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Faculty Insights

Rethinking the Merits of Merit Pay and Other Pay-for-Performance Tools

By Charlie Trevor

February 22, 2017

You’re a sales manager in charge of a five-person team of sales representatives. Three of your employees do an adequate job: They are professional, they meet their quotas, they pitch in for the good of the team when asked. Maybe they’re not going out of their way to exceed goals, but they are still loyal and valued employees who have long-standing client accounts.

The other two team members, however, are go-getters. Consistently exceeding their sales quotas, these two are forward thinkers, always coming up with creative suggestions about how to make the team stronger and the firm better.

It’s nearing the end of the year and you need to start thinking about evaluations and end-of-year bonuses. Your company has a performance-based compensation system in place should you decide to use it. What will you do?

In the working world, pay-for-performance (PFP)—rewarding employees financially for work well done—is designed to recognize and reward high performers by separating the outstanding from the good enough. Pay-for-performance programs exist in more than 90% of firms. Merit pay, which increases an employee’s base salary incrementally, and bonus pay, a one-time, lump-sum payment, are the most common.

Do the programs actually work? Critics often cast them in a negative light, saying they are difficult to implement, create unnecessary competition in the workplace, and tend to distort an employee’s natural motivation.
But PFP works. There’s enough evidence from other studies out there that financial compensation has a positive impact on employee performance. The more relevant question might be, under what conditions does it work best?

Charlie Trevor
WSB’s Charlie Trevor. PHOTO: Paul L. Newby II

In a five-year study I conducted with co-authors Anthony Nyberg of the University of South Carolina and Jenna Pieper of the University of Nebraska–Lincoln (both of whom are graduates of the Wisconsin School of Business doctoral program), we examined  PFP at a large insurance firm that used both merit and bonus pay. The company had multiple locations and maintained more than 11,000 employees with a variety of job types including sales and nonsales positions, and supervisory roles.

We found that, while both types of PFP were linked to better subsequent employee performance, bonus pay had a much stronger impact than merit pay. Contrary to classical economic models that would suggest employees might act according to the rational financial choice—focusing on the merit pay increase over an equivalently sized bonus—the subjects studied appeared to appreciate the immediate windfall nature of the bonus payment more than the relative subtlety of the merit benefits that are spread out over the year.

Similarly, because people tend to fear losses more than they value gains, bonuses may be more motivating. While merit pay may be thought of as a gain that is gradually acquired over time, bonuses are immediately in-hand upon receipt but will be “lost” next year if high performance does not continue. The lump-sum aspect seems to matter; employees might put it toward immediate financial concerns or to their heart’s desire, but they responded to it more strongly than to the longer-term, incremental merit pay raise.

From an employer standpoint, allocating only bonuses could be cheaper in some instances, depending on the firm and the situation. If you’re an employer and you give out a $5,000 bonus, that’s a win-win: higher employee performance, lower fixed costs. You don’t have to hand out another bonus next year unless the employee earns it. If you give an employee a $5,000 merit pay raise, on the other hand, you’re committed to that indefinitely. The compounding over time is what makes it a much more expensive proposition.

But before you rush to any conclusions about using bonus pay alone, here’s a three-word caveat: recruitment and retention. Without some type of merit pay program in place, you may not be able to attract the kinds of employees you want to hire, and you might lose the people you want to keep. That may be too high a price to pay for what are essentially short-term savings. That is, employees (particularly high performers) are sensitive—in terms of attraction and retention—to how well they are paid relative to market rates. So, pay levels will need to be adjusted over time anyway, and merit pay is one way to do that.

Here are some other observations from our study:

  • Employees seem to be more responsive to PFP during periods of relative scarcity. Bonus had a bigger effect on future performance when merit pay was low, and both bonus and merit had larger effects when recent PFP trends were negative.
  • PFP effects appeared to be considerably (more than 50%) stronger in jobs where performance outcomes can be measured more easily. Sales positions, for example, often have a verifiable, quantitative basis for evaluation and achievement that other occupations do not.

In summary, performance-based compensation is not a one-size-fits-all strategy. Merit pay may be a better fit for some work environments while bonus pay may best suit others; or circumstances may suggest that both, or neither, are optimal. So, while the devil is in the details, we can say that PFP works under certain conditions, and that employers should attempt to understand when it works, rather than question if it works.

Read the paper “Pay-for-Performance’s Effect on Future Employee Performance: Integrating Psychological and Economic Principles Toward a Contingency Perspective” published by Journal of Management.
Charlie Trevor is the chair of the Department of Management and Human Resources and the Pyle Bascom Professor in Business Leadership at the Wisconsin School of Business.