It's Differentiation Season (Redux)

I wrote this article about a year ago and thought it worth re-posting (updated a bit and modestly edited). Not much has changed in the past year, in fact, many companies have doubled down on differentiation as cost pressures intensify and compensation budgets tighten. If the pie is smaller, conventional wisdom says, we need to differentiate even more.

Differentiation is a key part of the game we play with employees. The game goes something like this: Employees work for rewards. Rewards are distributed on the basis of individual performance. Performance is measured by supervisor ratings. Employees compete with one another for ratings and rewards. The winners get top ratings and a disproportionate share of the rewards, the losers resolve to try harder next year.

The game is a given, so...here we go again. If this year is like prior years, few will come out the other end feeling satisfied and energized. Maybe it’s time to stop trying to improve how we play the game and instead stop playing the game entirely?

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At this moment, many 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, dutifully conforming to expectations on how many employees can receive each rating, and they are now making decisions about merit increases and bonuses for employees. The game is in full swing.

‘Tis the season.

Conventional wisdom says that we need to differentiate rewards, we should give better performers more and poorer performers less. This differentiation creates inequality or variation pay, a condition economist call “dispersion.” Differentiation of rewards based on performance causes dispersion in pay.

Why do we do this? Why do we deliberately create pay inequality by differentiating 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’ve heard these fears directly from leaders. “We must keep our foot on the gas; if we don’t differentiate, 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 (small or non-existent raises and bonuses, or worse, being fired).

Period.

This doctrine also strikes us as simply common sense--we can’t give everyone the same. This is Socialism, and we certainly can’t have that…at least not in organizations. Organizations are meritocracies where those who get big rewards earn them by way of superior talent, hard work and outstanding performance . There is a continuum, Meritocracy is at one end and Socialism is at the opposite end.

But is it true? Are differentiation and dispersion in pay (which I will hereafter refer to as inequality) good for employees and organizations? The answer is No, not necessarily. It turns out there is scientific research related to this question (much of it in economics). A review of this research by economist Benoit Mahy and his colleagues called the evidence supporting the beneficial effects pay inequality “inconclusive”. Other reviews reach similar conclusions. The reality is sometimes inequality is good, sometimes it’s bad and sometimes whether it’s good or bad depends on how much inequality there is and whether the reasons for the inequality are based on legitimate or illegitimate factors.

Although 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 these practices might be a problem:

In environments where more collaboration is needed, higher levels of pay inequality tends to be harmful.
Pay inequality due to more legitimate factors tends not to be harmful and can even be beneficial. The problem is much of the growth in inequality in pay observed in organizations (especially at higher income levels) is caused by variable-pay programs. Anyone who has talked to employees and those responsible for these programs knows they are less than thrilled with their fairness and effectiveness. And research support for the broad effectiveness of these programs is lacking. Classifying these programs as legitimate sources of pay inequality is a stretch and research shows pay inequality based on non-legitimate factors is more uniformly harmful to individuals and organizations.
The payouts from many variable-pay programs are based on supervisor ratings of performance—we “pay for performance ratings.” While many researchers consider performance ratings to be “legitimate” factors on which to differentiate rewards (and many of you might agree), legitimate doesn’t mean accurate. It is widely acknowledged by researchers these ratings are poor indicators of employee performance. In fact, they are better measures of the biases, idiosyncrasies, and questionable motives of the supervisors doing the rating. For this reason, it would be hard to consider these ratings as legitimate bases for differentiating rewards, further weakening the argument that pay inequality created by variable pay programs (which use performance ratings as input) is legitimate.
Finally, if it is retention we’re interested in, then higher levels of pay inequality 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.

Conventional wisdom would say that teams with the highest pay differentials, that reward their stars disproportionately would do better, and that individual players on those teams would be more motivated and do better as well. 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 and in non-sport contexts; more inequality in pay can definitely be bad for individuals, teams, and organizations.

My best guess as to “truth” in this area is that there is a curvilinear (bell-shaped) relationship between pay inequality and productivity. Paying everyone the 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. Beyond a certain level, additional pay inequality is bad…it simply can’t be defended as legitimate. This means there may be a “sweet spot” for pay inequality and it may be lower than many expect.

So what do you do? Differentiate less? The answer is Yes. I realize many of you and most executives and HR leaders will resist this with every fiber of your being. But the answer is Yes. You may be getting the results you get from your employees despite the differentiation and pay inequality 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. Here are some options to consider:

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.
Implement bonus programs based 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 on which their reward depends, they won’t be motivated and they will “free-ride” on the rest of the group. This is a myth. 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 themselves, which is a strong motivator. Research on these programs (e.g., 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 variable-pay programs.
Use cost-of-living adjustments (COLAs) to increase base pay. I know what you’re thinking…give employees more money just for surviving another year? Give them “non-contingent” pay? The answer is Yes. You are not telling a “motivation” story with COLAs, you are simply ensuring your employees don't lose ground to inflation. These increases also served to keep employees up with the market. If you don’t do this, you risk losing them to an outside opportunity.
Use market-based adjustments. When someone’s skills become more valuable, increase their pay.
Increase employee pay using promotions. Promote people more often, especially your high-potential employees. This can create headaches for those of you who have 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 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 motivation, performance and retention.
Pay the person instead of 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. Many supervisors do this anyway, balancing the money available across all reward programs at their disposal to accomplish what they want for an individual employee.

Reducing the amount of differentiation won’t be easy, especially given our worship of meritocracy, our bias toward extrinsic motivation, and the blindness of executives and HR professionals to alternatives to individually-based financial motivational schemes. And there will certainly be change management challenges involved in transitioning away from these traditional practices. But do you want easy or do you want effective? And this topic isn’t going away. Companies in the US just completed their first year of reporting the ratio of CEO pay to average employee pay, a measure of…you guessed it, pay inequality. And the results are shocking to say the least. More on that in a future article.

References and Further Reading

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 performance management (reference below) which contains a heavy dose of content on this topic as well as on the use of money and pay-for-performance programs in organizations.

There are lots of articles and books to read on the general topic of meritocracy and pay inequality. If you want to go deeper here, consider the following sources, and all of these discuss the role of corporations in contributing to pay inequality to some extent:

Hayes, C. (2012). Twilight of the elites. America after meritocracy. New York: Random House.

Payne, K. (2017). The broken ladder: How inequality affects the way we think, live, and die. New York: Viking.

Frank, R. H. (2016). Success and luck: Good fortune and the myth of meritocracy. Princeton New Jersey: Princeton University Press.

For those interested in reading more on the topic of pay inequality and related 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.

Colquitt, A. L. (2017). Next-generation performance management: The triumph of science over myth and superstition. Charlotte, NC: IAP Information Age Publishing.

Mahy, B., Rycx, F., & Volral, M. (2011). Does wage dispersion make all firms productive? ScottishJournal of Political Economy, 58, 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, 559–609.