Strategic Reward Systems I

HR Management
MBAO 6030

MBAO 6030 Human Resource Manageme

Strategic Reward Systems I:

Pay for Performance
Reward Systems consist of the following
elements:
Financial Rewards Compensation
1. Base Salary
2. Pay Incentives
3. Employee Benefits

Non-financial Rewards
1. Intrinsic Rewards centers on the work itself
2. Praise, recognition, time off and other rewards
given to the employee by peers or superiors.

Strategic Reward Systems I:

Pay for Performance
Reward Systems in most cases should be
consistent with other HR systems.
The Reward System is a key driver of:
HR Strategy
Business Strategy
Organization Culture

Strategic Reward Systems I:

Need for Consistency with Other HR Systems
Skill-based pay

Training
Overtime
pay rules in
contract

Labor
Relation
s

Sign-on Bonus

Culture
Merit pay reinforces
performance culture

Rewards

Performance
Management
Employment
Merit Pay

Strategic Reward Systems I

Critical Thinking Question:
1. Should pay policies lead or lag the
development of other HR systems?

Theoretical Models of Pay and Performance:

Equity theory (Adams, 1963)
Assumptions:
People develop beliefs about what is a fair reward
for ones job contribution - an exchange
People compare their exchanges with their
employer to exchanges with others-insiders and
outsiders called referents
If an employee believes his treatment is inequitable,
compared to others, he or she will be motivated to
do something about it -- that is, seek justice.

Theoretical Models of Pay and Performance:

Equity theory (Adams, 1963)
Is/Os

versus

Ir/Or

O = Outcomes: the type and amount of

rewards received

I = Inputs:

employees contribution to
employer

R = Referent:

comparison person

S = Subject:

the employee who is judging

the fairness of the exchange

Equity Theory Exchange Scenarios

Case 1: Equity -- pay allocation is perceived to

be to be fair - motivation is sustained
Case 2: Inequity (Underpayment) -- Employee
is motivated to seek justice. Work motivation is
disrupted.
Case 3: Inequity (Overpayment) -- Could be
problem. Inefficient. In other cultures
employees lose face.

Consequences of Inequity

The employee is motivated to have an equitable

exchange with the employer.
To reduce inequity, employee may

Reduce inputs (reduce effort)

Try to influence manager to increase outcomes
(complain, file grievance, etc.)
Try to influence co-workers inputs (criticize others
outcomes or inputs)
Withdraw emotionally - or physically (engage in
absenteeism, tardiness, or quit)

Equity Theory Implications

There is tension between internal and external pay

equity: Decide where to place the emphasis.
Example: In and out versus lifelong employment
system
Let employees know who their pay referents are in the
pay system: identify pay competitors and internal pay
comparators.
Strive for consistent pay allocations
Monitor internal pay structure and position in the labor
market for consistency.

Agency Theory

Agency theory is a theory of governance in the

workplace.
It tries to solve the problem of separation of
ownership (atomistic shareholders) and control
(professional executives and non-owners)
It also tries to solve conflicts of interest between
managers and employees with delegated
responsibilities.

Agency Theory
1. Principals = owners or managers who delegate
responsibilities
2. Agents = managers or employees who manage
firm assets for owners or other principals.
3. Information asymmetry = managers or other
agents have greater access to strategic
information than principals, who are not willing
to bear the cost of directly monitoring the agents
due to steep agency costs.

Agency Theory
4. Risk Preferences principals are risk neutral
and willing to bear greater risks than agents
because their asset wealth is more likely to be
diversified between corporate assets and other
equities/investments. Agents are more risk
averse than principals, because most of their
wealth is concentrated in the firm and received
in the form of pay and opportunities for
promotion.

Agency Theory
5. Moral Hazard agent is tempted (and some
cases succeeds) in taking advantage of
information asymmetry with principal and act
opportunistically (defined as making decisions
not aligned with principals interests) and use
the firm resources to maximize wealth of the
agent (often at the expense of the principal).

Agency Theory
6. Agency Contract provides solution to moral
hazard/agency problem, by establishing rules
of the game to control agent opportunism
agents performance will be judged by
outcomes (often financial benchmarks) not
behaviors (which require direct supervision of
agents actions). These outcomes will reflect
principals goals and risk preferences.

Agency Theory
7. Incentive alignment the agency contract will
specify a compensation plan that aligns the
interests of the principal and agent. This agency
contract will be a type of pay for performance plan.
Meeting or exceeding pre-agreed upon financial or
non-financial outcomes triggers various forms of
compensation (individual or group-based) for the
agent. Some agency costs are borne by the
principal in the form of financial incentives for the
agent.

Tournament Theory
1. Tournaments are competitions between peers to
achieve a promotion to a higher rank along with the
pay and perks that go with it.
2. Tournaments are likely to result in a winner take all
outcome.
3. Managers who enter the tournament must forego
other alternatives (such as jobs with other firms, start
own business, receive more pay with an alternative
opportunity) to compete in the tournament.

Tournament Theory
4. A high pay differential (such as the CEO
receiving much greater pay than any
subordinates) attracts more players to the
tournament.
5. Players must invest (work long hours, accept
less pay, show loyalty to their boss) to enter the
tournament firm captures value from these
players, more than what it gives up to the
winner for the prize.

Controversies that Surround Pay for

Performance Plans
1. Single Mindedness you get what you pay
for no more, no less. The activities that are
rewarded get done, to the exclusion of other
activities that are not rewarded. Example: The
dysfunctional behaviors that are observed when
a sales representative is put on straight
commission.

Controversies that Surround Pay for

Performance Plans
2. Control externalities can control the
outcomes, positive or negative. There can be
windfall affects (the bull market improving the
stock value of all stock options) or negative
externalities (a bear market or recession that
lowers the value of all stocks). Employee
performance results may be magnified or
diluted by these effects.

Controversies that Surround Pay for

Performance Plans
3. Measurement error some measures can be
gamed or manipulated and may not reflect
true performance. Sales reps can withhold
sales and report it in a different period so they
are not penalized by a cap on sales
commissions. Managers can use creative
accounting measures to report greater profits
than were actually experienced by the firm.

Controversies that Surround Pay for

Performance Plans
4. Inflexibility managers or employees may
resist change of the basis of compensation
because they are comfortable with current basis
for pay and want to avoid risk of taking
reduction in earnings in new system.

Controversies that Surround Pay for

Performance Plans
5. Misalignment of incentives if pay emphasis is on a
goal that is no longer relevant, that goal will continue
to be emphasized until the pay system places
emphasis on a different objective.
For example, managers may emphasize short-term
goals, even if long-term goals are more relevant, until
the pay system recognizes long-term goals to a
greater extent than short-term goals. The reward mix
for complex jobs with several goals must reflect the
relative value of attaining the mix of goals.

Controversies that Surround Pay for

Performance Plans
6. Line of Sight problem - division performance and
corporate performance should be reflected in the
pay system. If division performance and corporate
performance are closely linked than both division
and corporate performance should contribute
incentives to the managers pay for performance
plan. If division performance is independent of
corporate performance, then the emphasis should
be on rewards for meeting division goals.

Some Suggestions for More Effective Pay For

Performance Plans
Pay and Performance should be Loosely
Coupled this gives managers more flexibility
to make changes when new situations arise.
Example: a formula with a bonus based on a
moving average of a 3-year historical
performance period. A 3-year period smoothes
out performance over a longer cycle.

Some Suggestions for More Effective Pay For

Performance Plans
It is Necessary to Nurture the Belief that
Performance Makes a Difference there are
important cultural values that are supported with
pay for performance even if the accuracy of the
performance metrics and the fairness of the pay
allocations fall short of an ideal situation.
Abandoning pay for performance may be more
problematic than having an imperfect pay
system.

Some Suggestions for More Effective Pay For

Performance Plans
Pay for Performance systems should be
designed to fit each firms unique situation
imitation of other firms plans should be avoided

Six Myths about Pay (Pfeffer, 1998)

1. Labor rates and labor costs are the same thing.
2. Labor costs can be reduced by lowering labor rates.
3. Labor costs are a significant portion of total costs.
4. Low labor costs are a potent source of competitive
advantage.
5. The most effective way to work productively is
through individual incentive compensation.
6. People work primarily for money.

Critical Thinking Questions

1. Sears Roebuck Auto Center paid its auto mechanics a
commission based on the volume of services sold to
each customer. This basis of pay resulted in law suits
filed against Sears by angry customers who claimed
they were over-charged for services they did not
need. Sears was forced to pay millions of dollars of
penalties to these customers which hurt its reputation.
Pfeffer believes that Sears mistake was that it should
have realized that individual pay incentives are
dysfunctional. Do you agree with this conclusion?

Critical Thinking Questions

2. Charles Schwab, the discount broker, does not use
commissions as pay incentives for its brokers, bucking
financial services industry pay practices. Why do you think
Schwab did this?
3. Do you think that the point of view of the author (of the 6
Myths of Pay) would work at a Wall Street investment bank
such as Morgan Stanley?
4. The author of the 6 Myths of Pay article prefers groupbased pay for performance rather than individual pay for
performance plans. What is the reason behind this? Do you
agree?