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Has pay for performance had its day?

Rewarding performance is gospel in modern business practice--especially in the technology world. But most rewards focus too much on the present, say McKinsey experts, who suggest an alternative.

"Pay for performance" has achieved the status of a management mantra.

A generation of executives, motivated by performance-measurement systems linking their actions to results and, ultimately, to compensation, has embraced the creed and practice of making assets "sweat." To continue flourishing, however, companies need to innovate as well as to exploit their existing assets. Yet most find it very hard to motivate their people to develop new business ideas and, simultaneously, to manage current performance.

The natural reflex might be that people should receive higher pay for innovating effectively. But our research suggests otherwise. Surprisingly, the secret of persuading people to focus simultaneously on developing new businesses and managing current operations may be to rely less on pay for performance.

In fact, companies that achieve both objectives de-emphasize performance pay or use it in a more nuanced, less intense manner. Crucially, they combine it with an unusually inclusive culture. In these companies, employees feel that their interests and those of the business are much the same, so they naturally try to do what is best for its current and long-term welfare, just as they do for themselves in their personal lives.

Pay for performance may still have an important job to do in such a culture, but as a supplemental boost rather than a primary driving force.

With few exceptions, corporate incentive schemes encourage managers to concentrate either on executing current tasks, or on developing and implementing new business ideas to fuel future growth--but not on both. Most such schemes are designed to motivate current performance: Retail organizations, for example, tie rewards to current sales; manufacturing companies, to production costs and volumes. In such companies, the need to meet performance targets leaves people with little time to innovate. As one harried manager in a global industrial company put it, "We are very welcome to do innovative stuff--after 11:30 PM."

With few exceptions, corporate incentive schemes encourage managers to concentrate either on executing current tasks, or on developing and implementing new business ideas to fuel future growth--but not on both.
Incentive mechanisms emphasizing current performance tend to be more common because measuring the familiar tasks that boost it--the exploitation that leverages existing competencies--is so much easier than measuring the exploration and experimentation that may lead to future growth. So, for example, a company that wants to motivate its sales representatives to sell more goods or services will track how many contracts its agents close, then adjust the scores for differences beyond their control (such as the number of customers in each area), and reward them accordingly. Effort and score are usually clearly linked, so the company can expect agents to work hard if high scores are well rewarded.

But the achievements of these agents would be a lot harder to measure if the company wanted them to bring back ideas for new product offerings based on the changing needs of its customers. A simple tally wouldn't do, since it might be years before an idea's real value could be assessed. The company would also have to adjust for more elusive factors, such as the willingness of customers to provide information about their preferences.

All this is so difficult to quantify that to use formal incentives effectively a company would have to monitor, in minute detail, the way each sales agent actually behaved with customers.

And performance in highly exploratory tasks--biochemical research, for instance, or scenario planning--can't really be measured at all. Who knows, in advance, which experiments will yield fruitful results or which scenarios will yield valuable insights?

Proxy measurements can give a rough idea in some contexts. Management consultants, for example, who often work in teams, use peer observation to assess one another's ability to come up with new ideas. But few companies have a performance-management system that assesses how well employees deal with growth-oriented tasks as accurately as it assesses their current performance.

Some companies try to get around the problem of measuring exploratory activities by promising a big, one-off bonus to anyone who comes up with an idea that is later commercialized. But these arrangements can prove difficult to operate. In 1964 Peter Roberts developed an innovative socket wrench as an employee of Sears, Roebuck. For the rights to the patent, Sears paid him $10,000, a handsome sum to the 18-year-old inventor. Five years later he sued Sears, claiming that it had deliberately underestimated the tool's sales potential, which had proved to be in the millions of dollars. Roberts received an award of more than $8 million and, after Sears appealed the judgment, settled for an undisclosed sum.

The problem of measuring performance in exploratory tasks makes it hard to design effective financial-reward systems that motivate innovation. It is doubly difficult to design incentive schemes that induce people to pay proper attention to current performance as well as exploration.

Who should multitask?
Of course, not everyone, or even every manager, must allocate time between both. Quite the contrary, the benefits of having some people concentrate exclusively on one or the other can be enormous. To this end, some companies actually put exploratory and current activities in different business units--an approach known as "cocooning." But even in these companies, some people need to allocate scarce resources between current and future activities.

Cocooning tends to shift the burden of balancing growth and performance upward: Top managers--sometimes CEOs--must select the new ideas that are pursued, drive promising ideas to fruition, ensure that current assets are sweated effectively, and get rid of businesses that have passed their sell-by date. In the extreme version of cocooning, everyone other than the CEO would have only one task: to find new ideas for the company or to expand existing businesses.

Weak ideas may get too much attention merely because the boss happens to like them, while great ideas end up outside the business.
In practice, this approach is unworkable except in the smallest companies. In larger ones, top managers are generally too far from the places where ideas are generated to be effective judges and motivators. Weak ideas may get too much attention because the boss happens to like them, while great ideas can end up outside the business as frustrated employees leave. Moreover, if the trade-offs between growth and performance are pushed upward, the result can be bottlenecks at the top of the organization and frustrated senior executives who are overloaded with information but still need to make timely decisions.

The better practice is to have managers at many levels pursuing new business ideas and better current performance simultaneously. This approach keeps innovation alive and ensures that new ideas are linked to the company's customers and markets. But how can top management motivate people at a number of levels to pursue the seemingly conflicting objectives of encouraging future growth and, at the same time, improving current performance? How can these people most effectively be persuaded to divide their time between the two?

The rule of balanced incentives
To encourage any activity, companies can use either high- or low-powered incentives. High-powered incentives offer people big financial rewards for good performance, and penalties or much lower rewards for poor performance. Top athletes on professional sports teams, for example, have high-powered incentives. Their performance is easy to observe. Those who do well receive vast sums of money; bad performers leave the game.

By contrast, with low-powered incentives--such as financial bonuses linked to the fortunes of a group or an entire corporation--individual differences in performance have less impact on the rewards employees receive. Still more low-powered are the kinds of rewards that confer recognition and status rather than pay. In some jobs (those of judges and the clergy may be examples), it is perfectly normal to offer little or no financial incentive for performance, even when it is measured.

High-powered incentives call for a relatively clear and sure link between actions and results, which is why companies tend to award strong incentives for current performance and weaker incentives for exploration. But with two disparate tasks to perform, people naturally turn to the task they think will bring them the greatest reward relative to the risks. So if companies follow the natural path--giving high-powered rewards where they can and less intense ones where they must--their people will probably respond by focusing on the well-rewarded tasks.

High-powered incentives for undertaking exploratory tasks may create a higher degree of financial uncertainty than many employees can bear.
Clearly, companies need to balance the incentives they attach to familiar and exploratory tasks, if they want people to do both in equal measure. This imperative may mean going against the vogue of pay for performance; indeed, it may require companies to reduce the power of the incentives they use to encourage their employees to undertake the more easily measured, familiar tasks. The incentive encouraging the least easily measurable task then becomes the standard for all activities. If a retailer, for instance, wants its salespeople to spend more time exploring the needs of its customers, the best course may be to lower the incentives for selling until they are comparable to those for gathering information.

Many managers think that the logic of relaxing pay for performance in this way is counterintuitive. Yet with a few exceptions, a system of low-powered incentives balanced between exploitative and exploratory tasks will probably work better than either balanced but high-powered incentives or the mismatched incentives that many organizations use today.

A balance of high-powered incentives is rarely appropriate, for two reasons. One of them is the fear of risk: High-powered incentives for undertaking exploratory tasks may create a higher degree of financial uncertainty than many employees can bear. Since it is hard for any one person in the organization to control the factors that make exploratory activities successful and recognized, employees might be penalized--indeed even fired--for events that they couldn't influence. Few line managers will be able or willing to accept financial risk.

The disputes that erupt over sharing the upside of innovation are the second problem. A company that installs a system of balanced high-powered incentives must often give much of the value it generates back to employees in compensation not just for their contribution but also for the extra risk they assume. Shareholders too will naturally want a piece of the cake, but there may not be enough left to satisfy them.

Partnerships in professional-service firms actually can afford to offer their people high-powered incentives for undertaking both routine and exploratory tasks, partly because the senior employees of these firms also happen to be the shareholders. But few other companies are in a similar position in this respect.

It is therefore unlikely that a balance of high-powered incentives will suit many companies that want to encourage their people to pursue routine and exploratory activities simultaneously. A more promising approach would be to orchestrate a system of weak--though balanced--incentives. But then the incentive system doesn't give employees much reason to go the extra mile and exert the extra effort that is so valuable to companies. The solution lies in their culture.

Fostering a high-commitment culture
The companies that most effectively motivate their employees to pursue future growth and, at the same time, to concentrate on current performance use weak, balanced incentive structures but take care to supplement them with unusually inclusive and motivating corporate cultures. At a company of this kind, employees see a close fit between its long-term interests and their own. Consequently, they are better motivated not only to work diligently and creatively, with relatively low levels of explicit incentive pay, but also to divide their time between exploratory and predictable tasks in a way that serves the business well. In such companies, the culture and incentive schemes serve to reinforce each other.

By contrast, employees in many companies don't feel that their personal interests are aligned with those of the organization. Thus they need explicit incentives to work as hard as the company wants them to and don't automatically divide their time between predictable and exploratory activities. Such companies go to great lengths to motivate employees and allocate their efforts wisely.

Employees in many companies don't feel that their personal interests are aligned with those of the organization.
In private life, people usually manage the trade-offs between executing their daily routine tasks and preparing for the future--planning their children's schooling, for example, or moving to a new apartment. By pursuing their own perceived interests, they make the right choices because they themselves directly reap the benefits and pay the costs of their actions.

But in most companies, the chain linking the performance of an individual to a consequence for him or her is much more cumbersome. Managers must identify each useful activity they want an employee to perform, tie an incentive to it, measure the employee's performance, and grant or withhold the reward. A company that relies strictly on such formal incentives to shape employee preferences must construct these chains with exquisite care and accept the risk that they will fail to measure performance accurately and will thus motivate employees to do the wrong things.

However, a company that creates and nourishes a culture in which its employees identify its interests with their own increases the odds that they will strike the right balance in their allocation of effort, without any strong explicit incentives, just as they do in their private lives.

A few companies have evolved such cultures over time. Generally, their dominant values are service to customers, fairness, empathy with the concerns of employees, and open access to information. The key element of such a culture is the way it promotes the employee's sense of belonging to, or identity with, the company. Although we don't thoroughly understand how companies can build such a culture, our research has shown how it promotes simultaneous innovation and current performance when combined with balanced low-powered incentives.

Managers seeking to encourage high performance on current tasks and, at the same time, innovative thinking about future opportunities ought to look beyond simple pay-for-performance formulas and instead try to create a proper balance among the formal incentives that are used to promote both of these goals. Those incentives can be even more effective if they are supported by a culture that aligns the interests of a company with those of its employees.

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