Stop Paying for Performance

post # 43 — April 3, 2006 — a Managing post

The disadvantage of pay-for-performance compensation systems is that they provide a wonderful excuse not to manage. If someone’s performance is down, instead of management seeing that there is an obligation to go help that person, they have a wonderful cop-out. They say – “We cut his pay. We’ve done our job. The rest is up to him or her.”

Contrast this with what happens in a system where everyone gets a relatively fixed salary or share of profits, which changes as you get more seniority – if you survive.

In such a system (often called a lockstep system because people move in lockstep up the pay scale), if someone underperforms, you have only two choices. You either (a) work with that person and help them improve to deserve the same income as their peers or (b) if you cannot restore them to full share, you have to ask them to leave. Notice that having lockstep without the guts to deal with performance issues is clearly a disaster! A fixed-share or fixed salary system FORCES YOU to manage, ie to be intolerant of underperformance.

In other words, by not paying for performance, you end up with higher performance by tackling performance issues. By paying for performance, you get less performance because the system allows you to accommodate underperformance.

As Gilbert and Sullivan said in The Mikado – A most ingenious paradox!

There are further problems with pay-for performance systems. If you have lived for the last 20 years in a performance-based system, which is almost always based upon individual pay, then by definition you will have no institutional loyalty.

The system has said to you for the last 20 years – the heck with the firm, you will be paid on what you do. We neither require of you to have any loyalty nor do we give you any loyalty, because if your numbers are down, we cut your pay.

So, the individual pay system is designed to minimize firm cohesion and thereby create the sort of “jumping ship” syndrome that we have seen in every profession.

If, however, you have lived for the last 20 years in a system where everyone is in the same boat together, and have all risen and fallen together, based upon sharing in firm-wide results, the probability that the people will stay together through hard times is measurably higher.

For the last 20 years firms have gone out of their way to say, “You are on your own. Never forget that.” That’s the message that every partner in the majority of professional firms gets from their firms.

There has been a very unfortunate history with all this. Many countries (for example, the UK and the Netherlands) had two ancient traditions, which proved to be unfortunate in combination. One was a tradition of lock-step compensation. They also had a tradition of being “tolerant”. Collegiality in Europe meant – you leave me alone about my flaws and I will leave you alone about yours.

The combination of these two approaches were disastrous. If everyone gets a fixed share regardless of how they perform, and trhere is no tackling of performance, you get the famous “free rider” problem.

About twenty years ago, firms began to realize that they had to either start managing their people, or they had to start dropping the equal salary or equal share system, introducing pay for performance. The bad news, of course, is that instead of doing the sensible thing, which is going toward an intolerant, fixed share or salary system – in other words, start MANAGING – they decided to go the other way and remained tolerant (unmanaged)and switch to pay for performance to accommodate wide ranges of contribution. It has been disastrous.

Compensation as an incentive system is a cop-out or a crutch, just an excuse for not providing proper management.

There are two ways to assess the effectiveness of a compensation scheme. First, is the money going to the right people and, second, what is the system doing to create desired behaviors and prevent bad behaviors?

A compensation system is and must always pay those that have done well. Most systems end up paying the right people. However, the design of the system also influences how people behave, i.e. what aspects of performance they pay attention to.

In assessing a pay scheme, you have to ask whether the system is getting people to do the right things. Most are not. Any time you try to use compensation as an incentive scheme, it will backfire.

The minute you tell a bright person what three things will be rewarded, you give them permission to ignore the ninety-seven other things they should be doing to make the firm work. People do like specificity. Every year people will come to you and ask what three things they have to do to get a good bonus. And every year, you must say: “Gee! I don’t know, and if I knew I certainly wouldn’t tell you.”

You must pay people as well as you can. You must be generous and fair, but you must never reduce the compensation system to a formula based upon a limited number of things. With a formula, you give people the permission to be an ugly human being and no one can do anything about it.

The problem is that firms are trying to use compensation as a means of raising performance, which it is not well-equipped to do. Most compensation schemes in professional firms are basically saying, “If you succeed we will pay you.” This is a wonderful system for someone who is already a natural superstar and knows how to win, but in a sense unneeded for the superstar. It doesn’t add anything to the success of the firm because the superstar is going to win anyway.

For someone who is not a superstar – and doesn’t know how to win, doesn’t know how to develop business, doesn’t know how to delegate, doesn’t know how to get organized – then just saying, I will pay you if you do it, is not exactly a tactic that is going to work. For the person who doesn’t know how to raise his or her performance, changing the incentive won’t help. And what about the person who underperforms? Is cutting their pay really the right way to energize them to perform better?

If you really want to raise firm profits by increasing performance, what you must do is manage people, and that involves one-on-one interactions. Talk to people and help them raise their game, by encouraging them, exciting them, lift their enthusiasm, and help them deal with their issues.