Thursday, October 1, 2020

Nobel for figuring out how best to tie pay to performance

One of the enduring themes of out textbook is that to give employees enough information to make good decisions--and the incentive to do so--what we call "goal alignment," you have to tie pay to performance.  The not only attracts the most productive workers (adverse selection) but also motivates them to work hard once they arrive (moral hazard).  The tradeoff is that you expose the employees to risk, for which they have to be compensated.

The Nobel in Economics was just awarded to two economists who have figured out how best to do this.  Our friends at Marginal Revolution wrote a nice essay summarizing their contributions:

  • Use all signals of productivity to better measure performance ("informativeness principle").
  • Put greater weights on the best measures (least noisy).
  • Use a higher base salary when employees are risk averse (to compensate them for bearing risk).
  • Use relative performance metrics ("tournaments") when employees have similar abilities.
  • Use absolute performance metrics when employees do not (otherwise, employees with the most ability will easily win the tournament--without working hard).

We can use this analusis to critique executive pay:
...executive pay often violates the informativeness principle. In rewarding the CEO of Ford for example, an obvious piece of information that should used in addition to the price of Ford stock is the price of GM, Toyota and Chrysler stock. If the stock of most of the automaker’s is up then you should reward the CEO of Ford less because most of the gain in Ford is probably due to the economy wide factor rather than to the efforts Ford’s CEO. For the same reasons, if GM, Toyota, and Chrysler are down but Ford is down less then you might give the Ford CEO a large bonus even though Ford’s stock price is down. Oddly, however, performance pay for executives rarely works like a tournament. As a result, CEOs are often paid based on noise.


  1. As I learn about pay practices related to performance, I hadn't put much thought into the 'noise' of the environment. Using sales as an example, as cited in the essay linked above, many factors have a broad impact outside of the control of employees. When the economy is stagnant, and people simply aren't spending money on certain things, it impacts all of the sales people by reducing the potential sales. Conversely, when there is a boom and consumption goes up appreciably, sales would increase in part due to a growing number of transactions. Eliminating (or solving for) the impact of noise (external, uncontrollable) factors results in a program that truly addresses the employee's direct performance.

  2. It’s amazing how CEO’s can be paid so much money even if they underperform, which is why I understand how the information principle can be violated when it comes to executive pay. I have heard of the “golden parachute” term used when a CEO is ensured a financial blanket, usually with a combination of company stock, perks, and bonuses. I’ve seen this situation with my past employer. My past employer had a CEO come in and basically made drastic cuts (division sell off, layoffs, etc.). The stock price initially rose but the company still underperformed and the stock price decline a year later. The CEO was let go with a “golden parachute” anyway. I believe that if it was based on the information principle, then the CEO would not have gotten such a high financial severance package for the condition the company was left in.

    But now reading this post, I understand how due to the noise of the environment, it’s probably more difficult to evaluate a CEO’s performance outside of just the stock price. I would often wonder why each time a CEO would take over my past employer that there would be major re-organizations. Re-organizations would be a time of unrest, people relocating to different departments, sometimes a redefining the vision of the company. Then finally there would be a learning curve for employees once the re-organization was finished. All of this equates to “noise” to the employees of the company and I’m sure the company board. Perhaps to the company board this was good “noise” as the effort was put in place by the CEO they hired to steer the company towards a certain direction. I always felt that the CEOs at my past employer had the agenda to create this noise to justify their “golden parachutes”.

  3. As an employee who has been part of 3 different types of pay incentives, I can tell you that the one where I have enjoyed the most is the company where bonuses are not part of your hiring package but the company has the policy/procedure to award exceptional efforts. The company pays fairly on base wage and whenever you get that bonus, you get an award to put on your wall. It incentivizes me further because it’s almost like a competition of how many awards you can get on your wall.
    With the company who had my bonus as part of hiring package, I knew that I had to earn that bonus and if I went above and beyond, I would be compensated for that as well. However, it was well known that bonus time was coming so you would see employees over achieving in a short period of time rather than doing so throughout the whole year. It was frustrating to see other employees still earn their bonus (and sometimes more) for them only sprinting and exerting themselves at the end of the marathon.
    In the company where there was no bonus, there was no incentive for anyone to do their job well. I have always done my best at everything that I do but it was exceptionally hard to wake up every day to work for a company who didn’t seem to appreciate me. I worked for the company for 3 years and only my first year did they give us a 3% cost of living increase. After that, there was not another increase so I started to look elsewhere for work. I felt like I could leverage a better hiring package at another firm, which I was successful in doing
    While working for several firms, I have learned 2 important life lessons when it comes to compensation:
    1. If you are unhappy with where you are (financially, professionally, etc), only you have the power to change it. Throw your resume out there and see who bites and see what other offers you have on the table. If you find out that there is a better opportunity whether it’s more pay, closer to home, better benefits, whatever you value the most, take the opportunity. It can be hard to take that leap, but sometimes it’s a blessing in disguise and for your best interests.

    2. I once read the following joke about management:
    A crow was sitting on a tree, doing nothing all day. A small rabbit saw the crow, and asked him, "Can I also sit like you and do nothing all day long?" The crow answered: "Sure why not." So, the rabbit sat on the ground below the crow, and rested. All of a sudden, a fox appeared, jumped on the rabbit and ate it. Management Lesson: To be sitting and doing nothing, you must be sitting very, very high up (source:
    Typically, managers, CEOs, CFOs, etc, have spent a lot of time in the industry. Their expertise is known and their value to the company cannot be touched and that is what they are compensated for. From the outside, it might not seem fair how much they are paid and sometimes, I think CEOs are paid just from the “noise” they can create or how much media outlets cover their company. I understand that some companies pay their upper management above and beyond, but no one ever talks about how those same CEOs and CFOs started out making $8/hour in the mail room and worked their up to the top. Overall, your career is a marathon, not a sprint. Take the time to truly become an expert in the job you are doing and prove your value to the company. If the company values you back, you will see it in compensation, title, promotion, etc. Overall, take the time out of your day to have a good work life balance and don’t compare yourself to others. Focus on where your skills are at and hone in on things that you’re great at to become an expert at them and continuously work to improve the other skills that are lacking. You will grow professionally because of it ( Additionally, for other career advice I have read, see the above LinkedIn article. It has some great advice in it!

  4. When a new CEO joins a company there is a period of time where they want to make significant changes and reorganize people and goals (in my experience). This may also depend on the circumstances of the prior CEO’s departure. If it was due to retirement and not unfavorable conditions the actions of the new CEO may vary.
    In the example of Ford, what other metrics could be used to evaluate the CEO’s performance? Stock price is an obvious go to measurement of the overall health of the company and the satisfaction of customers and stakeholders. Social responsibility is another area that CEO’s are being ranked. However, as Albert Einstein once said, “Not everything that can be counted counts, and not everything that counts can be counted.” It is a delicate balance to measure the worth of an organization and their leader with metrics that stretch beyond financial data.
    How do you apply the thinking in the initial post to CEO’s? You have to select a hard working individual for the job (adverse selection) and motivate them to work their hardest once they are in the role (moral hazard). I would argue that the CEO is the employee that is exposed to the greatest amount of risk and is compensated as such. Sure, there is the “golden parachute” when they leave. Sometimes under favorable conditions and other times not, but it is that compensation that may make a CEO brave enough to make their mark, attempt change, and ultimately succeed or fail. A CEO usually is experienced in an industry or has worked their way up the ladder, so an expectation of pay for performance should not be questionable.

  5. From the Human Resources perspective, Pay for Performance is a delicate balance. How do we need leaders and employees to produce in a positive way the is strategically aligned with the company’s goals and mission? A pay system should benefit the employee, paying a fair compensation, and also benefit the employer, employee is moving the company forward and helping to achieve goals. It seems fairly simple and straight forward and a win-win situation if an organization brings the proper individuals into the organization who truly believe in the company’s mission and who is satisfied with their own contribution to the organization. A recent survey of Fortune 500 companies reveled that their performance management system had the most success when results are tied directly to a reward system (Aquinis, 2013, p. 265-66). Pay is not the only motivation for employees, other factors such as job satisfaction or being praised for a job well done are other influencing factors.

    Bringing in the wrong individual who has their own personal goal in mind with no regard to the organization creates risk for an organization. An individual may be motivated by compensation or commission but the way the reward is achieved is not in accordance to what is expected. Take for instance the employees at Wells Fargo bank that falsely opened over 5,000 bank accounts to reach sales goals and receive commission. These phony accounts created over $400,000 in bank fees that were passed onto consumers and fines of $185 million to be paid to Wells Fargo. As a result, Wells Fargo has updated many of their policies and procedures so this type of motivation by money and greed would not happen again (Egan, 2016).

    Aguinis, H. (2016). Performance Management (3rd ed.). Boston: Pearson.
    Egan, M. (2016, September 9). 5,300 Wells Fargo employees fired over 2 million phony accounts. CNN.

  6. Holmstrom’s research shows that pay for performance does work, but goal alignment and imperfect measurement are the issues that continue to cause pay for performance to continue to be scrutinized, and rightfully so. I do think that most employees welcome pay for performance, if implemented correctly. Pay for performance attracts the most productive workers (adverse selection) and can motivate them to work hard once they arrive (moral hazard), as long as performance plans are fair.

    Too many times I have worked for companies that continually “tinker” with the performance plans, ending up with distrust between employees and management. Misalignment and misunderstanding of goals are the issues, with goals not necessarily aligning with expected results, and thus re-engineering results. One of the issues that arise is when employees exceed expectations and then pay for performance plans get re-engineered because employees are outperforming expectations, the “carrot” gets moved further away, and employee distrust and commitment result.

    "Scholars have argued that the real problem is that incentives work too well. Specifically, they motivate employees to focus excessively on doing what they need to do to gain rewards, sometimes at the expense of doing other things that would help the organization," Beer and Cannon.

    Without proper alignment, which takes much effort and thought by management with employee involvement, employee trust and commitment can be undermined. Honest discussions about goals between employees and management regarding mutual expectations have to take place, but rarely happens. Management usually engineers the pay for performance systems in a vacuum with mixed or misaligned results.

    Employees want to feel appreciated, and open discussions on performance and reward will benefit any organization in the long run.


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