6 Pay and Performance: Individuals, Groups, and Executives

Abstract

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 trade‐offs. For example, strengthening PFP links can generate powerful motivation 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.

Notes

1. 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.

2. 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.

3. 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.

4. 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).

5. 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.

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

7. 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.

8. 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).

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

10. 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.

11. 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.

12. 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.

13. 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 1‐year 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 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%.

14. 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.

15. 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.

16. 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).

17. 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.

18. 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.

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

20. 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).

21. 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).