The Three Gravitational Laws of Performance Pay

One of the immutable truths of our universe is gravity. When you jump for joy, throw a ball, or drop your car keys, you experience gravity. If you own a cat, you probably observe gravity at work frequently; my cat pushes things off counters and tables all the time to ensure that gravity is still turned on and working properly. In short, the meaning of gravity in our day-to-day lives is “what goes up must come down.”

You may not recognize the gravitational constant in its mathematical form:

G = 6.67408 X 10-11m3kg-1s-2

But you certainly recognize it when you experience it, and you know that there’s no getting away from gravity. 

As it turns out, gravity has implications for your performance pay programs. Whether it’s the affordability of your program across business cycles, the efficacy of your program to build the value of your organization, or interest in your program (and in pay for performance in general), the gravitational adage of “what goes up must come down” couldn’t be more true.

(1) Your ability to afford your performance pay program will go up and down. The expansionary and contractionary phases of the business cycle are as close to a “law” as you an get in economics. Both the length of time between expansion and contraction varies, as does the “height” of the high and the depth of the low. Sometimes we’re able to sustain expansion for a relatively long period of time that results in soaring economic success. But it’s not sustainable indefinitely; you will experience a downswing sooner or later. When designing your performance pay program, it’s important to keep this in mind. It’s easy to follow through on your performance pay promises when things are going well and the organization is financially prospering. When the downturn ultimately comes, you must ensure that you will still have the financial ability to follow through on those performance pay promises. Overpromising and underdelivering in austere times an be fatal for your pay for performance program and can threaten the very existence of your organization.

(2) The ability of your performance pay program to increase firm value will degrade over time. One of the main purposes of a performance pay program is to increase firm value. When a performance pay program is “new” it can be very effective. But over time it will lose some of its efficacy. Lazear & Gibbs describe this phenomenon as follows: “consider a measure that had previously not been used for calculating an employee’s bonus. The firm believes that the measure is correlated usefully with firm value, so it decides to give the employee a bonus based on the measure. The employee now has an incentive to increase the measure’s value, possibly in part through manipulative behavior. If there is manipulation, this will tend to reduce the measure’s correlation with firm value – making it a less useful performance measure! The longer the employee has had a bonus based on the measure, and the greater the incentive placed on the measure, the more likely this phenomenon is to be a problem.” The upshot of this is that performance pay programs are not evergreen. To maintain efficacy, they must be periodically revisited and reinvigorated. Left on its own, the efficacy of your performance pay program will fall.

(3) Interest in your program will ultimately go down. Currently, the vast majority of organizations have a variable pay plan. Twenty years ago, less than half of organizations had a variable pay plan (Hewitt Salary Increase Survey, 1990-2009). Performance pay has been in fashion for several years. But like the patchwork peasant skirts of the 1970s and the velour tracksuits of the 2000s, performance pay is likely going to fall out of fashion. When “the next big thing” arrives, everyone – your employees, your senior management, and your competitors – will forget about the advantages of well designed, tried-and-true performance pay plans. Fashion works in cycles, so performance pay may come back in fashion at some point in the future. What will you do until it does? Don’t put all of your eggs in the same rewards basket. Spread things out and use a total rewards approach.  

No matter how well designed your performance pay program is, it cannot escape the inevitability of gravitational pull. What goes up must come down. If you’re not prepared, your entire compensation program could collapse into a singularity of infinite gravity, a.k.a., a black hole. And we all know that black holes suck. 

Image courtesy of Squashimono via Flickr

Stephanie Thomas, Ph.D., is a Lecturer in the Department of Economics at Cornell University. She teaches undergraduate and graduate courses on economic theory and labor economics in the College of Arts and Sciences and in Cornell’s School of Industrial and Labor Relations. Throughout her career, Stephanie has completed research on a variety of topics including wage determination, pay gaps and inequality, and performance-based compensation systems. She frequently provides expert commentary in media outlets such as The New York Times, CBC, and NPR, and has published papers in a variety of journals.

This post originally appeared on Compensation Cafe
Author: Stephanie Thomas