different conclusions on this issue.

Agency theory-based empirical research hit its stride in the 1970s and 1980s. Yet, despite this relatively long history, agency-based research has yet to yield a universal consensus on whether CEO pay is linked closely enough to performance. Early studies showed mixed results, arguably due to differences in methodology and choice of compensation and performance measures. For example, Murphy (1985, p. 11), an economist, concluded that “executive compensation is strongly positively related to corporate performance”, while management scholars Kerr and Bettis (1987) reported no relationship between shareholder returns and cash compensation.

In their seminal 1990 study, economists Jensen and Murphy lamented that CEO incentive alignment had declined since the 1930s, with CEO wealth (including equity holdings) increasing by an average of “only” $3.25 per $1000 increase in shareholder value, which they interpreted as a weak level of incentives. Both of these conclusions have been challenged, particularly by research in finance, accounting, and economics (Hadlock & Lumer, 1997; Hall & Liebman, 1998; Haubrich, 1994). Specifically, subsequent studies in this literature have found larger performance–pay relationships (e.g., $14.53/$1,000 in Aggarwal & Samwick, 1999a), while others have noted that both the Jensen and Murphy and Aggarwal and Samwick estimates imply large changes in executive compensation, given modest changes in market value, especially in large firms (Gerhart & Rynes, 2003).10 It is not that these other literatures conclude that performance is the only factor in executive pay. To the contrary, much research documents the existence of agency problems and the challenges in dealing with them. But, the important role of performance is also recognized to a greater degree than in management.

In the management literature, however, many scholars still focus primarily on Jensen and Murphy’s old (i.e., 1990) conclusion that the relationship between organizational performance and pay among executives is “small” (Tosi 2005; Dalton, Daily, Certo & Roengpitya, 2003; Dalton et al., 2007).

Further, empirical research in management is generally interpreted as being consistent with this conclusion. Meta-analyses by Dalton et al. (2003) and Tosi, Werner, Katz, and Gomez-Mejia (2000) report that variance explained estimates (for the executive PFP relationship as defined in these studies) of less than 1% and 4%, respectively. Based on these weak relationships, Tosi compared those who continue to believe that US CEOs have strong PFP incentives (Core, Guay, & Thomas, 2005) to those who resisted the idea that “the earth is round, not flat” (p. 485–486). Hitt (2005, p. 963) summarizes this literature as follows: Research in economics, finance, and management… originally supported the importance of equity ownership by managers and

284 • The Academy of Management Annals

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directors. However, a recent meta-analysis concluded that no systematic relationship exists between ownership structure and firm performance (Dalton, Daily, Certo, & Roengpitya, 2003). Stock options became popular mechanisms for tying executive compensation to firm performance and promoting executives’ equity ownership in firms.

However, anecdotal evidence and academic research suggest that they have not been highly effective in meeting these goals. In fact, the research shows only a small relationship between executive compensation in any form and firm performance. (Tosi et al., 2000) Thus, different literatures have reached different answers to the question of whether PFP exists among executives. (For a recent example, see the recent debate between Walsh (2008) and Kaplan (2008).) What explains the difference? One major factor is that the economics/finance literature incorporates the role of stock-based plans in achieving incentive alignment more fully than does the management literature. It has been established that observed incentive alignment (PFP) is much stronger when executive pay is defined and measured to fully incorporate the value of stock and stock option holdings accumulated over time and when researchers focus on how this value changes with changes in shareholder wealth (Aggarwal & Samwick, 1999a; Hall and Liebman, 1998; Jensen & Murphy, 1990).

To Murphy (1985), the relationship between the value of executive stock holdings and the firm’s stock market performance is sufficiently obvious that he described it as “mechanical” and later as “explicit” (Murphy, 1999). The reason is that both executive and shareholder return are based on the value of the same underlying asset, company stock (Conyon, 2006). By contrast, accounting measures such as profitability or earnings are used primarily as criteria in short-term (bonus) executive compensation plans, which account for much less of total executive compensation. Over time, earnings measures should also relate to total executive compensation, but that is primarily because earnings should converge more closely with stock returns over longer time periods (Dechow, 1994; Easton, Harris, & Ohlson, 1992; Warfield & Wild, 1992). Murphy (1999, p. 2522) described this relationship between earnings and CEO compensation over time as the “implicit” alignment with shareholder interests, by virtue of the relationship between accounting measures and stock performance.

The importance of capturing the explicit part of CEO incentive alignment can be seen by examining the annual survey of CEO pay published by the Wall Street Journal. As we saw earlier, that survey reported that the majority (67%) of CEO pay is based on what are commonly referred to as long-term incentive plans, which include stock options and restricted stock (Ellig, 2002).11 In turn, payouts to CEOs covered by these plans are typically based on shareholder return (Kim & Graskamp, 2006; Ellig, 2002). By contrast, accounting measures

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Pay and Performance • 285 of performance such as net income are generally used for determining bonus payouts under short-term incentive plans. Excluding stock-based payouts in measuring CEO compensation or excluding shareholder return in measuring firm performance is thus likely to lead to biased estimates of the strength of overall incentive alignment (Hall, 2000). Indeed, Murphy (1999) states that “virtually all of the sensitivity of pay to corporate performance for the typical CEO is attributable to the explicit rather than the implicit part of the CEO’s contract”.

Yet, most of the studies included in the Tosi et al. (2000) meta-analysis measured CEO compensation as salary plus bonus, and measured firm performance in terms of accounting measures of profitability such as net income, return on equity, or return on assets. In addition, these studies typically used short-term (i.e., 1 year) time periods. Thus, the (central) role of stock in creating PFP was not captured. Of the studies in the Dalton et al. (2003) meta-analysis that included CEO equity as a measure of (long-term) CEO compensation, the majority measured firm performance in terms of short-term accounting profitability (e.g., return on equity, return on assets), rather than measuring performance in terms of shareholder return or related measures. So, here stockbased compensation was included, but its main driver, stock performance/ shareholder return, was not.

Yet another issue concerns the choice and timing of stock option measures.

Even though stock options are assigned an estimated value (e.g., using an options pricing model such as Black-Scholes), their actual value is uncertain and depends on what the stock price does in the future.12 If the stock price does go up and options are later exercised, it can generate a sizable payout.

Some analyses (more often in the business press than in academic research) have specified models where such payouts are counted toward a single year’s compensation, and then highlighted cases where the large payout (e.g., in year 1) seems to be out of proportion with shareholder return in year 0. The problem with this approach is that the stock options exercised in year 1 and counted entirely as year 1 compensation may have been granted many years ago (e.g., in year –5). Shareholder return in year 0 may have been nothing special, but it may have been high over one or more of the preceding years. In this case, there would indeed appear to be little PFP if the correct choice of (relevant) time period for measuring shareholder return is not made.13 So, is it really plausible that executive pay and performance are unrelated, as now seems to be the conventional wisdom in the management literature? In our opinion, the answer is “no”. One would have to argue that the alignment between stock-based wealth of executives and shareholders is not relevant to estimating the PFP relationship. But, as Hall (2000) argues, this is actually “the most important component of the pay-to-performance link” (p. 123). A recent empirical study (Nyberg et al., 2008) that seeks to better recognize the role of company stock in PFP and also address other limitations of previous work

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286 • The Academy of Management Annals finds a much larger PFP relationship than previously reported in the management literature, more consistent with earlier studies in the economics and finance literatures (Aggarwal & Samwick, 1999a; Hall & Liebman, 1998).

Specifically, the addition of shareholder return (to measure performance) to their CEO return equation (CEO return is analogous to change in CEO wealth as percentage of beginning wealth level), after controlling for other determinants, resulted in an increase in variance explained (adjusted R2) from 23% to 66%. Further, they found that a 1% change in shareholder return was associated with a nearly identical change in executive return. Thus, conventional wisdom in the management literature, that there is little PFP among executives, may be largely a consequence of conceptual, specification, and measurement problems.

However, some important caveats to this conclusion must also be noted.

First, there are clearly companies where PFP is not strong and, more disturbingly, where executives have undertaken actions that not only destroyed shareholder value, but were also illegal. Second, executives often have very high compensation, even when their company performance is average or below average, relative to industry competitors. Third, severance payments to executives are often quite large and, on the face of it, largely independent of firm performance (Alexakis & Graskamp, 2007).14 Until recently, the magnitude of these payments has been difficult to estimate and include in studies of executive compensation. However, the SEC recently began to require more stringent reporting in this area and it remains to be seen in future research how incorporating these payments will affect the estimated PFP relationship.

Issues in Executive Compensation Research Choice of financial performance measure: stock returns or earnings? Over time, companies have moved toward greater reliance on market-based (i.e., stock return) measures, perhaps in an attempt to increase PFP and/or alignment with shareholders. As we saw in the preceding section, the choice of performance measure can have a major impact on size of the estimated PFP relationship among executives. Specifically, accounting-based measures such as earnings, at least when measured over short time periods, are less strongly related to executive pay than are market-based measures such as stock return.

Why is that the case?

Accounting-based measures of performance like earnings are backwardlooking in that they report what has already occurred. In contrast, stock prices are forward-looking in that they reflect “publicly available information concerning firms’ expected future cash flows” (Dechow, 1994, p. 12). In other words, the greater the present value of future cash flows or dividends as estimated by the market, the higher the stock price. Stock returns, in turn, are based on stock price appreciation plus actual dividend payouts. The main impact of earnings on current stock prices comes when earnings reports carry

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Pay and Performance • 287 new information (e.g., earnings above or below expectations) not already impounded by the market in the stock price (Ball & Brown, 1968; Nichols & Wahlen, 2004).

In the short run, an important potential drawback of using earnings as a measure of performance is that “management typically have some discretion over the recognition of accruals” and this can be used, for example “to opportunistically manipulate earnings” (Dechow, 1994, p. 5). Another problem with using earnings to measure performance is that there is often a “recognition lag” in accounting (Easton, Harris, & Ohlson, 1992; Warfield & Wild, 1992).

For example, for a loss due to an activity to be taken as an expense, the loss needs to be both probable and estimable. As an example, consider a lawsuit against a company. Typically, the expense of a lawsuit is not booked until it is resolved. By contrast, the market will have already impounded (or recognized) the estimated cost (albeit with varying degrees of accuracy that can only be assessed after the fact) into the stock price in advance of the lawsuit’s resolution. Thus, earnings and shareholder returns may not track each other closely during this period.

Over the long-run, however, earnings and stock returns are expected to converge as recognition lag and other sources of divergence (e.g., possible manipulation of earnings in the short run) cancel out and earnings estimates become more statistically reliable. Indeed, empirical evidence provides strong support for this hypothesis that earnings converge with shareholder return as the time period of study increases (Dechow, 1994; Easton et al., 1992; Warfield & Wild, 1992). For example, Warfield and Wild report the relationship between earnings and stock returns over different time intervals as shown in Table 5.2 Thus, what these results suggest is that the choice of whether to measure performance in terms of earnings or stock returns is most consequential for studies that use short time-frames. Our examination of research on executive PFP in the management literature suggests that a short time-frame is the norm, as is a preference for accounting-based measures of firm performance.

In our view, these design characteristics are likely to lead to incorrect inferences regarding the PFP relationship and go a long way toward explaining the different conclusions reached in the management and economics/finance literatures.

Table 5.2 Relationship between Earnings and Stock Returns over Different Time Intervals as Reported by Warfield and Wild (1992) Time period

Adjusted R2

Adjusted R

Quarterly

0.02

0.14

Annual (1 year)

0.09

0.30

Quadrennial (4 years)

0.40

0.63

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288 • The Academy of Management Annals In addition, from an agency theory standpoint, measuring performance as stock returns would appear to provide a better fit with the theory. For example, Devers et al. (2007, p. 1039) argue that “agency-theoretic arguments strongly support the conclusion that shareholder wealth maximization (e.g., market-based performance) should be the definitive criterion for compensation research”. Agency theory states that shareholders are residual claimants, meaning that they hold claims on (uncertain) “net cash flows for the life of the organization” (Fama & Jensen, 1983b, p. 328) where “net” means after other claims, expenses, and obligations are paid. The expected value of those future cash flows is most directly reflected in the stock price.

Under agency theory (with imperfect information on agent performance), the optimal contract to mitigate agency costs is one that also makes agents residual claimants who will also participate in future net cash flows (up to the point that agent risk-aversion allows). Thus, it would seem necessary to fully incorporate stock-based measures of executive compensation in such research.

Another issue in choosing a performance measure is whether it should be adjusted for performance of competitors. For example, if the median shareholder return in a particular industry is 30% over some time interval, then a 20% return for a firm in that industry would be, in relative terms, below average for the industry. Relative performance evaluation logic would then dictate that executive pay also be lower than the industry median.

Despite theoretical arguments for the logic of rewarding market-adjusted (or relative) rather than absolute firm performance (Holmstrom, 1979), most studies find little or no evidence for the existence of explicit relative performance evaluation (Aggarwal & Samwick, 1999b; Antle & Smith, 1986; Gibbons & Murphy, 1990). Similarly, consulting firm data indicate that, of the 250 largest US firms, less than 1% granted indexed (i.e., where relative performance is used) options and only about 4% granted options that had performance-contingent vesting requirements (versus time-based vesting) (Alexakis & Graskamp, 2007). Thus, even if, as we believe the literature shows, executive pay is related to shareholder return, this lack of relative performance evaluation suggests that executives can earn large compensation for large shareholder returns, even when these returns are arguably the result of an entire industry performing well, rather than uniquely strong performance by the firm (or executive). In addition, some evidence suggests that this relationship is asymmetric, such that executives benefit in up-markets, but are not penalized as strongly during down-markets (Garvey & Milbourn, 2006), providing further reason for concern with CEO pay.

Alternatively, others (Oyer, 2004; Rajgopal, Shevlin, & Zamora, 2006) suggest that the lack of relative performance evaluation in up-markets is due to CEO retention concerns. “If the supply of managerial talent is scarce and hence inelastic, then increases in aggregate industry or market returns should

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increase the equilibrium wage paid to CEOs” and “firms pay their CEOs more simply to match their increased outside opportunities” in up-markets (Rajgopal et al., 2006, p. 1818). In summary, while PFP is substantial among executives, the theoretical arguments for and against the use of relative performance evaluation in determining PFP, together with the empirical evidence on this issue, continue to evolve.

Choice of performance measure: beyond financials. There has long been a debate regarding whether firm performance can be evaluated using solely financial measures. Although much of our discussion focuses on financial measures of firm performance, the corporate social responsibility literature emphasizes that financial performance is one of many goals that a firm may pursue. In this view, businesses are responsible for outcomes related to all areas of involvement with society (Wood, 1991).15 One influential approach to corporate social performance is stakeholder theory, which recognizes that firms have a number of constituencies (e.g., shareholders, customers, suppliers, employees, society) and proposes that the successful management of the sometimes conflicting needs of these constituencies is the key to firm survival and success (Freeman, 1999). Intrinsic stakeholder theory suggests that firms adopt stakeholder management practices as part of a normative moral and ethical framework, where firm financial performance is not the overriding goal, but rather is balanced with the goals of other stakeholders (Freeman, 1999). In contrast, instrumental stakeholder theory (Jones, 1995) singles-out financial performance as the most important objective, suggesting that firms recognize and work to satisfy multiple stakeholders for the purpose of improving financial performance. An empirical study by Berman, Wicks, Kotha, and Jones (1999) examined the relationship between firm performance and the degree to which firms acted positively in five key stakeholder relationships: employee relations, diversity, local communities, natural environment, and product safety/quality. Two of the five relationships were statistically significant (and positive) in a return on assets equation: employee relations and product safety/quality. This finding—that serving multiple stakeholders can ultimately benefit shareholders—is consistent with evidence on the positive relationship between good employee relations and financial performance (Fulmer, Gerhart, & Scott, 2003) and with the finding that corporate social performance and financial performance were positively related (corrected r=0.36) in a meta-analysis of several hundred studies (Orlitzky, Schmidt, & Rynes, 2003). It is also consistent with research that shows higher shareholder return in firms that use both financial and nonfinancial measures of performance in executive compensation (Said, HassabElnaby, & Wier, 2003).

In summary, it is important to recognize that firms can be evaluated on performance dimensions other than financial performance. At the same time,

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without adequate financial performance, the ongoing viability of a firm is in doubt and, accordingly, its ability to serve the interests of multiple stakeholders would also be in doubt.

Contingency factors, incentive alignment and monitoring. As research in this area has matured, researchers have turned their attention to contingency factors that affect incentive structure (or PFP). As noted previously, outcomebased pay introduces an element of risk into the compensation contract that may necessitate payment of a risk premium to the executive and higher overall compensation costs (Eisenhardt, 1989; Garen, 1994). Similarly, if firm performance is highly variable, this also introduces an element of risk that has been shown to increase the overall required level of pay, reduce the use of incentive pay, and/or result in weaker pay/performance linkages (Aggarwal & Samwick, 1999a; Bloom & Milkovich, 1998; Gray & Cannella, 1997; Miller, Wiseman, & Gomez-Mejia, 2002). Aggarwal and Samwick (1999a) describe this hypothesis—that incentive intensity (PFP) weakens as risk increases (i.e., the incentives versus risk trade-off)—as the most central hypothesis of agency theory.

Thus, its strong support is viewed as important evidence of agency theory’s validity.

Because CEOs have the broadest scope of responsibility and the most direct accountability to shareholders, another agency theory-related hypothesis is that CEO compensation will be more closely linked (than that of those lower in the organization hierarchy) to shareholder return. Consistent with this logic, Aggarwal and Samwick (2003) find that pay sensitivity to shareholder wealth is higher for CEOs than it is for divisional managers, and that divisional managers’ pay is also sensitive to divisional performance, particularly when divisional performance measures are less “noisy” and therefore more informative.

Individual differences, too, have begun to receive attention as another contingency factor. This is because the motivational effects of performance-based pay, particularly stock and options, can vary across individuals with differing characteristics. In addition, depending on such variables as time to retirement, previously accumulated equity in the firm, and other personal wealth, executives may theoretically value the marginal stock and option compensation they receive differently from the value intended by the firm (Hall & Murphy, 2002; Lambert, Larcker, & Verrecchia, 1991; Meulbroek, 2001).

Similarly, the fact that some executives choose to protect their personal wealth through the use of hedging instruments that reduce their exposure to risk may also alter the incentive effects of their pay packages (Bettis, Bizjak, & Lemmon, 2001).16 The effect of incentives on subsequent performance may also depend on the type of pay used to create the incentives. For example, compared to outright stock ownership, stock options are generally associated with subsequent

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behavior that is viewed as riskier, such as corporate acquisitions (Sanders, 2001), and this riskier behavior may likewise result in greater variance in financial performance (Sanders & Hambrick, 2007). Other research finds that financial statement restatement, or “misreporting”, is predicted by the pay– performance sensitivity of stock options, but not the sensitivity of other types of pay, including restricted stock or other long-term incentives (Burns & Kedia, 2006).

Governance. Under agency theory, incentives and monitoring are substitutes. While some studies find that weak board governance is associated with higher pay levels (Core, Holthausen, & Larcker, 1999), overall, the accumulated research evidence is mixed on the effects of board governance on executive pay level, incentive alignment, and decisions to reprice underwater stock options (Carter & Lynch, 2001; Chance, Kumar, & Todd, 2000; Gomez-Mejia, Tosi, & Hinkin, 1987; Finkelstein & Hambrick, 1989; Pollock, Fischer, & Wade, 2002). Moreover, even when focusing specifically on the compensation committee, which has the most direct impact on executive pay, the evidence for governance effects is relatively weak. Director fees paid to compensation committee members are positively predictive of pay and negatively associated with incentives in intial public offeing (IPO) firms (Conyon & He, 2004), but board composition seems to have little effect. Independence of the compensation committee, the CEO’s presence on the committee, and the presence of current and retired executives of other firms on the committee seems to have no effect on pay level or incentives in US samples (Anderson & Bizjak, 2003; Conyon & He, 2004; Daily, Johnson, Ellstrand, and Dalton, 1998), but the existence of a compensation committee with a higher proportion of outside directors was associated with stronger PFP as well as higher overall pay in the UK (Conyon & Peck, 1998).

A firm’s ownership structure, which may also capture monitoring intensity, seems to provide more meaningful constraints. The overall concentration of ownership held by institutional investors is associated with greater incentives and lower overall pay (Hartzell & Starks, 2003), although institutional ownership by firms that are subject to influence (e.g., banks) is associated with higher CEO pay (David, Kochhar, & Levitas, 1998). The presence of any large outside blockholder (greater than 5% and not necessarily an institution) is also associated with greater PFP and higher compensation risk (Gomez-Mejia et al., 1987; Tosi & Gomez-Mejia, 1989).

Sociopolitical considerations in executive pay design. In part as a reaction to the perceived lack of strong incentive alignment among top executives (à la Jensen & Murphy, 1990), a body of research has emerged that departs from the typical focus of agency theory, in that the effectiveness of incentive alignment and monitoring in controlling agency costs is fundamentally questioned.

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292 • The Academy of Management Annals (In another sense, though, it could be said to confirm the importance of agency theory’s focus on the challenge of controlling agency costs.) Relying heavily on theories of managerialism, organizational power and politics, and social influence, research in this vein maintains that executive pay levels are high and incentive alignment weak as a consequence of factors that diminish the arm’s length, oversight relationship between boards of directors and top executives (Bebchuk, Fried, & Walker, 2002). To the extent that this argument is empirically supported on a broad scale, it calls into question the existence of PFP among executives. As our review later indicates, there is ample evidence documenting the influence of sociopolitical factors on executive compensation. However, that fact does not necessarily mean that sociopolitical factors play a dominant role (Fulmer, in press).

Originally described by Berle and Means (1932), “managerialism” has been widely applied in the executive pay context to describe motivations that managers have for entrenchment (Shleifer & Vishny, 1989), for seeking to gain influence over the board, and for increasing firm size in ways that are not necessarily beneficial for shareholders (Tosi et al., 2000). Under this view, increasing firm size provides a way for sympathetic boards to legitimate or rationalize the pay of executives, rather than representing either a legitimate job characteristic that requires a higher level of human capital or achievement of a shareholder objective that should be rewarded with higher pay (Tosi et al., 2000). For example, in a study of banks, Bliss and Rosen (2001) found that whether growth in firm size occurred through mergers or non-merger growth, CEO compensation increased with growth, even though stock price typically declined after a merger announcement. As such, they suggest that mergers represent “a fast way to increase the size of the firm” (Bliss & Rosen, 2001, p. 110) and thus “an easy way to rapidly increase compensation”. Harford and Li (2007) similarly found that mergers typically result in higher CEO compensation, despite poor post-merger stock price performance. However, in contrast to Bliss and Rosen, Harford and Li report that growth through mergers has a larger effect on CEO compensation than does growth through other means. Work by Lee, Shakespeare, and Walsh (2008) indicates that the story could be more complex, as they found that CEOs engaging in both acquisition and divestiture of assets (what Lee et al. (2008) describe as a churning strategy) actually received higher compensation over time than CEOs following only an acquisition (or only a divestiture) strategy. (All three strategies were associated with higher CEO compensation than strategies involving no acquisitions or divestitures.) Finally, other research reports that growth through mergers and/or acquisition does carry some risk for CEOs (and have a PFP element) in that they “pay a price, in the form of their jobs, for making acquisitions that destroy [shareholder] value” (Lehn & Zhao, 2006, p. 1761).17 Theories of organizational politics and social influence have been used to explicate the mechanisms of managerial entrenchment. Relationships are

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Pay and Performance • 293 cultivated over time as executives become entrenched in the organization and perhaps even appoint members of the board; consequently, tenure and CEO shareholdings are viewed as important levers for gaining influence over boards of directors (Finkelstein & Hambrick, 1989; Hill & Phan, 1991; Westphal & Zajac, 1995). Social cognitive theories have also been used to explain CEO pay levels. For example, research finds that CEO pay is predicted by the external pay levels of the members of compensation committee—a finding that has been attributed to the existence of social comparison processes (O’Reilly, Main, & Crystal, 1988), but that could also reflect labor market factors if committee members are in similar industries as the CEO. CEOs with higher social status relative to the chairs of their compensation committees also receive higher pay, presumably in part because of their ability to exert greater influence on lower-status chairs (Belliveau, O’Reilly, & Wade, 1996). Social status, legitimacy, and resourcedependence arguments have also been used to explain why CEO networks of external board memberships are related to pay when firms are highly diversified (Geletkanycz, Boyd, & Finkelstein, 2001). This influence may be wielded by executives to increase their pay levels or to reduce the intensity of PFP, or both.

Shareholder and regulatory influences on executive PFP. The separation of ownership and control and the potential negative impact on firm financial performance due to agency costs means that there is widespread interest in whether PFP exists in executive pay (Bebchuk & Fried, 2004; Bebchuk et al., 2002). There is little evidence that either negative press coverage (Core, Guay, & Larcker, 2008) or greater financial statement transparency (now required by the SEC as part of its ongoing effort to give shareholders better information to evaluate and improve executive pay) has had much of an effect on the structure or level of executive pay. In recent years, shareholders have become increasingly active in executive pay issues, with the number of shareholder proposals related to executive pay approximately tripling between 2000 and 2004 (Loring & Taylor, 2006). Although executive compensation proposals rarely receive a majority vote (Loring & Taylor, 2006), at firms that are targets of proposals, subsequent CEO pay shows a slight tendency to increase more slowly and to shift more toward cash and away from long-term pay (Thomas & Martin, 1999).

SEC reporting requirements (and investigations) have, however, seemingly had the effect of shutting down some of the ways of gaming PFP plans, such as the practice of backdating stock option grants, which has an effect on stock option valuation.18 Empirical evidence highlighting aberrant stock return patterns around option grant dates during the period 1992–2002 suggested a systematic problem with backdating of stock option grants (Lie, 2005, p. 802). Heron and Lie (2007) found that after August 2002, when the

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294 • The Academy of Management Annals SEC began requiring option grants to be reported within two business days, these aberrant patterns had disappeared. Another important recent development is the large growth in the use of “clawback” provisions in executive contracts, which allow the Board to recover incentive payments made to executives in the event that a subsequent restatement of financial results is necessary due to misconduct by the executive. According to Equilar, more than one-half of Fortune 100 companies had such a provision in 2007, up from 18% in 2005.19 Federal tax policy since 1993 has attempted to shape the executive pay landscape by limiting the deductibility (though not the payment) of nonperformance-contingent pay over $1 million (Internal Revenue Code Section 162[m]). Results are mixed on whether this policy has had the effect of increasing the sensitivity of pay to performance for affected firms (Perry & Zenner, 2001; Rose & Wolfram, 2002) but it has had virtually no effect on overall pay levels, as the level of all pay components has increased since 1993 (Conyon, 2006). In addition, many firms simply choose to forfeit the deduction and pay non-performance-based pay over $1 million anyway (Balsam & Yin, 2005).

The Emergency Economic Stabilization Act of 2008 provides “authority and facilities that the Secretary of the Treasury can use to restore liquidity and stability to the financial system of the United States”. A component of the Act, the Troubled Assets Relief Program (TARP), places restrictions and requirements on executive compensation in financial institutions in which the Treasury takes a debt or equity position. First, compensation that would encourage executives “to take unnecessary and excessive risks that threaten the value of the financial institution” is to be limited. Second, there is a (clawback) provision stronger than that currently available (e.g., under Sarbanes-Oxley) for the recovery of “any bonus or incentive compensation paid to a senior executive officer based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate”. Third, there are restrictions on the use of golden parachute payments and additional limitations on corporate tax deductibility (although not payment) of executive pay. Thus, in return for government/taxpayer assistance, TARP seeks to limit certain executive compensation practices.

Executive PFP and its potential effects on other employees. Executives are unique in that their compensation—at least for the CEO, CFO, and the three highest paid other executives in US corporations—is public, thus making it possible for the way they are paid to influence not only their own performance, but also that of others. Relative pay differences within firms, to the degree they represent PFP, theoretically influence not only employees’ fairness perceptions and willingness to cooperate (e.g., as predicted by equity theory and relative deprivation theory), but also their motivation to work

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Pay and Performance • 295 hard to advance in the organization (e.g., as predicted by tournament theory (Lazear & Rosen, 1981; Rosen, 1986)). Thus, large differentials in pay as a function of job level can be seen as a positive from an incentive point of view, or as a negative if believed to be so large as to be unjustified (Gerhart & Milkovich, 1992). Indeed, the popular press, some politicians, and labor organizations often argue that the pay differentials between executives and rank and file workers are unfair and engender widespread worker resentment. Although there is at least one study that reported a negative association between size of pay differential between employees and upper-level business unit managers (although not the highest-level executives) and managers’ perception of product quality (Cowherd & Levine, 1992), the study did not measure any employee perceptions (e.g., resentment toward high executive pay, intention to decrease effort toward quality, etc)., so it is difficult to tell if large pay differentials really caused lower quality via employee reactions.

Because of concerns about employee reactions to high executive pay, a handful of firms over the years have attempted to cap executive pay (usually just the salary component) at some multiple of average worker pay (Ben & Jerry’s Homemade; Laabs, 1995). At the time of this writing, Whole Foods Market has a cap on executive base salary of 19 times average worker pay, or $631,500 (Annual proxy statement dated January 28, 2008).20 Given that most (88% in the Wall Street Journal/Hay Group survey) executive pay comes in forms other than fixed salary (12% in the same survey), it is unclear what effect capping salary really has on the overall pay gap, although it may be good for public relations. Equally unclear, as noted previously, is whether employees actually care; other than one survey of working adults given a hypothetical scenario about a fictional firm (Andersson & Bateman, 1997), there is little published research documenting employee resentment about (and more importantly, behavioral consequences, in terms of either incentive or sorting effects, due to) executive pay. In saying this, though, we acknowledge that providing such evidence in forms most likely to be acceptable to top-tier journals (e.g., employee attitudes combined with objective performance indicators or behavioral assessments of performance by their supervisors) is difficult to come by (e.g., not many firms want researchers poking around regarding issues of perceived pay inequity).

In contrast, there has been more research on pay differentials by job level— and their consequences—among top managers. Such differentials, which generally arise as a result of PFP, have been hypothesized to have consequences for outcomes such as financial performance and turnover. A first step has been to understand what factors explain the size of the differentials. The magnitude of the gap between the pay of the CEO and other executives in the firm is seemingly better explained by tournament theory—which conceptualizes such pay differentials or gaps as providing strong incentives for effort and

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296 • The Academy of Management Annals advancement—than by other, non-economic theories (Henderson & Fredrickson, 2001; Main, O’Reilly, & Wade, 1993). Consistent with this logic, pay dispersion is also higher when firms have greater investment opportunities (which theoretically engenders a stronger need for the best managers to rise to the top as suggested by tournament theory), and also when firms are more highly diversified (Bloom & Michel, 2002). Conversely, when CEOs are powerful and are themselves “overpaid” (relative to what would be expected given firm size, human capital, etc.), research finds that lower-level managers will also tend to be “overpaid” (Wade et al., 2006). Overpayment, of course, is detrimental to financial firm performance, all else equal. However, from an efficiency wage theory perspective, high-paying firms may reap certain benefits such as greater ability to attract, retain, and motivate higher-quality executive talent.

A second step has been to study the effects of pay dispersion. Evidence indicates that dispersion is associated with lower executive tenure and higher turnover among top managers (Bloom & Michel, 2002). The degree to which top managers are highly paid relative to lower-level managers also predicts the turnover of lower-level managers (Wade et al., 2006). Recent research suggests that across firms, pay dispersion among top managers is positively related to firm performance, consistent with tournament theory, and that this relationship is stronger in firms with strong governance (Lee, Lev, & Yeo, 2008). Other research finds that the effects of dispersion on performance are moderated by organizational context. For example, the pay gap between the CEO and other members of the highly paid executive group is negatively associated with performance in multinational firms, especially in firms with a stronger international presence (Carpenter & Sanders, 2004).

Similarly, pay disparities among top managers are negatively associated with performance in high technology firms but not in low technology firms (Siegel & Hambrick, 2005).

To conclude, pay differentials between executives and non-executives (e.g., front-line employees) and between executives at different levels is often seen as having performance consequences. One view is that larger differentials induce perceptions of unfairness, which could harm performance. This view is most often raised in discussions of differentials between executives and front-line employees and some firms apparently accept this logic, given that they have placed restrictions on at least the base salary component of executive compensation. However, there is little empirical research on employee reactions to differentials or the effect of policies restricting differentials. An alternative view, consistent with tournament theory, is that pay differentials serve a motivational purpose by encouraging the performance necessary to progress up the ranks to higher paying jobs (where such progression is possible). Some empirical evidence seems to support this hypothesis, although it appears to depend on contextual factors.

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Summary Agency theory emphasizes the use of PFP contracting schemes as a means of controlling agency costs. Empirically, this suggests that we should observe both that PFP exists, and that firms with PFP (or that execute it more effectively) will perform better (unless the vast majority of firms are already at optimal PFP levels). On the first point, the management literature is skeptical, while the economics/finance literature generally takes the relationship between executive compensation (mainly the stock-based portion, which accounts for the largest part) and shareholder wealth as a given. Our reading of the evidence concurs with the latter view. On the second point, evidence has been slow to accumulate. Skepticism regarding the existence of PFP has contributed to a search in the management literature for other explanations for executive pay, such as sociopolitical factors. The challenge for researchers is to more successfully determine the relative importance of PFP, sociopolitical, and other factors in explaining executive pay. Such evidence has great potential for influencing PFP design in organizations, regulatory actions and, perhaps, the motivation and performance of other executives and employees in organizations.

Conclusion and Suggested Research Directions In the opening of this chapter, we identified several issues of interest regarding PFP: conceptual mechanisms; empirical evidence on effectiveness of different programs such as merit pay or group incentives; the risks and challenges that are often encountered in using such programs; and the case of PFP among executives. We also saw in the opening of our chapter that there are strong (and conflicting) opinions regarding what the empirical evidence says about the existence and effectiveness of PFP. Some of our most important conclusions are as follows.

First, as we stated earlier, “one best way” advice (e.g., do or do not use individual PFP plans) or “sound-bite” conclusions (e.g., pay does or does not motivate) are rarely valid, but rather depend on the circumstances.

Pfeffer and Sutton (2006, p. 133), in emphasizing the importance of evidence-based management, state that “the use of financial incentives is a subject filled with ideology and belief—and where many of those beliefs have little or no evidence to support them” and that “consultants, gurus, and executives charge ahead with assumptions and practices that reflect a reckless disregard for the evidence”. As we saw earlier, Pfeffer (1998, pp.

214–215) has argued that “Literally hundreds of studies and scores of systematic reviews of incentive studies consistently document the ineffectiveness of external rewards”. Although we agree on the importance of evidence-based management, we disagree that such a simple and clear-cut interpretation of the effectiveness of PFP is correct, based on the evidence we have reviewed.

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298 • The Academy of Management Annals Second, while there are several longstanding theories of compensation and motivation, most of these concentrate on the effect that PFP has, holding the employee population constant, something we describe as the incentive effect.

This overly narrow focus has resulted in management research largely overlooking one of the most important mechanisms by which PFP can have an impact. Increasingly, however, scholars have recognized that PFP may change the employee population and its attributes. This sorting effect can be as (or more) important than the incentive effect in some circumstances. We believe that future research should strive to do a better job of incorporating and estimating the magnitude of sorting effects, as well as incentive effects. An especially interesting area for future research is the interplay between incentive and sorting effects in group and organization-based plans where both cooperation and strong individual contributions are needed.

Third, the empirical evidence demonstrates that the use and intensity of PFP programs is typically associated with better individual, group, and organization performance. However, as with many areas of management research, whether the causality of this relationship has been established to the degree necessary to confidently advise organizations is something that can be questioned. Certainly, what is beyond question is that PFP can and does fail, both in the case of executives and nonexecutives. Thus, there is a risk/return trade-off. PFP can be a major positive influence on effectiveness, but can also harm it. Better evidence on survival, success, and failure of PFP plans would be helpful. Another area of recommended attention is merit pay. Although widely used, we continue to have remarkably little good evidence on its effects and encourage researchers to “circle back” to more thoroughly examine this important issue. One aspect of merit pay for which we found somewhat more evidence concerns the question of how much PFP in the form of merit pay actually exists. Although the strength of merit pay likely varies from organization to organization, our review finds that merit pay is often defined too narrowly (e.g., excluding other consequences of merit ratings such as promotion, inter-organization mobility, and associated pay growth), thus probably leading to an overly pessimistic view of its strength and potential impact.

Fourth, any discussion of whether PFP “works” must, to be practically useful, provide some sort of cost–benefit or ROI analysis (Sturman, Trevor, Boudreau, & Gerhart, 2003). For almost any job, there will likely come a point where increasing incentive intensity (PFP) will change behavior.

Whether it is worthwhile to do so depends on what the value of the change in behavior is and what it costs to achieve it. Cost includes not only the higher cost of compensation, but also potential unintended consequences such as the use of undesirable means to achieve the ends and lessened attention to objectives not emphasized in the PFP plan.21 Such a “devil is in the details” approach is, of course, not as straightforward as saying that PFP

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Pay and Performance • 299 either works or does not work, but it is more realistic and thus necessary for effective decision making.

Fifth, we devoted significant attention to the special case of executive PFP. Executives are unique in terms of the impact they can have on organization performance and the public nature of their earnings. Because of what some believe to be no meaningful relationship between firm financial performance and pay among executives, the validity and relevance of agency theory has been increasingly challenged and supplemented with alternative theories. Our review, however, suggests that the field of management has gone too far in its skepticism, largely dismissing the existence of PFP in executive pay and focusing almost exclusively on the role of “mischief” (Dalton et al., 2007). Although there certainly is mischief in executive pay, it is not the whole story. We encourage researchers to more carefully consider how to define and estimate the magnitude of PFP among executives in their research and whether current conventional wisdom in the management literature is consistent with the full range of evidence available in related fields. To us, it seems that the management literature on executive compensation—as well as PFP among nonexecutives—has done a thorough job of documenting all of the things that can go wrong. While that line of research is important, it is most useful to the degree that it also incorporates the role of performance, thus providing insight into the relative importance of performance and non-performance factors under varying conditions.

We have seen that the use and effectiveness of PFP, both for executives and nonexecutives, is viewed with skepticism in parts of the management literature (Dalton et al., 2007; Hitt, 2005; Pfeffer, 1998; Pfeffer & Sutton, 2006).

Some degree of skepticism is always healthy, as long as it is based on facts. In this vein, we saw that Pfeffer and Sutton (2006) warned against the influence of “ideology and belief” and called for evidence-based management instead.

However, ideology and belief can perhaps help explain some of the skepticism regarding PFP. A series of articles bemoans the influence of economic ideas in management (Ferraro, Pfeffer, & Sutton, 2005; Ghoshal, 2005; Pfeffer, 2005).

Pfeffer (2005) says that “economics is indeed taking over management and organization science” and that some aspects of this influence “can be harmful” (p. 96). Further, a question is raised as to the evidence base for this influence.

Ferraro et al. (2005), in talking about the influence of economics, state that “theories can ‘win’ in the marketplace for ideas, independent of their empirical validity, to the extent that their assumptions and language become taken for granted and normatively valued, therefore creating conditions that make them come ‘true’” (p. 8). One of their two examples to make this argument, that (economic) theories can “win” despite a lack of solid evidence is “the increasing reliance on contingent, extrinsic incentives” (p. 18). In contrast, our view is that any increased reliance on contingent, extrinsic incentives is not necessarily “independent of their empirical validity”. Rather, our reading

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300 • The Academy of Management Annals is that there is rather strong empirical evidence showing that PFP can improve performance.

One concern we have is that management scholars may be too focused on differentiating what they do from what is done in other business school disciplines, especially those grounded in economics. Differentiation is good, as long as it is based on solid logic and carefully generated empirical evidence.

However, differentiation does not require showing that the other discipline has got it all wrong. In the case of compensation, management research has been of great value in showing how economic principles of incentives and PFP can be informed by other social science perspectives (Gerhart & Rynes, 2003).

Nevertheless, doing so does not require (nor does the evidence in our view support) almost blanket dismissals of the effectiveness of PFP or the importance of the role it plays in determining the pay—and performance—of employees and, especially, executives.

One of the areas that management research has identified as important and under-researched, and one that it should be uniquely qualified to study, is whether executive pay has indirect effects on firm performance by influencing employee behaviors. Do employees pay attention to the amount of money paid to executives in their organizations? Do they care? Do they act differently as a result? Do their reactions depend on how the company has performed?

There is much opinion on these questions, but little evidence that we could find. This is certainly an area where management scholars are well-positioned to provide some valuable insights.

Finally, we encourage researchers to pay more attention to the reporting and interpreting of effect sizes in compensation research. We continue to see examples where only the statistical significance of results is discussed with no interpretation or discussion of regression coefficients or variance explained.

In an area like compensation, where key variables (compensation, financial performance) are measured in inherently meaningful ratio-level scales, such interpretations should take center stage. Knowing, for example, that performance and/or sociopolitical factors have a relationship with executive pay that is likely to be non-zero (i.e., statistically significant) is not very interesting by itself. As argued earlier, the magnitude of such relationships needs to be the focus, both for evaluating theories and for drawing practical implications.

Endnotes 1.

2.

Further, in some areas of compensation, such as executive compensation, the way it is managed can also have wider repercussions, with employees, shareholders, the public, and regulators all taking an interest (and sometimes action) in response.

Nonmonetary rewards are also relevant to employee motivation, but we limit our discussion here to financial/monetary rewards which, by themselves, constitute a very large literature.

Pay and Performance • 301 3.

4.

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5.

6.

7.

8.

9.

10.

11.

12.

13.

The d statistic is defined as the difference between the dependent variable mean for Group A versus Group B, divided by the pooled standard deviation of Groups A and B. Thus, it gives the difference between Group A and B in terms of standard deviation units.

For a discussion of empirical work on the importance of monetary rewards relative to other rewards, see Gerhart and Rynes (2003) and Rynes, Gerhart, and Minette (2004). For a discussion of evidence on the relationship between monetary rewards and intrinsic motivation (in work settings), see Gerhart and Rynes (2003) and Rynes, Gerhart, and Parks (2005).

There appears to be some shift toward the use of merit bonuses, where, unlike merit pay, performance awards do not become a (permanent) part of base salary, thus limiting growth of fixed costs.

Single-loop suggestions are those that do not question fundamental procedures or assumptions; double-loop are the opposite.

There were two likely reasons for this change. First, Microsoft is no longer a growth company, making stock price appreciation, and thus growth in employee wealth via increased stock option value, a less powerful PFP program. Second, changes in accounting standards (from intrinsic value to fair value) have made stock options more costly for companies to use.

Although some authors (Katzenbach & Smith, 2003) make a distinction between groups and teams, in this review we use the terms interchangeably to mean “interdependent collections of individuals who share responsibility for specific outcomes” (Sundstrom, DeMeuse, & Futrell, 1990).

Executives, unlike most rank-and-file employees, are also prohibited from shortselling stock in their own companies, and must publically disclose their sales, transfers, and investment hedging transactions involving company stock.

To interpret these PFP sensitivities, consider that in 2007, the median Fortune 500 company had a market value of $10 billion and the 50th company on the list had a market value of $57 billion. Using the Jensen and Murphy (1990) estimate of $3.25, a 10% increase in market value would imply $3.25 million and $18.53 million higher executive compensation, respectively. Using the Aggarwal and Samwick (1999a) estimate of $14.53, a 10% increase in market value would imply $14.53 million and $82.8 million higher compensation, respectively.

Indeed, it seems that one consequence of the agency theory idea that executives should be encouraged to act in the best interests of owners has been a concerted effort by organizations over time to have executives hold significant amounts of stock and stock options.

In addition, stock options ordinarily have vesting requirements, meaning that they cannot be exercised immediately. Executive stock options are also not tradable, meaning that option pricing models likely overstate their value.

Consider the example of Richard Fairbank, the CEO of Capital One, as reported in the annual Wall Street Journal/Mercer CEO Compensation Survey (April 13, 2006). According to the Survey, in 2005, shareholders of Capital One earned a 1year total return of 2.7%. Over 5 years, shareholders earned an (annualized) total return of 5.8%. Under the column, Total Direct Compensation Realized, the

302 • The Academy of Management Annals

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14.

15.

16.

17.

18.

Survey reported that Fairbank received $249.3 million from Capital One in 2005.

This apparent lack of alignment between shareholder return and CEO compensation was reported widely in the popular press. Less widely reported, however, was the fact that most of the $249.3 million received by Fairbank resulted from his stock ownership, specifically his exercise of stock options granted to him in 1995 (and that would have expired in 2005 if they had not been exercised), and that shareholder wealth increased by $23 billion between 1995 and 2005 for a cumulative shareholder return of 802%.

One type of severance payment that has received much attention is the golden parachute, which refers to the provision typically found in CEO employment contracts that provides an often sizable severance payment to the CEO upon change in control (e.g., when there is a takeover of the company). Critics question the logic of paying a large sum of money to a CEO who facilitates a sale of the company and then leaves, especially where other stakeholders such as employees are adversely affected (e.g., by the lay-offs that often happen in such cases). The stated rationale for a golden parachute is that it prevents a CEO from being so entrenched as to be unwilling to facilitate a sale of the company, even if it is a good deal for shareholders, for fear of losing his/her position.

An alternative view, expressed by Milton Friedman, is that “the social responsibility of business is to increase profits” (Friedman, 1970). In Friedman’s view, a single-minded focus on business goals can be seen as a moral imperative because managers have a fiduciary duty under the principal-agent relationship to maximize the wealth of shareholders.

Age or time to retirement can also be a contingency factor. For executives who receive pensions, as retirement approaches, a larger proportion of overall wealth is in the form of debt (their accrued pension benefit) rather than equity, which is in turn related to more conservative behavior (Sudaram & Yermack, 2007).

One challenge in studying the firm performance consequences of mergers and acquisitions is the potential for unobserved heterogeneity if firms that engage in this activity differ in their performance prospects from firms that do not. For example, mergers and acquisitions that take place in declining industries may be followed by poorer firm performance. However, one does not know what performance would have been in the absence of the merger or acquisition.

Typically, when options are issued, the strike price (i.e., the price at which stock can be purchased in the future) is set equal to the current stock price. For example, if the options are issued on June 15 and the stock price is $20/share, the strike price would also be $20/share. Then, if the stock price increases in the future (and prior to the expiration of the option) to, for example, $30/share, the holder can exercise the option and make a profit of $30–$20=$10/share. In contrast, backdating occurs if the option is actually issued on June 15, but the date of issue is reported as an earlier date when the stock price was lower, giving the option more value. For example, if the stock price had been at $10/share on February 10 of that year and February 10 (instead of June 15) is the date that is reported, then the option holder has already realized a profit of $10/share on June 15 when the options are (actually) granted.

Pay and Performance • 303 19.

20.

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21.

The Sarbanes-Oxley Act also has a clawback provision, but its coverage is limited.

Whole Foods’ pay multiple has increased from 10 in 1999 to 14 in 2000–2005 to 19 today (www.wholefoodsmarket.com/investor/proxy08.pdf, retrieved March 22, 2008), suggesting that the definition of internal equity changes periodically, or, more likely, as was the case with Ben and Jerry’s, the realities of the external labor market override the desire for internal equity (Laabs, 1995).

Also, at a meta-level, it would be very helpful not only to know the average expected ROI on PFP plans of different types, but also the variance of such ROI, which serves as a measure of the risk of using such plans (Gerhart et al., 1996).

Another challenge is to estimate the mean and variance of return in the face of selection bias (i.e., where only plans with some minimum level of success survive long enough to be observed).

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