28 Dec 2010Working Paper Summaries

The Psychological Costs of Pay-for-Performance: Implications for Strategic Compensation

by Ian Larkin, Lamar Pierce and Francesca Gino

In studying pay-for-performance-based compensation systems, economic scholars often adhere to agency theory, which hypothesizes that firms should prominently use performance-based compensation—it alleviates the problems of employee "shirking" and ensures highly skilled employees' desire to work for the company. However, firms use performance-based pay far less frequently than agency theory predicts. This paper posits that the psychological costs of pay-for-performance systems often dominate their benefits to firms, and proposes an integrated theory of strategic compensation that takes into account the economic and psychological benefits and costs of pay-for-performance. Research was conducted by Harvard Business School professors Francesca Gino and Ian Larkin, and Lamar Pierce of Washington University. Key concepts include:

Three psychological factors most prominently influence compensation strategy: social comparison processes, overconfidence, and loss aversion on the part of employees.
Social comparison processes imply that employees care not only about their own pay but also about the pay of relevant others. If employees are overconfident about their abilities, which is often the case, they may become unmotivated or even engage in sabotage if they perceive unfair pay gaps between their and others' pay.
Loss-averse employees are more motivated by potential failure to meet sometimes arbitrary levels of desired pay than they are by potential gains. This phenomenon implies that employees may work less hard than firms desire even if paid for performance.
In response to these psychological factors, firms rely on flat salaries or "scale-based" systems where the pay-for-performance relationship is much less prominent than predicted by agency theory.

Author Abstract

An organization's compensation strategy plays a critical role in motivating workers and attracting high-performing employees. Most of the research linking compensation to strategy relies on the principal-agent model of economics, a model that has been largely unsuccessful in predicting the extent to which companies use performance-based pay. We argue that while agency theory provides a useful framework to analyze strategic compensation, it fails to consider a host of psychological factors that affect employee motivation and attraction. This paper examines how psychological costs from social comparison, overconfidence, and loss aversion reduce the viability of individual performance-based compensation systems and provides a framework that integrates insights from psychology and decision research into the traditional compensation framework of agency theory. The paper also discusses empirical implications and possible theoretical extensions.