It's Differentiation Season
At this moment, all over the US and in many parts of the world companies are winding down their performance management (PM) cycles and cranking up their pay processes.
Supervisors have “distributed” their employees into the buckets defined by their PM rating scale and they are deciding what merit increase or bonus to give employees. ‘Tis the season. Conventional wisdom holds that not everyone can get the same increase; better performers get more and poorer performers get less. We “differentiate” rewards and that differentiation creates inequality or variation pay…a condition economists call “dispersion.” Differentiation of rewards based on performance causes dispersion in pay.
Why do we do this? Why do we differentiate and create inequality in rewards? This may sound like a silly question. When I ask executives and HR leaders this question most look at me like I’ve lost my mind, as if I asked them why they walk upright. “How else would you do it?” they ask me. After all, employees expect organizations to differentiate; they want organizations to differentiate. Leaders and HR executives fear all hell would break loose if they didn’t. I have heard these fears directly from the mouths of leaders. “We must keep our foot on the gas; if we don’t, our best people will disengage and leave us.” In organizations, the doctrine is: Employees must be rated, ratings must be distributed and rewards must be differentiated. So let it be written…so let it be done.
But why? Why must we “keep our foot on the gas?” In a word…motivation. Money motivates and more money motivates…well…more. This statement reflects the most basic principles in economics and psychology. People are motivated by money and are self-interested, so they will try and get as much as they can. Behavior (and performance) is a function of its consequences. People will work hard for positive consequences (big raises and bonuses) and to avoid negative consequences.
This doctrine also strikes us as simply common sense--we can’t give everyone the same. This is socialism. Organizations aspire to be meritocracies where those who get the big rewards earn them by way of superior talent and hard work. There is a continuum and Socialism is on one end and Meritocracy is at the opposite end. Meritocracy is fair and Socialism isn’t.
So we assume rewards must be unequal because performance and talent are unequal. This inequality is fair and will be good for employees and organizations. So, is it true?
The answer is no, not necessarily. It is definitely not the case that differentiation of rewards and the dispersion in pay it creates is good for individuals or organizations. It turns out there is real scientific research related to this question (much of it in economics) and there have been a handful of reviews of this research. I am amazed at how few PM and compensation professionals are aware of this research or other research related to the practices they design and implement every day. For example, a review by economist Benoit Mahy and his colleagues called the evidence supporting the beneficial effects of pay dispersion “inconclusive”. The reality is sometimes dispersion is good, sometimes it’s bad and sometimes whether it’s good or bad depends on how much dispersion there is and whether the reasons for the dispersion are based on legitimate or illegitimate factors.
While this research isn’t definitive (and this isn’t unusual in the social sciences), there are still important conclusions that can be drawn about conditions under which differentiation of rewards and the resulting dispersion of pay it creates might be a problem.
In environments where more collaboration is needed, higher levels of pay dispersion tends to be harmful.
Pay dispersion due to more “legitimate” factors tends not to be harmful and can even be beneficial. The problem is much of the dispersion in pay observed in organizations is due to individual pay-for-performance programs. And most of these programs are based on supervisor ratings of performance—we “pay for performance ratings.” While many researchers consider performance ratings as a “legitimate” factor on which to differentiate rewards (and many of you might agree), “legitimate” doesn’t mean accurate. It is widely acknowledged by researchers the ratings produced by PM systems are poor indicators of an employees overall performance. In fact, they are a better measure of the biases and idiosyncrasies of the supervisor doing the rating than the performance of the employee being rated. Based on the scientific evidence available, it would be hard to consider these ratings as legitimate information to use in differentiating rewards and pay dispersion based on illegitimate reasons is more uniformly harmful to individuals and organizations.
Finally, if it is retention we care about (vs. performance and productivity), then higher levels of pay dispersion is more uniformly bad for organizations.
Notre Dame economist Matt Bloom did one of the more interesting studies in this area. Bloom studied major league baseball teams from 1985 to 1993. This study and others like it are interesting because they allow us to look at the effects of pay inequality on both individual and organizational performance.
Traditional thinking would hold that teams with the highest pay differentials, that reward their stars with the highest salaries would do better. That’s not what Bloom found. Bloom looked at measures commonly used by baseball teams to judge player performance: Adjusted batting runs; fielding runs; total player rating for non-pitchers; adjusted earned run average; pitching runs; and total pitcher rating for pitchers. In all cases teams with higher levels of pay inequality had players that performed more poorly. Bloom found the same results for team performance. Teams with the higher levels of pay inequality had lower win percentages, lower levels of fan attendance, lower finishing positions and poorer financial performance (gate receipts, media income, total income and franchise value). Similar results have been found in other sports; more inequality in pay tends to be bad for both individuals and teams.
The research in this area is messy especially as it has evolved over the years, but my best guess as to “truth” in this area (if one can talk about such a thing) is that there is a curvilinear (bell-shaped) relationship between pay inequality and productivity. Paying everyone this same is bad. After all, employees bring different credentials and experience to the table. Some inequality in pay is OK as long as it is based on “legitimate” factors (and “legitimate” is to some extent in the eye of the beholder—the employee). Beyond a certain level of pay dispersion, additional dispersion is bad…it simply can’t be deemed legitimate or defensible. This means there is a sweet spot for pay dispersion and I think it is fairly low.
So what do you do? Differentiate less? The answer is yes. I realize most of you (and most of your executives and HR leaders) will resist this with every fiber of your being.
But the answer is yes.
I will argue you are getting the results you get from your employees despite the differentiation you are imposing on them, not because of it.
Differentiating less doesn’t mean you treat everyone the same. There are lots of ways to treat employees differently without differentiating their end-of-year rewards. So what should you do? Here are some options:
Decrease the individual performance multiplier that contributes to employee rewards decisions. I would prefer that you eliminate it, but if you can’t do that at least reduce it.
Make bonus decisions based more on group or organizational performance versus individual performance. I know what you’re thinking…if employees feel they can’t easily affect the group or organizational outcome, they won’t be motivated and they will “free-ride” on the group. This is a myth. The research on free-riding is very clear; free-riding effects are minimal to non-existent in the circumstances under which most employees work (performance that is visible to others, relatively permanent, intact teams). Focusing employees on the outcomes of the team or the organization has the added benefit of making employees feel a part of something bigger than them, which is a strong motivator. Research on these kinds of programs (profit sharing, gain-sharing, stock ownership programs) is very clear, they work and they don’t have the toxic side effects of traditional individually-based incentive programs.
Use cost-of-living adjustments to increase base pay. I know what you’re thinking…give them more money just for surviving another year? Give then “uncontingent” pay? The answer is yes. This keeps employees whole with the market (assuming you are paying them relative to the market). If you don’t do this, you risk losing them to an outside opportunity that at least gets them to market wages.
Use market-based adjustments. When someone’s skills become more valuable, increase their pay.
Increase employees’ pay using promotions. Promote people more often, especially your high potential employees. This will create headaches for those of you who have adopted a “broad banding” job structure (which is probably all of you). You may need to adjust your job structure to allow for more promotions, which itself will pay big motivational dividends. A robust internal labor market with lots of movement opportunity will beat an incentive program any day in driving higher levels of performance and retention.
Pay the person instead of (or in addition to) the job. This sounds crazy but it’s what Netflix does. If they can get more money outside of your company, increase their pay. If they can’t, don’t.
Reducing the amount of differentiation won’t be easy, especially given our worship of meritocracy and the blindness of executives and HR professionals to alternatives to individual financial motivational schemes. And there will certainly be change management challenges involved in transitioning away from traditional practices. Honestly, it is easier to throw money at people. But do you want easy or do you want effective?
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Listed below are references to research discussed above and to additional readings you might enjoy if you want to go deeper. I would certainly argue you should read my book on PM which contains a heavy dose of content on this topic as well as the use of money and pay-for-performance programs in organization.
There are lots of articles and books to read. Some tackle the subject of inequality from a societal (and political) point of view. If you want to read something like this see: Hayes, C. (2012). Twilight of the elites. America after meritocracy. New York: Random House.
An interesting new book recently published by Ken Payne discusses this issue from a larger societal context but also discusses inequality within the corporate walls: Payne, K. (2017). The broken ladder: How inequality affects the way we think, live, and die. New York: Viking.
For those interested in reading more on this topic as it relates to pay and PM practices inside organizations, see the following:
Adler, S., Campion, M., Colquitt, A., Grubb, A., Murphy, K., Ollander-Krane, R., & Pulakos, E. (2016). Getting rid of performance ratings: Genius or folly—a debate. Industrial and Organizational Psychology, 9, 219-252.
Bloom, M. (1999). The performance effects of pay dispersion on individuals and organizations. Academy of Management Journal, 42, 25–40.
Bloom, M., & Michel, J. G. (2002). The relationships among organizational context, pay dispersion, and managerial turnover. Academy of Management Journal, 45, 33-42.
Mahy, B., Rycx, F., & Volral, M. (2011). Does wage dispersion make all firms productive? Scottish Journal of Political Economy, 58, 4, 455-489.
Pfeffer, J., & Langton, N. (1993). The effect of wage dispersion on satisfaction, productivity, and working collaboratively: Evidence from college and university faculty. Administrative Science Quarterly, 38, 382-407.
Shaw, J. D. (2014). Pay dispersion. Annual Review of Organizational Psychology and Organizational Behavior, 1, 521-544.
Trevor, C. O., Reilly, G., & Gerhart, B. (2012). Reconsidering pay dispersion’s effect on the performance of interdependent work: Reconciling sorting and pay inequality. Academy of Management Journal, 55, 585-610.
Weitzman, M. L., & Kruse, D. L. (1990). Profit sharing and productivity. In A. S. Blinder (Ed.), Paying for productivity (pp. 95–140). Washington, DC: Brookings Institution.
Welbourne, T. M., & Gomez-Mejia L. (1995). Gain-sharing: A critical review and a future research agenda. Journal of Management, 21, 3, 559–609.