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6 Pay and Performance: Individuals, Groups, and ExecutivesBarry Gerhart a; Sara L. Rynes b; Ingrid Smithey Fulmer c

a School of Business, University of Wisconsin-Madison, b Tippie College of Business, University of Iowa, c

College of Management, Georgia Institute of Technology,

First Published on: 01 June 2009

To cite this Article Gerhart, Barry, Rynes, Sara L. and Fulmer, Ingrid Smithey(2009)'6 Pay and Performance: Individuals, Groups, andExecutives',The Academy of Management Annals,3:1,251 — 315

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The Academy of Management Annals

Vol. 3, No. 1, 2009, 251–315

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ISSN 1941-6520 print/ISSN 1941-6067 online© 2009 Academy of ManagementDOI: 10.1080/19416520903047269http://www.informaworld.com

6

Pay and Performance:

Individuals, Groups, and Executives

BARRY GERHART

*

School of Business, University of Wisconsin-Madison

SARA L. RYNES

Tippie College of Business, University of Iowa

INGRID SMITHEY FULMER

College of Management, Georgia Institute of Technology

Taylor and FrancisRAMA_A_404899.sgm10.1080/19416520903047269Academy of Management Annals1941-6520 (print)/1941-6067(online)Original Article2009Taylor & [email protected]

Abstract

In this chapter, we address three pay for performance (PFP) questions. First,what are the conceptual mechanisms by which PFP influences performance?Second, what programs do organizations use to implement PFP and what isthe empirical evidence on their effectiveness? Third, what perils and pitfallsarise on the way from PFP theory to its execution in organizations? Weaddress these questions in general terms, but also highlight unique issues thatarise in PFP for teams and for executives. We highlight the fact that researchand practice in the area of PFP requires one to deal with a number of trade-offs. For example, strengthening PFP links can generate powerful motivation

*

Corresponding author. Email: [email protected]

Downloaded By: [Academy of Management] At: 06:25 4 October 2009

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• The Academy of Management Annals

effects, but sometimes these are in unintended and unanticipated directions,resulting in undesirable effects. In addition, there are also trade-offs in decid-ing the degree of emphasis to give to individual versus team performance andto results versus behaviors in PFP plans. What all this means is that, as inother areas of management, “one best way” advice (e.g., do or do not use indi-vidual PFP plans) or “sound-bite” conclusions (e.g., PFP does not exist; PFPdoes or does not motivate) are rarely valid, but rather depend on the circum-stances and the organization. In the realm of executive pay, we question thecurrent conventional wisdom in the management literature that there is littleor no PFP. We close the chapter with a discussion of our key conclusions andsuggestions for what we think would be the most interesting and useful futureresearch areas. We encourage the management literature, which has increas-ingly become interested in the concept of evidence-based management, toexecute this concept more effectively in its research and when talking or writ-ing about pay.

Introduction

Literally hundreds of studies and scores of systematic reviews of incen-tive studies consistently document the ineffectiveness of externalrewards. (Pfeffer, 1998, pp. 214–215)

Money is the crucial incentive because, as a medium of exchange, it isthe most instrumental… No other incentive or motivational techniquecomes even close to money with respect to its incremental value.(Locke, Feren, McCaleb, Shaw, & Denny, 1980)

The link between pay and performance [of executives] has increasednearly tenfold since 1980. (Hall, 2000)

Research shows only a small relationship between executive compensa-tion in any form and firm performance. (Hitt, 2005).

On average, the single largest operating cost for an organization is employeecompensation (Blinder, 1990; European Parliament, 1999; Bureau of LaborStatistics, 2001). An organization’s success depends not only on the magni-tude of this cost, but also on what it gets in return for its investment.

1

Yet, asthe opening quotes suggest, there is considerable disagreement about both theexistence, and the effects, of pay for performance (PFP) among employees andexecutives. In this chapter, we hope to shed some light on which claims arebest supported by research evidence.

Compensation (also called pay or remuneration) can be defined toinclude “all forms of financial returns and tangible services and benefitsemployees receive as part of an employment relationship” (Milkovich &Newman, 2008, p. 9).

2

However, in this chapter, we focus on one dimension


Pay and Performance •

253

of compensation—PFP. Although there are multiple dimensions of compen-sation (e.g., pay level, pay structure, benefits), our decision to focus primarilyon PFP stems from its potential both as a basis for organization differentia-tion from competitors and as a potentially powerful driver of performance.In addition, PFP is a strategic compensation decision where organizationsappear to have more discretion than in other areas such as pay level, whichis more constrained by labor and product market parameters (Gerhart &Milkovich, 1990; Haire, Ghiselli, & Gordon, 1967). Also, PFP is of specialinterest because when it “works”, it seems capable of producing spectacularlygood results and when it does not work, it can likewise produce spectacularlybad results (Gerhart, 2001). Thus, it seems to be an area where organizationscan choose to be different in an effort to achieve high performance, but indoing so, also run higher risks (Gerhart, Trevor, & Graham, 1996). PFP isalso of interest because such plans (in one form or another) not only con-tinue to be prevalent in the private sector, but also seem to be makinginroads into sectors of the economy where they have not historically beenprevalent (e.g., the public sector, health care, education). Apparently, there isa growing belief that PFP can be used to improve effectiveness in these sec-tors as well.

In this chapter, we focus first on three general issues related to PFP. First,what are the conceptual mechanisms by which PFP influences performance?Second, what programs do organizations use to implement PFP and what isthe empirical evidence on their effectiveness? Third, what perils and pitfallsarise on the way from PFP theory to its execution in organizations? Finally, wedevote a separate section to PFP for executives. The issues in executive PFPare similar in some ways to the three general issues covered in our broaderdiscussion of employee PFP. At the same time, however, executive compensa-tion is unique in important ways (its magnitude, the key role of stock plans,the amount of public interest and regulatory scrutiny), suggesting the value ofa separate discussion. We close the chapter with a discussion of our key con-clusions and suggestions for what we think would be the most interesting anduseful future research areas.

We highlight in this chapter the fact that research and practice in the areaof PFP requires one to deal with a number of trade-offs and conundrums.Strengthening PFP links can generate powerful motivation effects, but some-times these are in unanticipated and undesirable directions. Similarly, therelative emphasis given to results-based and behavior-based measures ofperformance may contribute to too much or too little focus on certain perfor-mance objectives. In like fashion, the relative emphasis given to individual andgroup/organization performance in PFP plans may be beneficial for someobjectives, but detrimental to others. What all this means is that, as in otherareas of management, “one best way” advice (e.g., do or do not use individualPFP plans) or “sound-bite” conclusions (e.g., pay does or does not motivate)


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are rarely valid, but rather depend on the circumstances. This, of course, iswhat makes the field so interesting. In the case of executive compensation, thelarge sums of money involved, questions about its appropriateness anddisagreement regarding the degree to which it is determined by performanceversus less legitimate factors only adds to that interest.

Conceptual Issues

Incentive and Sorting Effects

Several social sciences, but particularly psychology and economics, haveoffered a variety of theories to explain the impact of pay in organizations.These include reinforcement, expectancy, equity, utility, agency, efficiencywage, and tournament theories (for reviews, see Bartol and Locke (2000) andGerhart and Rynes (2003)). To simplify greatly, these theories suggest that payoperates on motivation and performance via two different mechanisms—incentive effects and sorting (Gerhart & Milkovich, 1992; Gerhart & Rynes,2003; Lazear, 1986).

First, there is the potential for an

incentive effect

, which is the impact ofPFP on performance via its impact on current employees’ motivational states.In other words, the incentive effect is how pay influences the level or intensityof individual and aggregate motivation, holding attributes of the workforceconstant. More so than sorting effects, incentive effects have been the focus ofthe great majority of theory and research in compensation.

The most direct evidence of the power of incentive effects comes frommeta-analytic summaries of empirical work on individual incentive programs.This research aims to isolate the impact of individual contributions an objec-tive measures of performance. For example, in a meta-analysis of potentialproductivity-enhancing interventions in actual work settings, Locke et al.(1980) found that the introduction of individual pay incentives increased pro-ductivity by an average of 30%. These results are particularly compellingbecause the authors only included studies that were conducted in ongoingorganizations (as opposed to laboratories), that used either control groups orbefore–after designs, and that used objective performance measures (e.g.,physical output). A second meta-analysis by Guzzo, Jette, and Katzell (1985)likewise found that financial incentives had a large mean effect on productiv-ity (

d

=2.12).

3

More recent meta-analyses (Jenkins, Mitra, Gupta, & Shaw,1998; Judiesch, 1994; Stajkovic & Luthans, 1997) also provide similarly strongsupport for the impact of PFP incentives. In short, in contrast to Pfeffer’s(1998) assertion, there is strong evidence that PFP produces incentive effectsthat are very strong under certain conditions (e.g., individually-based withobjectively measureable outcomes).

4

Second, PFP may also produce higher performance through

sortingeffects

, which reflect the impact of pay on performance via its impact on the



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composition of the workforce (Gerhart & Milkovich, 1992). That is, differenttypes of pay systems may cause different types of people to apply to and staywith (i.e., self-select into) an organization. For example, individuals attractedto different types of pay systems may vary on the basis of ability (Trank,Rynes, & Bretz, 2002), responsiveness to PFP (Stewart, 1996), risk seeking(Cable & Judge, 1994), trait-like motivation (Amabile, Hill, Hennesey, &Tighe, 1994; Judge & Ilies, 2002), or other productivity-related attributes.Organizations too may differentially select and retain employees, dependingon the nature of their pay level and/or PFP strategies. The self-selectionaspect of sorting and its application to the effects of pay is based primarily onwork in economics (Lazear, 1986), but the idea is also consistent withSchneider’s (1987) attraction–selection–attrition (ASA) model in the appliedpsychology literature (Bretz, Ash, & Dreher, 1989). Critics of PFP, includingPfeffer (1998), tend to ignore this effect.

As with incentive effects, there also is rather compelling evidence of sortingeffects associated with PFP. For example, Lazear (2000) reported a 44%increase in productivity when a glass installation company switched fromsalaries to individual incentives. Of this increase, roughly 50% was due to exist-ing workers increasing their productivity (an incentive effect), while the other50% was attributable to less productive workers quitting and being replaced bymore productive workers over time (a sorting effect). Another study, a fieldexperiment by Bandiera, Barankay and Rasul (2007), demonstrated that whenmanagers were switched from straight salaries to a PFP system where their paydepended on the productivity of workers they managed, the managersincreased worker productivity both by hiring more productive workers (sort-ing) and by pushing existing workers (incentive) to be more productive.

Cadsby, Song, and Tapon (2007) likewise found that both incentive andsorting effects explain the positive impact of PFP on productivity. Their study,set in the laboratory, was designed so that subjects went through multiplerounds of a task. In some rounds, they were assigned to a PFP plan, in others,to a fixed salary plan. In yet other rounds, they were asked to choose betweenfixed salary or PFP. By the last rounds in three experiments, the PFP conditiongenerated 38% higher performance than the fixed salary condition, and thesorting effect (less risk averse and more productive subjects being more likelyto select the PFP condition) was approximately twice as large as the incentiveeffect in accounting for the performance difference.

Further evidence suggests that PFP is more attractive to higher performersthan to lower performers. For example, Trank et al. (2002) found that thehighest-achieving college students place considerably more importanceon being paid for performance than do their lesser-achieving counterparts.Likewise, people with higher need for achievement (Bretz et al., 1989; Turban& Keon, 1993) and lower risk aversion (Cadsby et al., 2007; Cable & Judge,1994) also prefer jobs where pay is linked more closely to performance.


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Other research shows that high performers are not only more likely to seekout PFP, but they are also more likely to quit and seek other employment iftheir performance is not sufficiently recognized with financial rewards(Nyberg, 2008; Salamin & Hom, 2005; Trevor, Gerhart, & Boudreau, 1997).Conversely, low performers are more likely to stay with an employer when pay–performance relationships are weaker (Harrison, Virick, & William, 1996).

Finally, we should note that to the degree sorting effects operate, it mayappear as though the PFP relationship is weak because selectivity in hiring byemployers (and/or self-selection by applicants), combined with the use ofselection procedures having predictive validity, will result in not only highermean performance, but also restricted within-organization variance in perfor-mance (Brogden, 1949). Under such range restriction, the observed PFP rela-tionship will be attenuated, but it would be a mistake to conclude that PFP isunrelated to performance. In any event, prior research has convincinglyshown that PFP can have substantial positive effects on performance, and thatthese effects occur through both incentive and sorting mechanisms.

Defining and Measuring Performance

A major decision in the design and success of PFP programs is likely to be thechoice of how to define and measure performance. We focus on two keychoices here. First, how much emphasis is placed on results-oriented/objectiveperformance measures (e.g., number of units produced, profitability) relativeto behavior-based ones (e.g., supervisory/merit evaluations of effort or qual-ity)? Second, how much emphasis is placed on individual contributionsrelative to collective contributions?

Behavior-based (subjective) versus results-based (objective) measures.

Behavior-oriented measures (such as traditional merit ratings) offer a numberof potential advantages relative to results-based measures (Eisenhardt, 1985a,1989; Gerhart, 2000; Holmstrom, 1982; Lawler, 1971; Ouchi, 1979). First, theycan be used for any type of job. Second, they permit the rater to factor in vari-ables that are not under the employee’s control, but that nevertheless influ-ence performance. Third, they permit a focus on whether results are achievedusing acceptable means and behaviors. Fourth, they generally carry less risk ofmeasurement deficiency, or the possibility that employees will focus only onexplicitly measured tasks or results at the expense of broader pro-social behav-iors, organizational citizenship behaviors, or contextual performance (Arvey& Murphy, 1998; Lawler, 1971; Milgrom & Roberts, 1992; Wright, George,Farnsworth, & McMahan, 1993).

On the other hand, the subjectivity of behavior-oriented measures can limittheir ability to differentiate employees (Milkovich & Wigdor, 1991). Meta-analytic evidence has found a mean inter-rater reliability of only 0.52 forperformance ratings (Viswesvaran, Ones, & Schmidt, 1996), making it difficult



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for organizations to justify differentiating employees based on such error-laden performance measures, especially if a single rater (usually the immediatesupervisor) is the source. Moreover, even if subjectivity could be sufficientlycontrolled and performance reliably and credibly differentiated, managersmay be reluctant to differentiate because of concerns about adverse conse-quences for workgroup cohesion, pro-social behaviors, and management–employee relations (Heneman & Judge, 2000; Longenecker, Sims, & Gioia,1987). Finally, behavior-based measures are not applicable in situations whereeither the opportunity to observe behaviors or the ability to judge behaviors isnot feasible.

At first blush, objective measures of performance, such as productivity,sales volume, shareholder return, and profitability, would seem to provide thesolution to the aforementioned problems. However, relevant objectivemeasures are not available for most jobs, especially at the individual level.Moreover, agency theory (which we discuss more fully in our section on exec-utive compensation) emphasizes that results-based plans—at least those thatseek to replace some part of fixed salary with an incentive component—increase risk-bearing among employees (Gibbons, 1998). Because mostemployees derive the bulk of their income from employment, they cannotdiversify their employment-related earnings risk, making them more risk-averse than others (e.g., investors) who can diversify their investments. Thus,employees prefer fixed pay to incentives, unless there is a compensatingdifferential (Cable & Judge, 1994; Weitzman & Kruse, 1990). This, then, is theclassic trade-off between designing plans that maximize incentives while keep-ing the negative effects of risk (in the form of negative employee reactions)under control.

Risk aversion is less of a problem where objective measures are seen ascredible and performance on such measures is high, providing significant pay-outs to employees. However, poor performance on such measures (and thusdecreasing or disappearing payouts)—especially if attributed to factorsemployees see as beyond their own control (e.g., poor decisions by top execu-tives or a sinking economy)—often results in negative employee reactions(Gerhart & Milkovich, 1992). In such cases, there will almost inevitably bepressure to revise (e.g., the experience at GM’s Saturn division (Gerhart,2001)) or abandon the plan (DuPont (Gerhart & Rynes, 2003)).

Another issue is that even though objective measures are possibly morereliable, they may also be more deficient. Lawler (1971) warned that “it isquite difficult to establish criteria that are both measurable quantitatively andinclusive of all the important job behaviors”, and “if an employee is not evalu-ated in terms of an activity, he will not be motivated to perform it” (p. 171).This is similar to the equal compensation principle from economics, whichstates that if an employee’s allocation of time or attention cannot be moni-tored by the employer, then marginal rates of return to employees for desired


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activities must be at least equal to or greater than rates of return to activitiesthat are not desired, or they will receive little or no time or attention(Milgrom & Roberts, 1992).

Finally, results-oriented measures often have a higher degree of incentive

intensity

(Gerhart, 2001). Two potential consequences, one good, one bad, ofhigher incentive intensity are: (a) higher motivational intensity; and (b) ahigher risk that this intensity will cause unintended consequences as thesehighly motivated employees use their “ingenuity” to find new ways to earnlarge payouts. We return to this concern later.

Individual and group (or collective) performance measures.

Criticisms havebeen leveled at organizations for focusing too much on individual perfor-mance and rewards (Deming, 1986; Pfeffer, 1998; Pfeffer & Sutton, 2006). Forexample, Deming (1986) argued that management’s “excessive” focus on indi-vidual performance ignores the fact that differences in individual performanceoften “arise almost entirely from the system that (people) work in, rather thanthe people themselves” (p. 110). Regarding teamwork, Deming cautioned thatunder individual PFP, “Everyone propels himself forward, or tries to, for hisown good… The organization is the loser” (Deming 1986, p. 110).

While the potential pitfalls of individually-based PFP are important, the lit-erature is quite clear that group-based plans also have their own potentialdrawbacks. One is that most employees (at least in the US) prefer that theirpay be based on individual rather than group performance (Cable & Judge,1994; LeBlanc & Mulvey, 1998). Another is that, as noted earlier in the sectionon sorting, this preference appears to be stronger among more productiveapplicants and employees, suggesting that group-based PFP might, on aver-age, be prone to unfavorable sorting effects.

Another concern has to do with the weakening of incentive effects (or “lineof sight”) under group plans (Schwab, 1973), particularly as group sizeincreases. Individuals are less likely to see a clear link between their effort andtheir pay when the PFP plan uses group or organization-level performancemeasures, which are influenced by a host of factors other than employee effortand many of which are beyond workers’ immediate control. In addition, thereis a concern that co-workers will not contribute equally to group performance,but nevertheless will receive the same level of rewards. Although Pfeffer (1998,p. 219) claims that evidence regarding the importance of the “so-called free-riding problem” is “surprisingly meager”, major reviews of team incentivesconclude that the free-rider problem is indeed an important phenomenonrequiring considerable attention if it is to be mitigated (Albanese & Van Fleet,1985; Cooper, Dyck, & Frohlich, 1992; Shepperd, 1993).

Summary.

A major issue in designing PFP plans is how to define andmeasure performance. Two principal decisions are the relative emphasis to be



259

placed on results- versus behavior-based measures and on individual versusgroup/collective performance. As we have seen, there are trade-offs involvedin each decision. In practice, many organizations fashion PFP plans thatcombine different types of performance measures, perhaps in the hope ofobtaining positive motivation intensity (and sorting) effects, while at the sametime focusing employee motivation on multiple objectives (Gerhart et al.,1996; Gerhart & Rynes, 2003). However, too much complexity in a PFP plancan also be a drawback by undermining line of sight.

Risk/Return and Fit/Misfit

The preceding discussion, especially that dealing with potential incentive andsorting effects, focuses primarily on the

mean

(i.e., average) and

main

(i.e.,noninteractive) effects of PFP programs. Of course, to focus only on averageand main effects is to oversimplify reality. Even if PFP has a positive effect onaverage, any organization considering a particular PFP program should alsobe interested in the variance of the effect across organizations, which can beinterpreted as a measure of risk (Gerhart et al., 1996). In addition, perspectiveson fit, alignment, and contingency seek to understand contextual factors (e.g.,business strategy, national culture, organization size, and HR practices otherthan compensation) that may further influence (strengthen or weaken) thesuccess of PFP plans (for reviews, see Gerhart (2000, 2007), Gomez-Mejia andBalkin (1992) and Milkovich (1988)).

Empirical Evidence on Individual and Group PFP Plans

In practice, organizations use specific PFP programs at the individual and/orgroup level (e.g., merit pay, profit-sharing, and so forth) in an attempt toenhance and support organization effectiveness. Thus, we organize our reviewof the evidence on specific PFP plans by whether the plans are individual-basedor group/organization-based. Within each of these sections, we also segmentresearch according to results-based versus behavior-based performance(Table 5.1). Although not explicitly included in Table 5.1, a third factor, incen-tive intensity, is implicitly included in that it tends to be stronger for results-based plans. We conclude with a discussion of risk/return and fit issues.

Table 5.1

Pay for Performance (PFP) Programs, by Level and Type of Performance Measure

Level of performance measure

Type of performance measure Individual Facility/plant Organization

Behavior-based Merit pay Merit pay for executives

Results-based Individual incentives sales commission

Gain-sharing Profit-sharing stock plans


260


Despite the fact that we describe each PFP program separately, it should bekept in mind that people are often paid using a combination of programs.Moreover, successful PFP programs (such as those at Lincoln Electric, NucorSteel, Whole Foods, Southwest Airlines, and General Electric, to name just afew) come in many different formats, with varying degrees of relative empha-sis on individual, group/unit, and/or organization level performance.

Individual-Based PFP Plans

Individual incentives.

Individual incentives provide results-based (ratherthan behavior-based) rewards. These can, for example, be in the form of piecerates (where production workers get paid on the basis of the number of piecesproduced) or sales commissions, where pay is based on revenue produced. Asshown earlier, much of the meta-analytic evidence on PFP comes from studiesof individual incentive plans. This research has shown substantial positive effectsfor PFP (Locke et al., 1980; Guzzo et al., 1985; Jenkins et al., 1998). However,because incentive systems cannot be applied in the absence of valid measuresof objective performance, their feasibility is limited for most job categories.

In addition, if used exclusively, individual incentive plans can cause unin-tended consequences (overly narrow motivational focus, ethical shortcuts toachieve results). Lawler (1971), for example, warned that “it is quite difficult toestablish criteria that are both measurable quantitatively and inclusive of allthe important job behaviors” and that “if an employee is not evaluated interms of an activity, he will not be motivated to perform it” (p. 171). Similarconcerns are raised by Milgrom and Roberts (1992). Even where individualincentives start out working well, problems often eventually arise if manage-ment begins to feel that the production standard is set too low and, as a result,increases the amount of production needed to earn the same incentive payout.If such rate-cutting is perceived to be unfair, workers may restrict their outputand management’s credibility may be irreparably harmed (Lawler, 1971; Roy,1952). Finally, individual incentive plans alone will not motivate cooperativebehaviors. As a consequence of such challenges, merit pay is a more commonPFP system.

Merit pay.

Merit pay is by far the most common PFP program, beingused in roughly 90% of US organizations (with managerial and professionalemployees most likely to be covered; Cohen, 2006), as well as in many othercountries (Heneman & Werner, 2000). Merit pay is typically defined as anincrease to base salary (often on an annual basis) that is based on (subjective)performance appraisal ratings, usually by an employee’s supervisor.

5

Merit paycan be said to exist objectively when performance ratings validly differentiateemployees on the basis of performance and these differences are positivelyand meaningfully correlated with salary increases in a particular year (and,over time, with salary levels).



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Although merit pay policies are very common, both employers andemployees are often less than satisfied with their results. One problemencountered in many organizations is that merit ratings have a high mean andlittle variance (Heneman, 1992). Without sufficient differentiation in meritratings (and thus, merit increases), it is easy to understand why many employ-ees are skeptical about the existence of genuine PFP in merit pay systems. In aHayGroup (2002) survey conducted in 335 companies, employees were askedwhether they agreed with the statement, “If my performance improves, I willreceive better compensation”. Only 35% agreed, while 27% neither agreed nordisagreed, and 38% disagreed with this statement.

Given these challenges with merit rating programs, an entire literaturearose that sought to estimate the extent of rating “errors”. These errors includeleniency (overly favorable ratings) and central tendency (not using the lowand high ends of the scale), both of which result in a lack of differentiation inmerit ratings. Researchers have also studied the effectiveness of potential solu-tions to these errors, such as rater training and re-design of performanceappraisal instruments to reflect behaviors rather than traits. However,Murphy and Cleveland (1995) argue that this approach views performanceappraisal too narrowly—“as a measurement process” (p. 30)—and thus hasnot been very fruitful because many so-called rater errors “are consciouslymade and that failure to discriminate among persons…is often a highly adap-tive behavior” (p. 28). For example, very high ratings are likely to requiregreater justification because they result in higher salary costs, while low rat-ings may require difficult conversations with the ratee or even more difficultdecisions, such as termination. Arvey and Murphy (1998) conclude that ratingerrors such as central tendency, halo, and leniency, “which occupied so muchresearch space, are [now] thought to be relatively unimportant, trivial, anddue to understandable factors” (p. 163). They also “find a trend in increasedoptimism regarding the use of supervisory ratings”.

Rather than studying and controlling rating “errors”, a more straightfor-ward and aggressive approach to achieving greater differentiation is to use aforced distribution policy, such that a certain percentage of employees mustfall into each of the performance rating categories. For example, rather thanhaving a distribution (using a four-point scale with 4 being high) that oftencomes out to be in the neighborhood of 5% rating a “1”, 25% “2s”, 55% “3s”,and 15% “4s”, a forced distribution policy might require a distribution morelike 20% “1s”, 30% “2s”, 40% “3s”, and 10% “4s”. A number of companies haveinstituted these forced distribution systems (Scullen, Bergey, & Aiman-Smith,2005). Some (e.g., General Electric) have continued to use them over time, whileothers have encountered problems having to do with employee morale and/orequal employment opportunity, leading them to discontinue or modify theirsystems (e.g., Ford and Pfizer; even GE seems to have tempered their systemrecently). In addition, there are concerns about perceived unfairness and effects


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on cooperation among employees. However, to the degree that such systemsare used to identify and discharge low performers (and reward high perform-ers), there are, as might be anticipated, potentially important sorting effects(Scullen et al., 2005).

Moreover, even where PFP does exist in an objective sense in merit paysystems, process issues may serve to either clarify or obscure this fact. Gomez-Mejia and Balkin (1992), for example, highlight the role of policy choices suchas pay disclosure versus pay secrecy (Colella, Paetzold, Zardkoohi, & Wesson,2007) and participative versus authoritarian pay system design. Where there isPFP, anything that increases employee awareness and understanding shouldincrease line of sight (and thus, motivation). For example, Shaw and Gupta(2007) reported that PFP was more strongly associated with lower turnoveramong higher performers to the extent that there was strong pay system com-munication, thus enhancing sorting effects.

Without in any way minimizing the challenges to PFP administration, itcan be argued that merit pay is stronger than usually believed for a number ofreasons (Gerhart & Rynes, 2003), a few of which we highlight here. First, asdiscussed, merit pay can have important sorting effects, even where thewithin-organization incentive effects of PFP appear to be small due to possiblerange restriction. Second, “merit pay” is often defined too narrowly. Merit rat-ings influence not only annual salary increases, but also promotions (Gerhart& Milkovich, 1989). The average pay increase due to promotion is in the rangeof 8–12% (Milkovich & Newman, 2008, p. 363), which is considerably largerthan the average within-grade merit increase (roughly 3% in recent years inthe US). Moreover, the pay increase due to promotion is considerably larger attop management levels, often more than 70% (Gerhart & Milkovich, 1990).

Consider one example of how different the PFP estimate can be, dependingon how promotion is treated. Konrad and Pfeffer (1990) concluded that,across 200 colleges and universities, the relationship between research pro-ductivity and faculty pay was “small”. Specifically, they reported that a onestandard deviation increase in research productivity was associated with onlya $400 increase in faculty pay. (The mean faculty pay in their study, whichused data collected in 1969, was $11,782 with a standard deviation=$4533.)However, their model included controls for faculty rank/level, meaning thatthey estimated the within-rank, PFP relationship, or the direct effect ofresearch productivity, excluding the (indirect) effect of research productivityon faculty salary via more productive faculty being more likely to be pro-moted. Konrad and Pfeffer’s (1990) Appendix Table A.2 shows that the corre-lation between research productivity and faculty salary was 0.493, whichprovides an estimate of the

total

(direct + indirect) effect of research produc-tivity on salary. This 0.493 correlation indicates that a one standard deviationincrease in productivity (without controlling for rank or other variables) wasassociated with pay that was higher by 0.493 salary standard deviations, which



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works out to an increase of $2234, an effect that is more than four times aslarge as the $400 estimate emphasized by Konrad and Pfeffer (1990). Considerthen that a faculty member one standard deviation above the mean of perfor-mance would have an expected salary of $14,016, compared to $9548 for a fac-ulty member one standard deviation below the mean, a difference of 47%.This does not strike us as a “small” PFP relationship.

Other studies, all using data on exempt employees in a wide range of jobs,also show that recognizing the promotion-related aspect of PFP results inlarger estimates of total PFP in merit pay systems. For example, Trevor et al.(1997) found that at one standard deviation below mean performance(mean=2.74,

SD

=0.66), mean salary growth over a 3-year period was $1705,compared with $2695 for performance at one standard deviation above themean, a difference of 58%. Gerhart (1990) reported that over a 5-year period,each one point increase in performance was associated with a 16.1% highersalary. Gerhart and Milkovich (1989) found that promotions, which play amajor role in salary growth (Milkovich & Newman, 2008), were influencedimportantly by performance. In the case of men, for example, those 1 pointabove the mean on a 4-point performance scale received 48% more promo-tions over a 6-year period than those with performance at the mean.

There has been surprisingly little empirical research on the influence ofmerit pay on worker performance, particularly in recent years. However, whatresearch does exist is primarily positive. For example, in a review of merit payresearch, Heneman (1992) found that reported relationships between meritpay and performance ratings are almost always positive, though not alwaysstatistically significant. Kopelman and Reinharth (1982) conducted a 3-yearstudy of 10 branch offices of a financial services organization. They examinedthe average size of the performance rating/merit pay increase relationship ineach branch and then correlated the size of these PFP relationships with aver-age performance ratings in each unit, both concurrently and lagged by 1 and2 years. They found that “the stronger the performance–reward tie, the higherthe level of

subsequent

performance” (p. 34). Greene and Podsakoff (1978)examined changes in production workers’ individual performance ratings andsatisfaction after

removal

of a merit pay system from a unionized paper plant.Relative to a control plant, average performance ratings dropped dramaticallyafter the removal of merit pay, as did satisfaction with pay and supervision forthose who had been rated as high performers.

In a contrary finding, Pearce, Stevenson and Perry (1985) reported thatperformance in 20 Social Security branch offices did not significantly improveafter the switch to a (nominally) merit pay system. However, there were avariety of problems with the study that made it a test of the effects of meritpay. For example, 8 of the 12 before-and-after tests were conducted at the

start

of the program, before any merit increases had actually been distributed. Inaddition, there was “evidence that the implementation of this federal merit


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pay program was flawed in several ways” (Pearce et al., 1985, p. 271), and theamount of money tied to merit was very small. As such, to the extent that a“merit system” was implemented at all, it appears to have been done in a veryweak fashion.

In summary, despite considerable skepticism about merit pay (Konrad &Pfeffer, 1990; Pfeffer, 1998), the actual evidence on merit pay is primarilypositive. Specifically, performance ratings are nearly always statistically sig-nificantly related to merit raises (Heneman, 1990), units with stronger meritpay programs have higher subsequent performance (Kopelman & Reinharth,1982), and removal of merit pay can result in lower subsequent performance,as well as lower satisfaction among top performers (Greene & Podsakoff,1978). High performers are less likely to leave (Trevor et al., 1997) and high-achievers are more attracted (Trank et al., 2002) to organizations where PFPis strong. Thus, as with individual incentive systems, there appear to be bothincentive and sorting effects associated with merit pay. In addition, meritratings are clearly associated with probabilities of promotion, which in turnare associated with considerably higher rewards than “regular” meritincreases and result in significant accumulations over time. Although moreresearch would certainly be welcome, a comprehensive look at the existingresearch suggests that merit pay exists in many organizations, and that it canpositively influence performance.

Rewards at the Supra-individual Level: Group- and Organization-level PFP Plans

Over the past two decades, organizations have increasingly moved towardevaluating and rewarding performance at plant, division, and corporate levels.There are a variety of reasons for this trend. One is that more jobs and projectsare being designed in such a way that success is dependent on the cooperationof multiple employees (Hollenbeck, DeRue, & Guzzo, 2004). Another is thatwhen jobs are designed independently and employees rewarded only on thebasis of their individual performance, aggregated individual performance maynot add up to optimal organizational performance (Schuster, 1984). Yetanother reason, as previously noted, is that influential management gurus(Deming, see Gabor (1992) and Pfeffer (1998)) have touted the superiority ofteam- or group-based systems, arguing that individual reward systems causeemployees to compete with one another, attaining personal success at theexpense of other employees or the larger organization.

In this review, we examine the evidence with respect to group-based plans.We begin with plans focused on relatively large units of analysis such as gain-sharing, profit-sharing, and employee stock ownership plans. We begin therebecause these plans have a longer history and a much stronger research base,particularly in ongoing employment settings. We then turn to reward systemsfor small work groups or teams, where evidence (particularly outside of thelaboratory) is scarce, and the results much less clear.



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Gain-sharing.

Gain-sharing is a results-based program that generallylinks pay to performance at the facility level. Theoretically, gain-sharingprograms are expected to be less motivational than individual incentiveprograms, given that outcomes are dependent on other workers as well asbroader environmental factors (e.g., economic downturns or entry of newcompetitors). However, they also have a number of expected advantages. Forexample, they can be customized to target multiple objectives in addition toproductivity, such as schedule attainment, safety, or customer satisfaction. Inaddition, goals are generally both objective and based on historical stan-dards—factors that are likely to facilitate employees’ goal acceptance (Case,1998). The various potential advantages of gain-sharing led Milkovich andWigdor (1991, p. 86) to suggest that it might:

provide a way to accommodate the complexity and interdependence ofjobs, the need for work group cooperation, and the existence of workgroup performance norms and still offer the motivational potential ofclear goals, clear pay-to-performance links, and relatively large payincreases.

Indeed, the empirical evidence on gain-sharing appears to be quite favorable(Gerhart & Milkovich, 1992; Lawler, 1990; Welbourne & Gomez-Mejia,1995). For example, one 5-year study of 28 sites found positive effects of avariety of gain-sharing plans on productivity (Schuster, 1984). Another study(Hatcher & Ross, 1991) found that changing from individual incentives togain-sharing resulted in a decrease in grievances and a fairly dramaticincrease in product quality (defects per 1000 products shipped declined from20.93 to 2.31). Arthur and Jelf (1999) examined gains (in labor costs, costs ofmaintenance materials, perishable tools, scrap, rework, and supplies) from a5-year gain-sharing plan in an auto parts manufacturing company with 1600employees. They found a total of $15 million in savings over the 5-yearperiod, as well as a decrease of 20% in absenteeism and 50% in grievances. In afollow-up study, Arthur and Aiman-Smith (2001) reported an increase (from40% to 60%) in the ratio of “double-loop” to “single-loop” suggestions

6

fromworkers over a 4-year period—a phenomenon that they interpreted asevidence of increased organizational learning.

In another study with positive results, Wagner, Rubin, and Callahan(1988) found a substantial increase in productivity (103.7%) under afoundry gain-sharing plan, as well as statistically significant decreases inlabor costs and grievances. An interesting feature of this particular study isthat in contrast to most gain-sharing plans (McAdams, 1995), the evaluatedplan did not have a strong worker participation feature. Despite this, theauthors also reported greater employee concern for cooperative behaviorsas well as co-worker “policing” of quantity and quality to assure equitablecontributions.


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Similarly, Banker, Lee, Potter, and Srinivasan (1996) compared resultsfrom 15 stores of a major retailer with store-level incentives against resultsfrom another 19 stores without incentives. Time-series analyses showed thatstores with the incentive plan had 4.9% higher sales, 3.4% higher customersatisfaction, and 4.4% higher profit than stores without the incentive plan. Inaddition, there were three contextual variables that proved to be important(positive) moderators: tough market competition, upscale customer profiles,and low ratios of supervisors to sales associates.

Petty, Singleton, and Connell (1992) compared one division of an electricutility company that implemented a gain-sharing plan to another division thatdid not. The gain-sharing division performed better on 11 of 12 objective per-formance measures, providing an estimated savings of somewhere between$857,000 and $2 million. In addition, there were also positive differences inemployee perceptions of teamwork, fairness, employee involvement, andother attitudes.

Despite this generally positive evidence, gain-sharing plans are not withouttheir problems. For example, the program studied by Petty et al. (1992) wassubsequently discontinued due to a breakdown in union negotiations overhow to distribute the gain-sharing pie among employees. Based on the initialsuccess of the gain-sharing unit, unionized employees in other divisionspressed to be covered by the plan and to share in the payouts. However, man-agement wanted the bonus to be distributed as a percentage of worker salarieswhile the union wanted identical (flat) bonuses for all employees. The impasseover this issue resulted in the entire plan being discontinued.

Gain-sharing programs can also come under pressure in years when thereis no bonus payout. For example, a plan at DuPont’s Fibers Division was dis-continued, and one at Saturn substantially watered down in terms of the vari-able pay component (Bohl, 1997) over this issue. In fact, programdiscontinuation seems to be relatively common. For example, Kaufman(1992) found that of 104 companies that had implemented a particular kind ofgain-sharing program (Improshare) between 1981 and 1988, 23% had discon-tinued the plan by the time of his study. In addition, another 163 companiesthat were known to have implemented Improshare plans during the perioddid not return the survey, so it is likely that the discontinuation rate washigher than the one measured.

As discussed earlier, another potential concern is a negative sorting effect.For example, a study by Weiss (1987) at AT&T found that extreme performers(at both the top and bottom) were more likely to leave under a gain-sharingplan. More generally, as we have noted, high performers have been found tobe highly sensitive to relative rewards and more favorably inclined towardindividual (versus group) PFP (Trevor et al., 1997; Trank et al., 2002).

Finally, the returns from gain-sharing programs appear to dwindle withincreasing plan size. For example, Kaufman (1992) reported that doubling the



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number of employees covered by Improshare from around 200 to 400 wasassociated with a reduction in the average productivity gain of nearly 50%. Inaddition, Zenger and Marshall (2000) found that incentive intensity in groupand organization plans was negatively associated with the administrative unitlevel of the plan (e.g., department or work team versus entire organization)and unit size. As such, it appears that organizations’ incentive design deci-sions are consistent with theory and research on the negative relationshipbetween group size and incentive effects. Thus, while Pfeffer (1998) claimsthat the “evidence for the effectiveness of various group incentives is compel-ling, while the empirical evidence for free-riding is sparse” (p. 219), the evi-dence in fact indicates that as group or organization size increases, theeffectiveness of group/organization-based PFP plans becomes weaker. (Seealso the studies by Kruse (1993) and Blasi, Conte and Kruse (1996) in thefollowing two sections.)

Profit-sharing.

Profit-sharing plans pay out based on meeting a profit-ability target (e.g., return on assets or net income). Profit-sharing can be eitherdeferred (i.e., to fund retirement) or paid in cash, while payouts may be eitherformula-based (e.g., a fixed percentage of net income) or discretionary. Interms of employee attitudes, Weitzman and Kruse (1990) reported generallypositive employee attitudes toward profit-sharing, although this was“tempered…by the risk of fluctuating income” (p. 123).

Several researchers have provided estimates of the effect of profit-sharingon productivity. Weitzman and Kruse (1990) estimated the mean effect at 7.4%,and the median at 4.4%. A meta-analysis by Doucouliagos (1995) of 19 studiesand 32,752 firms reported a correlation between profit-sharing and productiv-ity (generally measured as value added or sales per employee) of

r

=0.05.However, the correlation was significantly higher in employee-managed firms(

r

=0.26) than in more traditional firms (

r

=0.04). We note, however, thatDoucouliagos’ definition of profit-sharing included other plans such as gain-sharing. Thus, it is possible that plans covering smaller numbers of employees(such as gain-sharing) may have partly driven the results.

In perhaps the most extensive study to date, Kruse (1993) surveyed 275firms employing a total of approximately 6 million employees. Kruse foundthat productivity growth in profit-sharing companies was 3.5–5.0% higherthan in companies not using profit-sharing. However, there were someimportant contingency factors. For example, cash plans exhibited substan-tially higher productivity growth than deferred plans, particularly in within-industry models. Size was also an important contingency factor, with annualproductivity growth of 11–17% in companies having fewer than 775 employ-ees versus 0–6.9% growth in companies with more than 775 employees. Athird contingency factor, formula versus discretionary, indicated an advantagefor discretionary plans, particularly using within-industry models. Kruse


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speculated that such plans probably require trust and a positive employee rela-tions climate in order to be effective.

Research on profit-sharing, like research on gain-sharing, suffers from anumber of limitations (Kruse, 1993). For example, both research streams arelikely to suffer from selection bias (i.e., successful profit-sharing plans aremore likely to be studied because unsuccessful plans are less likely to surviveor be written about). Secondly, because most studies have used cross-sectionaldata, there is the possibility of reverse causality (i.e., gain- and profit-sharingplans may be more likely to be adopted by companies that are more produc-tive or profitable in the first place). For example, when Kim (1998) used asimultaneous equations model to control for reverse causality and profits, thepositive effect of profit-sharing on profits disappeared. Third, the effects ofboth gain-sharing and profit-sharing programs may be confounded withother positive management practices that are not measured or controlled.

Finally, the typical measure of productivity in profit-sharing research isvalue added (the extent to which the price of a product exceeds the cost of thefactor inputs such as labor and capital), rather than a measure of physical pro-ductivity (e.g., units produced). Obviously, the price of a product can be influ-enced by many factors other than productivity, such as industry trends andmarketing (Gerhart & Rynes, 2003). Thus, finding a relation between profitsdistributed per worker (profit-sharing) and value added does not necessarilymean that profit-sharing causes higher productivity.

For these reasons, the following factors should be kept in mind withrespect to the modestly positive results summarized previously. First, profit-sharing appears to be associated with higher overall labor costs (Kim, 1998;Mitchell, Lewin, & Lawler, 1990), a finding consistent with agency theory pre-dictions that workers will require a compensating differential for acceptingthe risk involved in variable compensation programs. Second, even whereprofit-sharing has been found to have a positive relationship with productiv-ity, it is not clear whether the relationship is causal. Third, the hoped-foradvantage of making labor costs variable in relation to profitability will berealized only if profit- or gain-sharing plans survive years when no payoutsare made.

Stock plans.

According to the National Council on Employee Ownershipwebsite, as of February 2008, 11.2 million employees owned company stockworth more than $928 billion via employee stock ownership plans (ESOPs),stock bonus plans, or profit-sharing plans invested in stock. Another1.5 million employees held $133 billion in stock via 401(k) plans. In addition,9 million employees participated in broad-based stock options plans, whileanother 11 million participated in stock purchase plans. Thus, approximately33 million employees, or about one-third of all private sector employees,appear to have some degree of ownership in their employing companies.



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Moreover, partial employee ownership has grown from an estimated 1% ofcorporate equity in the 1920s to almost 5% (Blasi, Kruse, Sesil & Kroumova,2003). However, these same authors indicate that “significant” employeeownership (20% or more of a company’s stock) is mainly associated with smalland medium-sized family and independent businesses.

Another prominent feature of stock plans is that different types of planstend to be used for different employee groups. For example, stock purchaseplans and provision of company stock through 401(k) plans are roughlyequally prevalent across employee categories. In contrast, stock options,outright stock grants, and phantom stock plans (where pay is linked to stockperformance, but with no actual option or ownership) are still heavilyweighted toward officers and executives. As such, these latter plans will be dis-cussed primarily in our coverage of executive compensation.

With that said, it is worth noting that stock option plans have frequentlybeen used as a major attraction and retention strategy for non-executives ofhigh-tech companies and small start-up firms. Microsoft, for example, createdmore than 10,000 millionaires through its stock option program (although ithas now been discontinued, in favor of stock grants instead).

7

Also, in one ofthe few studies of stock options focused below the executive level, Gerhart andMilkovich (1990) examined the relationship between the percentage of topand middle level managers (within six levels of the Board of Directors) eligiblefor stock options in a firm and the firm’s return on assets. Their results sug-gested that a company having 20% of managers eligible for stock options hada predicted return on assets of 5.5%, as compared with a predicted return onassets of 6.8% (or roughly 25% higher) for companies having 80% of managerseligible. However, because these findings pertain to relatively high-level andhighly paid managers, results might be weaker for plans covering a broaderrange of employees, particularly in larger firms (Oyer & Schaefer, 2005).

Turning to stock ownership plans (as opposed to options), it is generallyassumed that whatever effect ESOPs might have on firm performance is likelyto be mediated through employee attitudes. Klein (1987) hypothesized thatESOPs might affect employee attitudes and motivation in three ways: (1)through a “pride in ownership” effect, regardless of financial benefit; (2)through the financial benefits yielded by the plan; and (3) through improvedtwo-way communication between employees and managers. She tested thesehypotheses on data from 2804 employees in 37 ESOPs. In addition, she alsoobtained data from key managerial respondents in each firm pertaining to theextent to which the ESOP was a core part of management’s philosophy, as wellas the resources devoted to ESOP communication.

Klein’s findings did not support the first hypothesis (mere pride of own-ership), but did support the second and third. Specifically, the

R

2

betweensize of employer financial contribution and organizational commitment was0.17, and the R

2

with turnover intention was 0.25 (higher contributions were


270


associated with lower intentions). Adding the management philosophy andESOP communication variables increased the

R

2

to 0.30 for organizationalcommitment, and 0.39 for turnover intentions. There was also support for arelationship between perceived worker influence on decisions and employeecommitment, but not with turnover intentions.

In a study of “psychological ownership”, Wagner, Parker and Christiansen(2003) examined how the 401(k) participation of employees and their percep-tions of organizational climate related to: (a) attitudes toward ownership (e.g.,beliefs that individual employees should share both the financial successes,and setbacks, of their employer); (b) ownership behaviors (e.g., trying to cutcosts, making suggestions for work improvement, and seeking informationabout their employer’s financials); (c) attitudes toward the organization; and(d) financial performance (sales per square foot, net sales, and ratio of netsales to planned sales). They examined these relationships at the group level ofanalysis, studying 204 work groups from 33 stores in a large retail organiza-tion. (Employees had the option of investing their 401(k) contributions incompany stock or mutual funds, whereas company matching contributionswere in the form of company stock). Their results showed that participation in401(k) plans and working in a climate supportive of self-determination wererelated to attitudes toward ownership, ownership behaviors, and attitudestoward the organization. In addition, ownership behaviors were positivelyrelated to group financial performance. Thus, both Klein (1987) and Wagneret al. (2003) suggest that employee attitudes are important determinants of theeffects of employee ownership.

Most other studies of ESOPs have examined their effects on productivity orfinancial outcomes, rather than attitudes. Overall, the results of these studiessuggest very modest benefits to stock ownership. For example, Blasi et al.(1996) examined 562 Employee Ownership Firms (EOFs) and compared theirfinancial performance (profitability and price/earnings ratios) to 4716 firmswithout such plans. Overall, they found no main effect for EOF on firm per-formance. Instead, the relationship between EOF and performance dependedto a “striking” (p. 75) degree on firm size. Specifically, Blasi et al. (1996) foundthat for the smallest quartile on firm size (maximum firm size=1015), EOFfirms were 1.3 percentage points higher on ROA, and 1.5 percentage pointshigher on price/earnings (P/E) ratio. In contrast, in the quartile where firmsize ranged between 3014–12,700 employees, EOF firms had ROAs that were1.9 percentage points

lower

, and P/E ratios that were 1.6 percentage pointslower. Thus, the coefficients generally revealed a declining pattern of returnsby firm size. Similarly, Doucouliagos (1995) conducted a meta-analysis basedon 17 studies and 31,323 firms and found a weighted mean correlationbetween employee ownership and productivity of only

r

=0.03. Thus, thisstudy also suggests that the typical effects of ESOPs on firm productivity arevery modest.



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More recently, Blasi et al. (2003) report that, based on seven large-samplestudies, “we observe at least neutral and generally positive effects of employeeownership on firm performance” (p. 908). However, they indicate that fewemployers (probably less than 1%) use stock ownership in a way that would beexpected to generate large incentive effects (i.e., in combination with highgoal-setting, active employee participation, and strong two-way communica-tions between workers and management). Rather, most companies adopt suchplans for their financial, tax, or takeover defense advantages—or as substitutesfor defined benefit pension plans—rather than as motivational plans designedto induce employees to “act like owners”. Nevertheless, results from Klein(1987), Blasi, Conte et al. (1996) and Blasi, Kruse et al. (2003) and Wagneret al. (2003) suggest that ESOPs

can

have a positive impact on firm perfor-mance under the right conditions (e.g., in smaller firms, in firms where own-ership improves communication and employee attitudes, and in firms havinggreater financial success).

Compensation for small groups and teams.

In small group or team-basedsystems,

8

conflicting reward objectives come to the forefront. “One objective isto foster member cooperation and cohesiveness in executing team projectsand assignments. The other is to recognize individual differences in thecontribution members make toward team accomplishments. While the firstobjective is compatible with extending reward payouts to members as equalshares, the second objective argues for members receiving equitable rewardpayouts in proportion to their relative contribution” (Weinberger, 1998,p. 18). Or, as Hollenbeck et al. (2004, p. 362) put it: “The degree to whichteams should operate and be rewarded for behaving as cooperative or compet-itive systems is at the heart of the debate on reward structures for teams”.

Unfortunately, extant research does not provide a great deal of advice tomanagers on how to deal with this conflict. Although there have been a largenumber of studies of group rewards (not always pay) in laboratory settings,findings from field settings are very scarce. In addition, existing laboratorystudies often employ subjects and manipulations that are considerably differ-ent from those observed in employment settings. Perhaps not surprisingly,then, an extensive review of this literature by DeMatteo, Eby and Sundstrom(1998) presented few clear conclusions about the likely effects of differentways of compensating teams in ongoing organizations. We turn now to pro-viding our own updated review.

In one of the few field studies of small-group reward systems, Wageman(1995) examined the effects of implementing individual, group-based, and“hybrid” (mixed individual and group) rewards on intact groups of techniciansat Xerox’s Customer Service Division. Wageman sought to identify managerswho would be highly motivated to implement alternative reward structures(which in the past had been primarily individually-based). Specifically, she


272


identified five district managers “who expressed strong interest in participat-ing and were willing to alter the ways in which rewards were distributed intheir districts” (p. 155). In addition, she recruited two additional district man-agers who agreed to continue rewarding employees on an individual basis (i.e.,the status quo). Participation of these 7 districts yielded 60 groups (353 tech-nicians) in the group outcome condition, 77 groups (398 technicians) in thehybrid outcome condition, and 55 groups (369 technicians) in the individualoutcome condition.

All groups in a given district implemented the same type of reward condi-tion. Prior to implementation, all first-line managers received a one-daytraining session in “planned spontaneous” reward practices. In addition,managers developed monthly plans for delivering rewards to groups and/ortheir members. Furthermore, as the study progressed, managers recorded allrewards delivered each month and sent the list to the author. Three types ofoutcomes were measured: (1) archival data on group performance; (2) surveyand archival measures of group interactions; and (3) survey measures of indi-vidual motivation and satisfaction. In addition, an extensive measure of pre-implementation group interdependence (assessed via such things as theextent to which groups actively coordinated the queuing of service calls ormanaged their expenses collectively) was developed. This served as a “before”measure for assessing change in group interdependence as a result of thereward implementation.

Although Wageman (1995) reported a variety of results, the most notablewas that pure group or pure individual systems were associated with betterperformance than hybrid systems:

Findings showed that the work performed by the technicians in thisstudy can be done well in two different ways: independently and inter-dependently…. By contrast, a look at the dynamics of hybrid groupsshows that both the independent and the interdependent processeswere barely half-fueled in the hybrid-task/hybrid-outcome condition.Hybrid tasks required groups to act sometimes as groups, sometimes asindividuals. While the individual part came naturally, acting as a groupdid not. Individuals perceived the introduction of group-level elementsto their work and rewards as an add-on, not a fundamental change inthe work, and it undermined attention to the basic aspects of the task.(Wageman, 1995, p. 173–175)

In assessing the likely generalizability of Wageman’s findings, it is impor-tant to note that beyond praise and recognition from managers, the onlymoney managers distributed under the system came from their discretionarybudgets, which were not connected to annual merit increases. In addition,only one type of job was studied. Moreover, Wageman only observed perfor-mance over a 4-month period (although some individual difference variables



273

were measured eight months later), and those months did not include theend-of-the-year annual salary increase. Still, Wageman reported that: “theintervention produced significant differences in the reward practices of partic-ipating districts…and it created three distinct levels of outcome interdepen-dence—group, hybrid, and individual” (p. 160). As such, at the very least, herstudy suggests that the move from individual to hybrid systems may befraught with danger—perhaps more danger than moving to a more extreme(i.e., completely interdependent) system.

The balance between group and individual rewards was also addressed in astudy reported in a short research summary by Katz (2001). She was interestedin how to design group incentives that might encourage high performers tohelp weaker members, while simultaneously increasing weak performers’desire to improve their own performance. To do this, she tested 35 three- orfour-member teams in an interactive simulation that provided opportunitiesfor team members to both cooperate with and compete against one another.Thus, “although the simulation did not re-create a management setting per se,it did involve many of the conditions that characterize one: dispersedinformation, time pressures, easily evaluated performance, and the need forcollaboration” (Katz, 2001, p. 22).

Teams were compensated via one of five different structures: pay equality(all members received the same pay); pay equity (members were compensatedbased on individual performance) and three hybrid methods: group threshold(pay rose after the team as a whole reached a certain target); individual thresh-old (pay increased after every member of the team hit an established target),and relative ratio (team members were paid for individual performance, butonce the highest paid earned twice as much as the lowest paid, some of thehighest performer’s earnings were transferred to the poorer performers).

Results showed that the two threshold schemes were better at keepinghigh performers motivated than the equality scheme, and better than theequity scheme at encouraging high performers to share information withothers. In addition, the individual threshold scheme created a strong driveamong lower performers to improve their performance. In contrast, the rel-ative ratio scheme was the least effective because it placed a cap on rewardsand made groups members constantly concerned about how they were per-forming relative to others. Katz concluded that group and individual thresh-old systems might be most applicable, particularly in situations when groupoutputs are quantifiable, when members’ roles are not highly differentiated,when highly skilled workers are not enough to “carry” a whole team, andwhen there is sufficient time for high performers to teach less effectivemembers.

Because small-group compensation research is not yet plentiful, it is possi-ble that future meta-analytic studies will reveal a number of main effects orgeneralizable advice for compensating small groups or teams. At the present


274


time, however, the effectiveness of small-group compensation systems appearsto be affected by multiple contingency variables (DeMatteo et al., 1998).

For example, one variable (in addition to group size—see our earlier dis-cussion) that has long been hypothesized to moderate the effectiveness ofincentive plans is the extent to which tasks are truly interdependent. Forexample, Shaw, Gupta and Delery (2002) found that in an industry wheretasks are mostly independent (long-distance trucking), firm accident rates andtime spent out-of-service were lowest (i.e., performance was best) when therewere high individual pay incentives and high pay dispersion across drivers. Incontrast, in a second study in the concrete pipe industry, they found thatsafety performance was poorest when high pay differentiation was coupledwith high task interdependence (measured via the existence of self-managedteams).

However, some theoretical models have suggested that the relationshipsbetween task interdependence, reward systems, and performance may be evenmore complicated than suggested by Shaw et al. (2002). For example, Siemsen,Balasubramanian and Roth (2007) used mathematical logic to argue that theappropriate team reward system depends on the nature of the dependency(i.e., for output-, help-, or knowledge-sharing). Similarly, Siggelkow (2002)proposed that appropriate rewards depend on whether team outputs are com-plements, or substitutes, for one another. Chillemi and Gui (1997) suggestedthat employers’ optimal responses to individual salary demands by teammembers also depend on how much team turnover the group can afford.

Empirical laboratory studies, too, have suggested that things may be quitecomplicated with teams. For example, Beersma et al. (2003) engaged 75 four-person teams in a distributed decision making computer simulation task.Although the task was interdependent, half the teams were told that theywould be rewarded based on individual performance (with the highest-performing members winning $10 each), while the other half were rewardedbased on team performance ($40 to the highest-performing team). Eachteam participated in 1.5 hours of training appropriate to its reward condi-tion (i.e., teams rewarded on an individual basis received individual perfor-mance feedback, while teams rewarded on a team basis received team-levelfeedback).

Results showed that teams rewarded on an individual basis outperformedothers on

speed,

but under-performed on

accuracy

relative to those rewardedon a team basis. In addition, there was an interaction between two personalitycharacteristics of team members and the reward system. Specifically, teamswith higher levels of extroversion and agreeableness performed relatively bet-ter under the cooperative condition than did teams with lower levels of thesepersonality traits. Finally, analyses showed that the poorest individualperformers were more sensitive to the interaction of reward structure andpersonality than were the highest-performing individuals.



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In a subsequent study, Johnson et al. (2006) extended the findings ofBeersma et al. (2003) by putting 80 student teams through two rounds of asimilar computer simulation, utilizing four conditions. In one condition,teams were rewarded competitively (i.e., on the basis of individual perfor-mance) in both rounds (competitive/competitive); in a second condition, theywere rewarded cooperatively (based on team performance) in both rounds(cooperative/cooperative). For the other teams, the reward systems wereswitched between rounds, resulting in a competitive/cooperative conditionand a cooperative/competitive condition.

Results from this two-phase experiment showed that teams in the cooper-ative/competitive condition performed similarly in the second (competitive)round to teams that were competitively rewarded all along. In contrast, com-petitive/cooperative teams performed quite differently from teams that werecooperatively rewarded in both rounds. Specifically, in the second (coopera-tive) round, instead of being higher on accuracy than on speed (as were coop-erative/cooperative teams), they were higher on speed than accuracy.Moreover, competitive/cooperative teams slowed down at Time 2 but did notimprove on accuracy as compared to Time 1. In addition, cooperativelyrewarded teams shared significantly more information than competitivelyrewarded teams, with information-sharing partially mediating the relationshipbetween reward structure and team accuracy. The authors concluded that theirresults were more complicated than what would be predicted by simple con-tingency theories, since performance in Time 2 was dependent on how teamshad been rewarded in Time 1. As such, team results appeared to be path-dependent, as suggested by the resource-based view of the firm (Barney, 1991).

Summary

Every pay program has its advantages and disadvantages. Programs differ intheir sorting and incentive effects, their incentive intensity and risk, their useof behaviors versus results, and their emphasis on individual versus groupmeasures of performance. Individual-based plans are likely to fit better wherework is independent and competition between individuals is encouraged, butless well where there is interdependence and a greater need for cooperation.Group and organization-based plans would seem to provide the solution inthe latter case. However, as we have seen, such plans have potentially weakerincentive effects and may also have adverse sorting effects, particularly as thenumber of employees covered increases. Results-based plans can achievestrong incentive intensity, but a compensating differential for the increasedrisk borne by workers is likely to make such plans more costly, unless expectedperformance improvements actually materialize. Also, objectives not explic-itly included in the plan may be ignored. Behavior-based plans can be betteron these dimensions, but it is typically more difficult to achieve strong incen-tive intensity without objective performance measures.


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Because of the limitations of any single pay program, organizations oftenelect to use a portfolio of programs (e.g., merit pay combined with profit-sharing) that focus on different objectives, which may provide a means of hedg-ing the risks of particular pay strategies while still achieving most of the hoped-for benefits (Gerhart et al., 1996). Of course, as the Wageman (1995) researchsuggests, hybrid plans are not always superior, especially to the degree that thereare mixed or conflicting messages and the relative size of incentives tied todifferent performance objectives is not consistent with the stated priorities.

There continues to be a need for research on PFP programs of all types,with the most valuable research including measures of mediating variables (tobetter understand causal processes), and longitudinal designs (to betterunderstand survival, sorting effects, and also to satisfy time precedence stan-dards for understanding causal processes). In addition, given that most PFPplans are combination or hybrid plans, it would be useful to see more researchthat studies such plans as holistic entities, rather than studying only one aspect(e.g., profit-sharing) and not measuring other co-existing PFP plans.

In the previous review, we have emphasized the fact that the empiricalevidence shows that PFP programs can “work”, and work quite well.Nevertheless, we do not want to lose sight of the equally important fact thatPFP programs can also have unintended consequences that may negativelyinfluence effectiveness. (For example, executives at Enron were found to haveinflated earnings to increase the stock price and thus, their own compensa-tion.) The recent financial industry “meltdown” is attributed by some tooverly strong and risk-inducing incentive plans. Thus, there is a risk to usingPFP programs, especially those with high-intensity PFP.

The empirical evidence on this point is less systematic and organized, yet itis important to recognize. Often, the evidence comes from experiences of indi-vidual organizations. Typically, the problem is that PFP motivates “too well”,but in the wrong direction. Examples include mis-coding health conditions inhospitals to get higher government reimbursement rates and auto repair shopsfinding (non-existent) mechanical problems so they could sell more repairs(Gerhart, 2001) In both cases, the incentive plans were designed to rewardemployees for driving revenue. Both plans accomplished that, but employeesused unacceptable means to do so. (Our later section on executive PFP pro-vides further examples of unintended consequences.)

PFP plans, particularly to the degree they rely on results-based perfor-mance measures (e.g., profits), carry other risks as well. For example, PFPplans are expected to increase labor costs, particularly in plans that add a PFPcomponent with no reduction in base salary. Indeed, companies with aggres-sive PFP programs such as Whole Foods, Lincoln Electric, and Nucor Steel,do have relatively high labor cost per worker. However, to date these highercosts have been more than offset by higher productivity (i.e., fewer workers toproduce a particular level of output). So, the model is one of highly-paid,



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highly-productive workers, but fewer of them. Of course, not all companieshave been able to execute their PFP programs as successfully.

In plans that use the PFP component as a replacement for some portion ofbase pay, direct costs are more contained. However, employee relations prob-lems are likely to arise in years when the PFP portion does not pay out, orwhen management retrospectively decides that the performance hurdle forpayout is too low (Roy, 1952; Whyte, 1955). Consequently, in deciding on theuse and design of PFP programs, “One must consider whether the potentialfor impressive gains in performance” from such plans is “likely to outweighthe potential problems, which can be serious” and be aware that such plans arebest thought of as representing “a high risk, high reward strategy” (Gerhart,2001, p. 222).

In other cases, the failure of PFP programs may be less dramatic, but still aproblem. How long a PFP plan remains in place is sometimes used as a measureof its success. While a short-term gain in performance from a pay plan thatdoes not last long should not be dismissed (Gerhart et al., 1996), a plan thatgenerates longer-term performance gains is, of course, preferred. Also, chang-ing plans too often can result in a counterproductive “flavor-of-the-month”perception among employees (Beer & Cannon, 2004). So, survival is a usefulindicator. Evidence on survival is also important for estimating statistical effectsizes of PFP plans because studying only plans that survive would result in abiased sample (Gerhart et al.).

A recent paper by Beer and Cannon (2004) provides survival informationon 13 PFP experiments conducted at Hewlett-Packard in the mid-1990s. In 12of the 13 cases, the programs did not survive, in part, Beer and Cannon con-clude, because of a perceived lack of fit with H-P’s high-commitment cultureat the time. In the H-P case, the PFP initiatives had unintended consequencesand managers eventually decided that performance could be more effectivelyimproved “through alternative managerial tools such as good supervision,clear goals, coaching, training, and so forth” (Beer & Cannon, 2004, p. 13).They note that: “This decision [did] not imply that managers believed that paydid not motivate or that it could not be used effectively in other settings” (Beer& Cannon, 2004, p. 13). Rather, managers decided that at H-P, there were bet-ter alternatives. As Ouchi (1979), for example, pointed out, “control systems”can take many forms other than PFP (e.g., careful selection of committedemployees, socialization, as well as rituals and ceremonies to reward thosewho display attitudes and values seen as leading to organization success).Moreover, to the degree that it is difficult to measure both performanceoutcomes and the behaviors that lead to performance outcomes, it may provedifficult to use PFP and greater emphasis on alternative control systems maybe required (Ouchi, 1979; Williamson, Wachter, & Harris, 1975).

The high failure rate of this one set of PFP plans at H-P warrants a few addi-tional comments. First, the particular PFP programs that Hewlett-Packard


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experimented with appear to have been mostly team-based programs (Led-ford, 2004). Although these did not survive, H-P has for many years used andcontinues to use other PFP programs such as broad-based stock options andprofit-sharing (Beer & Cannon, 2004). Second, the fact that managers decidedto “experiment” with PFP plans may indicate the influence of what other orga-nizations were doing, as opposed to what would best fit H-P. Benchmarking isa standard and necessary practice in compensation, but as in any area of man-agement, it can devolve into following fads and fashions. Certainly, we knowthat institutional forces play a role in compensation policies and practices(Conlon & Parks, 1990; Eisenhardt, 1985b; Gerhart et al., 1996). Third, PFPprograms may generate desirable sorting effects, and it is possible that someperceived lack of fit with the pre-existing culture, resulting in dissatisfactionamong some employees is a necessary part of this process (Cannon & Beer2004; Gerhart & Rynes, 2003). Finally, whenever the risk of implementing anew PFP plan is discussed, it is also necessary to discuss the risk of not imple-menting such a plan (Gerhart et al., 1996), since changes in PFP strategy cansometimes pay off handsomely.

Executives and PFP

To this point, our discussion has dealt with PFP issues as they affect a wide rangeof employee types. However, both employers and scholars recognize that, dueto their strategic importance to the organization—as well as the heightenedpotential for conflicts of interest and associated regulatory scrutiny—certainemployee groups require special attention in the design and study of their pay(Milkovich & Newman, 2008). Certainly, executives are one such group.Executives, especially chief executives, are also unique, of course, in that theirpay levels are much higher than those of nonexecutives and represent a sizeablepercentage (roughly 6% according to Bebchuk & Grinstein, 2005) of net income.According to the chief executive officer (CEO) Compensation Survey/2007conducted by the

Wall Street Journal

and the Hay Group (

Wall Street Journal

,2008), median CEO pay (defined as base pay, annual incentive/bonus, and thevalue of grants of stock options, restricted stock, and other long-term incentives)in 200 large US companies in 2007 was $8.85 million. However, the compositionof executive pay is also notable. Of the $8.85 million, only about $1.1 million,or 12%, was in the form of base pay, with the remainder in the form of eithershort-term (21%) or long-term (67%) incentives. In the great majority ofcompanies, the long-term incentive component is based on stock returns.

As will be seen, there is less research than might be expected on the effec-tiveness of PFP programs for executives. However, there is more research onthe degree to which PFP

exists

among executives (enough to generate twometa-analyses), as well as on the degree to which PFP intensity and use vary asa function of contextual organizational factors. Other work examines how thedesign of executive pay packages may influence the business objectives that



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executives choose, which likely has implications for performance as judged byshareholders. There is also research on the degree to which factors other thanperformance (e.g., sociopolitical factors) influence executive pay. (By implica-tion, the greater the role played by these non-performance factors, the smallerthe role played by PFP.) Finally, executive pay is also sometimes seen as influ-encing how non-executives (and other executives) in an organization feel andperform (Cowherd & Levine, 1992; Wade, O’Reilly, & Pollock, 2006). Thus,executive pay not only has potential consequences for firm performancethrough its effect on the performance of the executive, but also via its possibleimpact on the performance of other employees.

There is also great public interest in the level of executive pay. Walsh (2008,p. 30) observes that “Public concern about executive pay… is about fairness.Taken-for-granted norms of fairness are essential to the health of the freemarket system”. The question here is whether anyone, regardless of their per-formance, deserves to be paid so much. Public interest in this question can beseen to some degree in the congressional and regulatory attention given toexecutive pay (see our later discussion). Most recently, it has been readilyapparent as struggling private sector companies ranging from financial ser-vices institutions to auto manufacturers turn to the federal government forfinancial assistance. The norm to date has been that any firm expecting toreceive such assistance must agree to restrictions on executive pay. (For exam-ple, see our later discussion of the Troubled Assets Relief Program.)

We begin our review of executive PFP with a discussion of agency theory,the dominant theoretical framework in the area.

Agency Theory

For non-executives, motivational theories such as goal-setting, expectancytheory, reinforcement theory, and to some extent agency theory, havegrounded research and practice around performance-based pay. In the case ofexecutives, however, agency theory has overwhelmingly dominated the scene.Agency theory starts from the observation that once an entrepreneur hireshis/her first employee, there is separation of ownership and control (Jensen &Meckling, 1976). The entrepreneur (and/or others having ownership stakes, asin larger firms) retains ownership, but now must deal with an agency relation-ship, under which the owner (i.e., principal) contracts with one or moreemployees (i.e., agents) “to perform some service on their behalf whichinvolves delegating some decision making authority to the agent” (Jensen &Meckling, 1976, p. 308).

Agency costs: executives behaving badly.

Agency theory posits that self-interested, effort-averse, and relatively risk-averse managers (i.e., agents) maysometimes fail to act in the best interests of shareholders (principals) due todivergence of interests and information asymmetry (Fama & Jensen, 1983a,


280 • The Academy of Management Annals

1983b; Jensen & Meckling, 1976). As a result, shareholder welfare can sufferdue to such factors as suboptimal executive decisions, empire building,gaming of incentive systems, shirking, sociopolitical activities, excess perqui-sites extracted by executives, and so on. Dalton, Hitt, Certo and Dalton (2007)provide a thorough review of the evidence on the existence of agency costs andthe challenges in controlling them. They describe “the central tenet of agencytheory” to be “that there is potential mischief when the interests of owners andthose of managers diverge” and that this may allow executives “to extracthigher rents than would otherwise be accorded to them by owners of the firm”(Dalton et al., 2007, p. 2).

Although such costs are difficult to eliminate entirely, they can, underagency theory, be reduced through contracting (i.e., PFP) schemes that arebased on monitoring of executive behaviors and/or presumed outcomes (e.g.,firm performance) of such behaviors. Thus, boards of directors, acting onbehalf of shareholders, must decide the most efficient mechanism for aligningthe interests of the executive with those of shareholders. The costs of reducingagency losses plus any remaining unmitigated agency losses are referred tocollectively as agency costs (Jensen & Meckling, 1976).

Because executive behaviors are difficult to specify in advance and costly tomeasure due to unobservability, compensation that is contingent on firm-level performance is commonly used to motivate executives to act in share-holders’ interests (Eisenhardt, 1989; Gomez-Mejia & Balkin, 1992; Murphy,1999). But outcome-based contracts involve shifting risk from the principal tothe agent, and the greater the uncertainty inherent in this risk-shifting, thehigher the overall cost of compensation. This trade-off makes it challenging tospecify the exact nature of the “optimal” compensation contract (i.e., “one thatmaximizes the net expected economic value to shareholders after transactioncosts and payments to employees” (Core, Guay & Larcker, 2003, p. 27)). Thereis also evidence that there is a “dark side” (Dalton et al., 2007, p. 18) to execu-tive PFP in that it may motivate undesired or “untoward activities” (e.g., mis-representation of earnings (Harris & Bromiley, 2007)) despite being designedwith the intent of aligning interests of executives with those of shareholders.(As we saw earlier in this chapter, a similar challenge exists for nonexecutivePFP plans.)

As noted, compared with most nonexecutive employees, executives havea much larger percentage of their compensation is in the form of perfor-mance-contingent pay. Executives are also unique in that they are generallyrequired to maintain a large personal equity stake in the corporation on anongoing basis.9 This effectively increases their own personal investment riskthrough a lack of portfolio diversification, making the fundamental agencytheory challenge (the trade-off between incentives and risk) particularlysalient. These large-equity stakes usually come from stock and option hold-ings that have accumulated over the years. Effectively, then, executive PFP


Pay and Performance • 281

plans have long-term effects because they lead to equity accumulation, thevalue of which is very sensitive to the firm’s stock performance (Nyberg,Fulmer, Gerhart, & Carpenter, 2008).

Effects of Executive PFP: Empirical Evidence

Does PFP → performance?. In his review, Murphy (1999) concluded thatthere was surprisingly little direct evidence on the effects of executive PFPprograms on firm performance. There is, however, plenty of evidence thatPFP design influences the goals and actions chosen by executives (see reviewsby Gerhart (2000) and Devers, Canella, Reilly and Yoder (2007)). Examples ofexecutive behaviors affected by PFP (usually defined in terms of the extent ofequity-related incentives) reported in these reviews include extent of diversifi-cation, research/development and capital investment decisions, choice ofstrategy, risk-taking, earnings manipulation, reaction to takeover attempts,stock option backdating, and option grants being more likely in advance ofstrong earnings. Although some of these outcomes of PFP are clearly undesir-able and sometimes even illegal (as in the case of backdating options, whichwe discuss later), in other cases, the alignment of actions with shareholderinterests can only be assessed after the fact. Most importantly, these studies, bythemselves, do not directly address the question of the net effect of suchincentives on financial performance.

Some early research suggested positive effects of PFP (defined in terms ofuse of executive stock plans) on financial performance. For example, Masson(1971) found that firms with greater emphasis on stock-based compensationhad higher shareholder return, while Brickley, Bhagat, and Lease (1985)found that announcement of stock-based incentives was associated with anabnormal (i.e., a deviation unpredicted by other variables) return to share-holders of 2.4% during the period between the Board of Directors’ first meet-ing to discuss the plan and the day that the Securities and ExchangeCommission (SEC) received the proxy statement describing the plan (meandays in period=58.4). Similarly, Gerhart and Milkovich (1990) found thatincentive pay for middle and top managers (defined as eligibility for stock-related incentives, but also as bonus/base ratio) was positively associated withsubsequent financial performance (Gerhart & Milkovich, 1990). Consistentwith agency theory’s focus on the trade-off between incentives and risk, how-ever, firm risk seems to be a moderator of this relationship, with high-riskfirms performing more poorly when they emphasize incentive pay than whenthey do not (Aggarwal & Samwick, 2006; Bloom & Milkovich, 1998).

It may be that Murphy’s conclusion about the lack of research on PFP con-sequences reflected not only a judgment about the amount of research avail-able on the topic at the time of his review, but also its credibility. The task ofcredibly isolating the impact of PFP from the other determinants of firm per-formance is a challenging one. Theory and research on this question is also



fragmented and often conflicting in its world views and inferences. For exam-ple: “[t]here is presently no theoretical or empirical consensus on how stockoption and managerial equity ownership affect firm performance” (Core et al.,2003, p. 34).

A recent study by Hanlon, Rajgopal, and Shevlin (2003) shows some ofthe challenges in studying the PFP → performance question. They examinedthe degree to which the Black–Scholes value of executive stock option grantspredicted future financial performance. Interestingly, rather than stockreturns, they used earnings (over 5-year periods) to measure financial perfor-mance. (This was to avoid the complication of announcements of optionsgrants influencing stock price, see Brickley et al. (1985).) As discussed later,earnings and stock returns show substantial convergence over longer timeperiods like the 5-year period used here (but not over shorter periods), so thisis a viable study design. Hanlon et al. (2003) found that for each $1.00increase in the value of stock option grants, earnings increased $3.71, a verystrong rate of return to shareholders. However, Hanlon et al. (2003) alsofound that this return estimate depended on the functional form and the esti-mation method. Using a linear model, there was actually a negative earningsreturn (–$0.69) to stock option grants. Only when a nonlinear relationshipwas specified, did the overall return estimate turn positive. In addition, the$3.71 estimate was obtained using instrumental variables (in an effort to cor-rect for simultaneity bias). Using ordinary least squares (with the nonlinearfunction form) yielded an even higher estimate. Thus, the Hanlon et al.(2003) study shows that the estimation of the PFP effect is not as robust asone might wish across alternative specifications, limiting its ability to providea strong conclusion.

Still, the work that does exist generally seems to find that executive PFP isassociated with higher subsequent firm performance. Does this mean, then,that firms should use more equity incentives, or are firms already generallyusing an optimal level? Some researchers imply that firms can improve perfor-mance by simply granting more equity (Morck, Schliefer, & Vishny, 1988),while others researchers argue that since firms generally contract optimally,observed equity ownership levels are likely to be efficient given a particularfirm’s own unique circumstances (Core et al., 2003), such as managerial riskaversion and firm risk (Aggarwal & Samwick, 2006).

Does PFP actually exist for executives?. Although some evidence suggeststhat PFP may positively influence performance, given the lack of researchconsensus, scholars in both finance/economics and management have soughtto address the related question of whether PFP truly exists among executives.If the answer is no, the key role of incentive alignment expected under agencytheory can be questioned and a search for alternative (e.g., sociopolitical)explanations for observed CEO pay becomes more important. As we will see,



the fields of management and economics/finance have reached differentconclusions on this issue.

Agency theory-based empirical research hit its stride in the 1970s and1980s. Yet, despite this relatively long history, agency-based research has yetto yield a universal consensus on whether CEO pay is linked closely enough toperformance. Early studies showed mixed results, arguably due to differencesin methodology and choice of compensation and performance measures. Forexample, Murphy (1985, p. 11), an economist, concluded that “executivecompensation is strongly positively related to corporate performance”, whilemanagement scholars Kerr and Bettis (1987) reported no relationshipbetween shareholder returns and cash compensation.

In their seminal 1990 study, economists Jensen and Murphy lamented thatCEO incentive alignment had declined since the 1930s, with CEO wealth(including equity holdings) increasing by an average of “only” $3.25 per $1000increase in shareholder value, which they interpreted as a weak level of incen-tives. Both of these conclusions have been challenged, particularly by researchin finance, accounting, and economics (Hadlock & Lumer, 1997; Hall &Liebman, 1998; Haubrich, 1994). Specifically, subsequent studies in this liter-ature have found larger performance–pay relationships (e.g., $14.53/$1,000 inAggarwal & Samwick, 1999a), while others have noted that both the Jensenand Murphy and Aggarwal and Samwick estimates imply large changes inexecutive compensation, given modest changes in market value, especially inlarge firms (Gerhart & Rynes, 2003).10 It is not that these other literatures con-clude that performance is the only factor in executive pay. To the contrary,much research documents the existence of agency problems and the chal-lenges in dealing with them. But, the important role of performance is alsorecognized to a greater degree than in management.

In the management literature, however, many scholars still focus primarilyon Jensen and Murphy’s old (i.e., 1990) conclusion that the relationshipbetween organizational performance and pay among executives is “small”(Tosi 2005; Dalton, Daily, Certo & Roengpitya, 2003; Dalton et al., 2007).Further, empirical research in management is generally interpreted as beingconsistent with this conclusion. Meta-analyses by Dalton et al. (2003) andTosi, Werner, Katz, and Gomez-Mejia (2000) report that variance explainedestimates (for the executive PFP relationship as defined in these studies) ofless than 1% and 4%, respectively. Based on these weak relationships, Tosicompared those who continue to believe that US CEOs have strong PFPincentives (Core, Guay, & Thomas, 2005) to those who resisted the idea that“the earth is round, not flat” (p. 485–486). Hitt (2005, p. 963) summarizes thisliterature as follows:

Research in economics, finance, and management… originallysupported the importance of equity ownership by managers and



directors. However, a recent meta-analysis concluded that no system-atic relationship exists between ownership structure and firm perfor-mance (Dalton, Daily, Certo, & Roengpitya, 2003). Stock optionsbecame popular mechanisms for tying executive compensation to firmperformance and promoting executives’ equity ownership in firms.However, anecdotal evidence and academic research suggest that theyhave not been highly effective in meeting these goals. In fact, theresearch shows only a small relationship between executive compensa-tion in any form and firm performance. (Tosi et al., 2000)

Thus, different literatures have reached different answers to the question ofwhether PFP exists among executives. (For a recent example, see the recentdebate between Walsh (2008) and Kaplan (2008).) What explains the differ-ence? One major factor is that the economics/finance literature incorporatesthe role of stock-based plans in achieving incentive alignment more fully thandoes the management literature. It has been established that observed incen-tive alignment (PFP) is much stronger when executive pay is defined andmeasured to fully incorporate the value of stock and stock option holdingsaccumulated over time and when researchers focus on how this value changeswith changes in shareholder wealth (Aggarwal & Samwick, 1999a; Hall andLiebman, 1998; Jensen & Murphy, 1990).

To Murphy (1985), the relationship between the value of executive stockholdings and the firm’s stock market performance is sufficiently obvious thathe described it as “mechanical” and later as “explicit” (Murphy, 1999). Thereason is that both executive and shareholder return are based on the value ofthe same underlying asset, company stock (Conyon, 2006). By contrast,accounting measures such as profitability or earnings are used primarily ascriteria in short-term (bonus) executive compensation plans, which accountfor much less of total executive compensation. Over time, earnings measuresshould also relate to total executive compensation, but that is primarilybecause earnings should converge more closely with stock returns over longertime periods (Dechow, 1994; Easton, Harris, & Ohlson, 1992; Warfield &Wild, 1992). Murphy (1999, p. 2522) described this relationship betweenearnings and CEO compensation over time as the “implicit” alignment withshareholder interests, by virtue of the relationship between accounting mea-sures and stock performance.

The importance of capturing the explicit part of CEO incentive alignmentcan be seen by examining the annual survey of CEO pay published by the WallStreet Journal. As we saw earlier, that survey reported that the majority (67%)of CEO pay is based on what are commonly referred to as long-term incentiveplans, which include stock options and restricted stock (Ellig, 2002).11 In turn,payouts to CEOs covered by these plans are typically based on shareholderreturn (Kim & Graskamp, 2006; Ellig, 2002). By contrast, accounting measures



of performance such as net income are generally used for determining bonuspayouts under short-term incentive plans. Excluding stock-based payouts inmeasuring CEO compensation or excluding shareholder return in measuringfirm performance is thus likely to lead to biased estimates of the strength ofoverall incentive alignment (Hall, 2000). Indeed, Murphy (1999) states that“virtually all of the sensitivity of pay to corporate performance for the typicalCEO is attributable to the explicit rather than the implicit part of the CEO’scontract”.

Yet, most of the studies included in the Tosi et al. (2000) meta-analysis mea-sured CEO compensation as salary plus bonus, and measured firm performancein terms of accounting measures of profitability such as net income, return onequity, or return on assets. In addition, these studies typically used short-term(i.e., 1 year) time periods. Thus, the (central) role of stock in creating PFP wasnot captured. Of the studies in the Dalton et al. (2003) meta-analysis thatincluded CEO equity as a measure of (long-term) CEO compensation, themajority measured firm performance in terms of short-term accountingprofitability (e.g., return on equity, return on assets), rather than measuringperformance in terms of shareholder return or related measures. So, here stock-based compensation was included, but its main driver, stock performance/shareholder return, was not.

Yet another issue concerns the choice and timing of stock option measures.Even though stock options are assigned an estimated value (e.g., using anoptions pricing model such as Black-Scholes), their actual value is uncertainand depends on what the stock price does in the future.12 If the stock pricedoes go up and options are later exercised, it can generate a sizable payout.Some analyses (more often in the business press than in academic research)have specified models where such payouts are counted toward a single year’scompensation, and then highlighted cases where the large payout (e.g., in year1) seems to be out of proportion with shareholder return in year 0. The prob-lem with this approach is that the stock options exercised in year 1 andcounted entirely as year 1 compensation may have been granted many yearsago (e.g., in year –5). Shareholder return in year 0 may have been nothing spe-cial, but it may have been high over one or more of the preceding years. In thiscase, there would indeed appear to be little PFP if the correct choice of (rele-vant) time period for measuring shareholder return is not made.13

So, is it really plausible that executive pay and performance are unrelated,as now seems to be the conventional wisdom in the management literature? Inour opinion, the answer is “no”. One would have to argue that the alignmentbetween stock-based wealth of executives and shareholders is not relevant toestimating the PFP relationship. But, as Hall (2000) argues, this is actually “themost important component of the pay-to-performance link” (p. 123). A recentempirical study (Nyberg et al., 2008) that seeks to better recognize the role ofcompany stock in PFP and also address other limitations of previous work



finds a much larger PFP relationship than previously reported in the manage-ment literature, more consistent with earlier studies in the economics andfinance literatures (Aggarwal & Samwick, 1999a; Hall & Liebman, 1998).Specifically, the addition of shareholder return (to measure performance) totheir CEO return equation (CEO return is analogous to change in CEO wealthas percentage of beginning wealth level), after controlling for other determi-nants, resulted in an increase in variance explained (adjusted R2) from 23% to66%. Further, they found that a 1% change in shareholder return was associ-ated with a nearly identical change in executive return. Thus, conventionalwisdom in the management literature, that there is little PFP among execu-tives, may be largely a consequence of conceptual, specification, and measure-ment problems.

However, some important caveats to this conclusion must also be noted.First, there are clearly companies where PFP is not strong and, more disturb-ingly, where executives have undertaken actions that not only destroyedshareholder value, but were also illegal. Second, executives often have veryhigh compensation, even when their company performance is average orbelow average, relative to industry competitors. Third, severance payments toexecutives are often quite large and, on the face of it, largely independent offirm performance (Alexakis & Graskamp, 2007).14 Until recently, the magni-tude of these payments has been difficult to estimate and include in studies ofexecutive compensation. However, the SEC recently began to require morestringent reporting in this area and it remains to be seen in future researchhow incorporating these payments will affect the estimated PFP relationship.

Issues in Executive Compensation Research

Choice of financial performance measure: stock returns or earnings? Overtime, companies have moved toward greater reliance on market-based (i.e.,stock return) measures, perhaps in an attempt to increase PFP and/or align-ment with shareholders. As we saw in the preceding section, the choice ofperformance measure can have a major impact on size of the estimated PFPrelationship among executives. Specifically, accounting-based measures suchas earnings, at least when measured over short time periods, are less stronglyrelated to executive pay than are market-based measures such as stock return.Why is that the case?

Accounting-based measures of performance like earnings are backward-looking in that they report what has already occurred. In contrast, stock pricesare forward-looking in that they reflect “publicly available information con-cerning firms’ expected future cash flows” (Dechow, 1994, p. 12). In otherwords, the greater the present value of future cash flows or dividends as esti-mated by the market, the higher the stock price. Stock returns, in turn, arebased on stock price appreciation plus actual dividend payouts. The mainimpact of earnings on current stock prices comes when earnings reports carry



new information (e.g., earnings above or below expectations) not alreadyimpounded by the market in the stock price (Ball & Brown, 1968; Nichols &Wahlen, 2004).

In the short run, an important potential drawback of using earnings as ameasure of performance is that “management typically have some discretionover the recognition of accruals” and this can be used, for example “to oppor-tunistically manipulate earnings” (Dechow, 1994, p. 5). Another problem withusing earnings to measure performance is that there is often a “recognitionlag” in accounting (Easton, Harris, & Ohlson, 1992; Warfield & Wild, 1992).For example, for a loss due to an activity to be taken as an expense, the lossneeds to be both probable and estimable. As an example, consider a lawsuitagainst a company. Typically, the expense of a lawsuit is not booked until it isresolved. By contrast, the market will have already impounded (or recognized)the estimated cost (albeit with varying degrees of accuracy that can only beassessed after the fact) into the stock price in advance of the lawsuit’s resolu-tion. Thus, earnings and shareholder returns may not track each other closelyduring this period.

Over the long-run, however, earnings and stock returns are expected toconverge as recognition lag and other sources of divergence (e.g., possiblemanipulation of earnings in the short run) cancel out and earnings estimatesbecome more statistically reliable. Indeed, empirical evidence provides strongsupport for this hypothesis that earnings converge with shareholder return asthe time period of study increases (Dechow, 1994; Easton et al., 1992; Warfield& Wild, 1992). For example, Warfield and Wild report the relationshipbetween earnings and stock returns over different time intervals as shown inTable 5.2

Thus, what these results suggest is that the choice of whether to measureperformance in terms of earnings or stock returns is most consequential forstudies that use short time-frames. Our examination of research on executivePFP in the management literature suggests that a short time-frame is thenorm, as is a preference for accounting-based measures of firm performance.In our view, these design characteristics are likely to lead to incorrect infer-ences regarding the PFP relationship and go a long way toward explainingthe different conclusions reached in the management and economics/financeliteratures.

Table 5.2 Relationship between Earnings and Stock Returns over Different Time Intervals asReported by Warfield and Wild (1992)

Time period Adjusted R2 Adjusted R

Quarterly 0.02 0.14

Annual (1 year) 0.09 0.30

Quadrennial (4 years) 0.40 0.63



In addition, from an agency theory standpoint, measuring performanceas stock returns would appear to provide a better fit with the theory. Forexample, Devers et al. (2007, p. 1039) argue that “agency-theoretic argu-ments strongly support the conclusion that shareholder wealth maximization(e.g., market-based performance) should be the definitive criterion for com-pensation research”. Agency theory states that shareholders are residualclaimants, meaning that they hold claims on (uncertain) “net cash flows forthe life of the organization” (Fama & Jensen, 1983b, p. 328) where “net”means after other claims, expenses, and obligations are paid. The expectedvalue of those future cash flows is most directly reflected in the stock price.Under agency theory (with imperfect information on agent performance),the optimal contract to mitigate agency costs is one that also makes agentsresidual claimants who will also participate in future net cash flows (up tothe point that agent risk-aversion allows). Thus, it would seem necessary tofully incorporate stock-based measures of executive compensation in suchresearch.

Another issue in choosing a performance measure is whether it should beadjusted for performance of competitors. For example, if the median share-holder return in a particular industry is 30% over some time interval, then a20% return for a firm in that industry would be, in relative terms, below aver-age for the industry. Relative performance evaluation logic would then dictatethat executive pay also be lower than the industry median.

Despite theoretical arguments for the logic of rewarding market-adjusted(or relative) rather than absolute firm performance (Holmstrom, 1979), moststudies find little or no evidence for the existence of explicit relative perfor-mance evaluation (Aggarwal & Samwick, 1999b; Antle & Smith, 1986;Gibbons & Murphy, 1990). Similarly, consulting firm data indicate that, ofthe 250 largest US firms, less than 1% granted indexed (i.e., where relativeperformance is used) options and only about 4% granted options that hadperformance-contingent vesting requirements (versus time-based vesting)(Alexakis & Graskamp, 2007). Thus, even if, as we believe the literature shows,executive pay is related to shareholder return, this lack of relative performanceevaluation suggests that executives can earn large compensation for largeshareholder returns, even when these returns are arguably the result of anentire industry performing well, rather than uniquely strong performance bythe firm (or executive). In addition, some evidence suggests that this relation-ship is asymmetric, such that executives benefit in up-markets, but are notpenalized as strongly during down-markets (Garvey & Milbourn, 2006), pro-viding further reason for concern with CEO pay.

Alternatively, others (Oyer, 2004; Rajgopal, Shevlin, & Zamora, 2006) sug-gest that the lack of relative performance evaluation in up-markets is due toCEO retention concerns. “If the supply of managerial talent is scarce andhence inelastic, then increases in aggregate industry or market returns should



increase the equilibrium wage paid to CEOs” and “firms pay their CEOsmore simply to match their increased outside opportunities” in up-markets(Rajgopal et al., 2006, p. 1818). In summary, while PFP is substantial amongexecutives, the theoretical arguments for and against the use of relativeperformance evaluation in determining PFP, together with the empiricalevidence on this issue, continue to evolve.

Choice of performance measure: beyond financials. There has long been adebate regarding whether firm performance can be evaluated using solelyfinancial measures. Although much of our discussion focuses on financialmeasures of firm performance, the corporate social responsibility literatureemphasizes that financial performance is one of many goals that a firm maypursue. In this view, businesses are responsible for outcomes related to allareas of involvement with society (Wood, 1991).15 One influential approachto corporate social performance is stakeholder theory, which recognizes thatfirms have a number of constituencies (e.g., shareholders, customers, suppli-ers, employees, society) and proposes that the successful management of thesometimes conflicting needs of these constituencies is the key to firmsurvival and success (Freeman, 1999). Intrinsic stakeholder theory suggeststhat firms adopt stakeholder management practices as part of a normativemoral and ethical framework, where firm financial performance is not theoverriding goal, but rather is balanced with the goals of other stakeholders(Freeman, 1999). In contrast, instrumental stakeholder theory (Jones, 1995)singles-out financial performance as the most important objective, suggest-ing that firms recognize and work to satisfy multiple stakeholders for thepurpose of improving financial performance. An empirical study byBerman, Wicks, Kotha, and Jones (1999) examined the relationship betweenfirm performance and the degree to which firms acted positively in five keystakeholder relationships: employee relations, diversity, local communities,natural environment, and product safety/quality. Two of the five relation-ships were statistically significant (and positive) in a return on assets equa-tion: employee relations and product safety/quality. This finding—thatserving multiple stakeholders can ultimately benefit shareholders—is consis-tent with evidence on the positive relationship between good employee rela-tions and financial performance (Fulmer, Gerhart, & Scott, 2003) and withthe finding that corporate social performance and financial performancewere positively related (corrected r=0.36) in a meta-analysis of severalhundred studies (Orlitzky, Schmidt, & Rynes, 2003). It is also consistentwith research that shows higher shareholder return in firms that use bothfinancial and nonfinancial measures of performance in executive compensa-tion (Said, HassabElnaby, & Wier, 2003).

In summary, it is important to recognize that firms can be evaluated onperformance dimensions other than financial performance. At the same time,



without adequate financial performance, the ongoing viability of a firm is indoubt and, accordingly, its ability to serve the interests of multiple stakehold-ers would also be in doubt.

Contingency factors, incentive alignment and monitoring. As research inthis area has matured, researchers have turned their attention to contingencyfactors that affect incentive structure (or PFP). As noted previously, outcome-based pay introduces an element of risk into the compensation contract thatmay necessitate payment of a risk premium to the executive and higher overallcompensation costs (Eisenhardt, 1989; Garen, 1994). Similarly, if firm perfor-mance is highly variable, this also introduces an element of risk that has beenshown to increase the overall required level of pay, reduce the use of incentivepay, and/or result in weaker pay/performance linkages (Aggarwal & Samwick,1999a; Bloom & Milkovich, 1998; Gray & Cannella, 1997; Miller, Wiseman, &Gomez-Mejia, 2002). Aggarwal and Samwick (1999a) describe this hypothe-sis—that incentive intensity (PFP) weakens as risk increases (i.e., the incen-tives versus risk trade-off)—as the most central hypothesis of agency theory.Thus, its strong support is viewed as important evidence of agency theory’svalidity.

Because CEOs have the broadest scope of responsibility and the mostdirect accountability to shareholders, another agency theory-related hypothe-sis is that CEO compensation will be more closely linked (than that of thoselower in the organization hierarchy) to shareholder return. Consistent withthis logic, Aggarwal and Samwick (2003) find that pay sensitivity to share-holder wealth is higher for CEOs than it is for divisional managers, and thatdivisional managers’ pay is also sensitive to divisional performance, particu-larly when divisional performance measures are less “noisy” and thereforemore informative.

Individual differences, too, have begun to receive attention as another con-tingency factor. This is because the motivational effects of performance-basedpay, particularly stock and options, can vary across individuals with differingcharacteristics. In addition, depending on such variables as time to retire-ment, previously accumulated equity in the firm, and other personal wealth,executives may theoretically value the marginal stock and option compensa-tion they receive differently from the value intended by the firm (Hall & Mur-phy, 2002; Lambert, Larcker, & Verrecchia, 1991; Meulbroek, 2001).Similarly, the fact that some executives choose to protect their personal wealththrough the use of hedging instruments that reduce their exposure to risk mayalso alter the incentive effects of their pay packages (Bettis, Bizjak, &Lemmon, 2001).16

The effect of incentives on subsequent performance may also depend onthe type of pay used to create the incentives. For example, compared to out-right stock ownership, stock options are generally associated with subsequent



behavior that is viewed as riskier, such as corporate acquisitions (Sanders,2001), and this riskier behavior may likewise result in greater variance infinancial performance (Sanders & Hambrick, 2007). Other research finds thatfinancial statement restatement, or “misreporting”, is predicted by the pay–performance sensitivity of stock options, but not the sensitivity of other typesof pay, including restricted stock or other long-term incentives (Burns &Kedia, 2006).

Governance. Under agency theory, incentives and monitoring are substi-tutes. While some studies find that weak board governance is associated withhigher pay levels (Core, Holthausen, & Larcker, 1999), overall, the accumu-lated research evidence is mixed on the effects of board governance on execu-tive pay level, incentive alignment, and decisions to reprice underwater stockoptions (Carter & Lynch, 2001; Chance, Kumar, & Todd, 2000; Gomez-Mejia,Tosi, & Hinkin, 1987; Finkelstein & Hambrick, 1989; Pollock, Fischer, &Wade, 2002). Moreover, even when focusing specifically on the compensationcommittee, which has the most direct impact on executive pay, the evidencefor governance effects is relatively weak. Director fees paid to compensationcommittee members are positively predictive of pay and negatively associatedwith incentives in intial public offeing (IPO) firms (Conyon & He, 2004), butboard composition seems to have little effect. Independence of the compensa-tion committee, the CEO’s presence on the committee, and the presence ofcurrent and retired executives of other firms on the committee seems to haveno effect on pay level or incentives in US samples (Anderson & Bizjak, 2003;Conyon & He, 2004; Daily, Johnson, Ellstrand, and Dalton, 1998), but theexistence of a compensation committee with a higher proportion of outsidedirectors was associated with stronger PFP as well as higher overall pay in theUK (Conyon & Peck, 1998).

A firm’s ownership structure, which may also capture monitoring inten-sity, seems to provide more meaningful constraints. The overall concentrationof ownership held by institutional investors is associated with greater incen-tives and lower overall pay (Hartzell & Starks, 2003), although institutionalownership by firms that are subject to influence (e.g., banks) is associated withhigher CEO pay (David, Kochhar, & Levitas, 1998). The presence of any largeoutside blockholder (greater than 5% and not necessarily an institution) isalso associated with greater PFP and higher compensation risk (Gomez-Mejiaet al., 1987; Tosi & Gomez-Mejia, 1989).

Sociopolitical considerations in executive pay design. In part as a reactionto the perceived lack of strong incentive alignment among top executives (à laJensen & Murphy, 1990), a body of research has emerged that departs fromthe typical focus of agency theory, in that the effectiveness of incentive align-ment and monitoring in controlling agency costs is fundamentally questioned.



(In another sense, though, it could be said to confirm the importance ofagency theory’s focus on the challenge of controlling agency costs.) Relyingheavily on theories of managerialism, organizational power and politics, andsocial influence, research in this vein maintains that executive pay levels arehigh and incentive alignment weak as a consequence of factors that diminishthe arm’s length, oversight relationship between boards of directors and topexecutives (Bebchuk, Fried, & Walker, 2002). To the extent that this argumentis empirically supported on a broad scale, it calls into question the existence ofPFP among executives. As our review later indicates, there is ample evidencedocumenting the influence of sociopolitical factors on executive compensa-tion. However, that fact does not necessarily mean that sociopolitical factorsplay a dominant role (Fulmer, in press).

Originally described by Berle and Means (1932), “managerialism” has beenwidely applied in the executive pay context to describe motivations that man-agers have for entrenchment (Shleifer & Vishny, 1989), for seeking to gaininfluence over the board, and for increasing firm size in ways that are notnecessarily beneficial for shareholders (Tosi et al., 2000). Under this view,increasing firm size provides a way for sympathetic boards to legitimate orrationalize the pay of executives, rather than representing either a legitimatejob characteristic that requires a higher level of human capital or achievementof a shareholder objective that should be rewarded with higher pay (Tosi et al.,2000). For example, in a study of banks, Bliss and Rosen (2001) found thatwhether growth in firm size occurred through mergers or non-merger growth,CEO compensation increased with growth, even though stock price typicallydeclined after a merger announcement. As such, they suggest that mergersrepresent “a fast way to increase the size of the firm” (Bliss & Rosen, 2001,p. 110) and thus “an easy way to rapidly increase compensation”. Harford andLi (2007) similarly found that mergers typically result in higher CEO compen-sation, despite poor post-merger stock price performance. However, incontrast to Bliss and Rosen, Harford and Li report that growth through merg-ers has a larger effect on CEO compensation than does growth through othermeans. Work by Lee, Shakespeare, and Walsh (2008) indicates that the storycould be more complex, as they found that CEOs engaging in both acquisitionand divestiture of assets (what Lee et al. (2008) describe as a churning strat-egy) actually received higher compensation over time than CEOs followingonly an acquisition (or only a divestiture) strategy. (All three strategies wereassociated with higher CEO compensation than strategies involving no acqui-sitions or divestitures.) Finally, other research reports that growth throughmergers and/or acquisition does carry some risk for CEOs (and have a PFPelement) in that they “pay a price, in the form of their jobs, for making acqui-sitions that destroy [shareholder] value” (Lehn & Zhao, 2006, p. 1761).17

Theories of organizational politics and social influence have been usedto explicate the mechanisms of managerial entrenchment. Relationships are



cultivated over time as executives become entrenched in the organizationand perhaps even appoint members of the board; consequently, tenure andCEO shareholdings are viewed as important levers for gaining influenceover boards of directors (Finkelstein & Hambrick, 1989; Hill & Phan, 1991;Westphal & Zajac, 1995). Social cognitive theories have also been used toexplain CEO pay levels. For example, research finds that CEO pay is pre-dicted by the external pay levels of the members of compensation commit-tee—a finding that has been attributed to the existence of socialcomparison processes (O’Reilly, Main, & Crystal, 1988), but that could alsoreflect labor market factors if committee members are in similar industriesas the CEO. CEOs with higher social status relative to the chairs of theircompensation committees also receive higher pay, presumably in partbecause of their ability to exert greater influence on lower-status chairs(Belliveau, O’Reilly, & Wade, 1996). Social status, legitimacy, and resource-dependence arguments have also been used to explain why CEO networksof external board memberships are related to pay when firms are highlydiversified (Geletkanycz, Boyd, & Finkelstein, 2001). This influence may bewielded by executives to increase their pay levels or to reduce the intensityof PFP, or both.

Shareholder and regulatory influences on executive PFP. The separation ofownership and control and the potential negative impact on firm financialperformance due to agency costs means that there is widespread interest inwhether PFP exists in executive pay (Bebchuk & Fried, 2004; Bebchuk et al.,2002). There is little evidence that either negative press coverage (Core, Guay,& Larcker, 2008) or greater financial statement transparency (now required bythe SEC as part of its ongoing effort to give shareholders better information toevaluate and improve executive pay) has had much of an effect on the struc-ture or level of executive pay. In recent years, shareholders have becomeincreasingly active in executive pay issues, with the number of shareholderproposals related to executive pay approximately tripling between 2000 and2004 (Loring & Taylor, 2006). Although executive compensation proposalsrarely receive a majority vote (Loring & Taylor, 2006), at firms that are targetsof proposals, subsequent CEO pay shows a slight tendency to increase moreslowly and to shift more toward cash and away from long-term pay (Thomas& Martin, 1999).

SEC reporting requirements (and investigations) have, however, seem-ingly had the effect of shutting down some of the ways of gaming PFP plans,such as the practice of backdating stock option grants, which has an effect onstock option valuation.18 Empirical evidence highlighting aberrant stockreturn patterns around option grant dates during the period 1992–2002 sug-gested a systematic problem with backdating of stock option grants (Lie,2005, p. 802). Heron and Lie (2007) found that after August 2002, when the



SEC began requiring option grants to be reported within two business days,these aberrant patterns had disappeared. Another important recent develop-ment is the large growth in the use of “clawback” provisions in executive con-tracts, which allow the Board to recover incentive payments made toexecutives in the event that a subsequent restatement of financial results isnecessary due to misconduct by the executive. According to Equilar, morethan one-half of Fortune 100 companies had such a provision in 2007, upfrom 18% in 2005.19

Federal tax policy since 1993 has attempted to shape the executive paylandscape by limiting the deductibility (though not the payment) of non-performance-contingent pay over $1 million (Internal Revenue Code Section162[m]). Results are mixed on whether this policy has had the effect ofincreasing the sensitivity of pay to performance for affected firms (Perry &Zenner, 2001; Rose & Wolfram, 2002) but it has had virtually no effect onoverall pay levels, as the level of all pay components has increased since 1993(Conyon, 2006). In addition, many firms simply choose to forfeit the deduc-tion and pay non-performance-based pay over $1 million anyway (Balsam &Yin, 2005).

The Emergency Economic Stabilization Act of 2008 provides “authorityand facilities that the Secretary of the Treasury can use to restore liquidity andstability to the financial system of the United States”. A component of the Act,the Troubled Assets Relief Program (TARP), places restrictions and require-ments on executive compensation in financial institutions in which theTreasury takes a debt or equity position. First, compensation that wouldencourage executives “to take unnecessary and excessive risks that threatenthe value of the financial institution” is to be limited. Second, there is a(clawback) provision stronger than that currently available (e.g., underSarbanes-Oxley) for the recovery of “any bonus or incentive compensationpaid to a senior executive officer based on statements of earnings, gains, orother criteria that are later proven to be materially inaccurate”. Third, thereare restrictions on the use of golden parachute payments and additional limi-tations on corporate tax deductibility (although not payment) of executivepay. Thus, in return for government/taxpayer assistance, TARP seeks to limitcertain executive compensation practices.

Executive PFP and its potential effects on other employees. Executives areunique in that their compensation—at least for the CEO, CFO, and the threehighest paid other executives in US corporations—is public, thus making itpossible for the way they are paid to influence not only their own perfor-mance, but also that of others. Relative pay differences within firms, to thedegree they represent PFP, theoretically influence not only employees’ fair-ness perceptions and willingness to cooperate (e.g., as predicted by equitytheory and relative deprivation theory), but also their motivation to work



hard to advance in the organization (e.g., as predicted by tournament theory(Lazear & Rosen, 1981; Rosen, 1986)). Thus, large differentials in pay as afunction of job level can be seen as a positive from an incentive point ofview, or as a negative if believed to be so large as to be unjustified (Gerhart &Milkovich, 1992). Indeed, the popular press, some politicians, and labororganizations often argue that the pay differentials between executives andrank and file workers are unfair and engender widespread worker resent-ment. Although there is at least one study that reported a negative associa-tion between size of pay differential between employees and upper-levelbusiness unit managers (although not the highest-level executives) andmanagers’ perception of product quality (Cowherd & Levine, 1992), thestudy did not measure any employee perceptions (e.g., resentment towardhigh executive pay, intention to decrease effort toward quality, etc)., so it isdifficult to tell if large pay differentials really caused lower quality viaemployee reactions.

Because of concerns about employee reactions to high executive pay, ahandful of firms over the years have attempted to cap executive pay (usuallyjust the salary component) at some multiple of average worker pay (Ben &Jerry’s Homemade; Laabs, 1995). At the time of this writing, Whole FoodsMarket has a cap on executive base salary of 19 times average worker pay, or$631,500 (Annual proxy statement dated January 28, 2008).20 Given that most(88% in the Wall Street Journal/Hay Group survey) executive pay comes informs other than fixed salary (12% in the same survey), it is unclear whateffect capping salary really has on the overall pay gap, although it may be goodfor public relations. Equally unclear, as noted previously, is whether employ-ees actually care; other than one survey of working adults given a hypotheticalscenario about a fictional firm (Andersson & Bateman, 1997), there is littlepublished research documenting employee resentment about (and moreimportantly, behavioral consequences, in terms of either incentive or sortingeffects, due to) executive pay. In saying this, though, we acknowledge that pro-viding such evidence in forms most likely to be acceptable to top-tier journals(e.g., employee attitudes combined with objective performance indicators orbehavioral assessments of performance by their supervisors) is difficult tocome by (e.g., not many firms want researchers poking around regardingissues of perceived pay inequity).

In contrast, there has been more research on pay differentials by job level—and their consequences—among top managers. Such differentials, whichgenerally arise as a result of PFP, have been hypothesized to have conse-quences for outcomes such as financial performance and turnover. A first stephas been to understand what factors explain the size of the differentials. Themagnitude of the gap between the pay of the CEO and other executives in thefirm is seemingly better explained by tournament theory—which conceptual-izes such pay differentials or gaps as providing strong incentives for effort and



advancement—than by other, non-economic theories (Henderson &Fredrickson, 2001; Main, O’Reilly, & Wade, 1993). Consistent with this logic,pay dispersion is also higher when firms have greater investment opportuni-ties (which theoretically engenders a stronger need for the best managers torise to the top as suggested by tournament theory), and also when firms aremore highly diversified (Bloom & Michel, 2002). Conversely, when CEOs arepowerful and are themselves “overpaid” (relative to what would be expectedgiven firm size, human capital, etc.), research finds that lower-level managerswill also tend to be “overpaid” (Wade et al., 2006). Overpayment, of course,is detrimental to financial firm performance, all else equal. However, froman efficiency wage theory perspective, high-paying firms may reap certainbenefits such as greater ability to attract, retain, and motivate higher-qualityexecutive talent.

A second step has been to study the effects of pay dispersion. Evidenceindicates that dispersion is associated with lower executive tenure and higherturnover among top managers (Bloom & Michel, 2002). The degree to whichtop managers are highly paid relative to lower-level managers also predictsthe turnover of lower-level managers (Wade et al., 2006). Recent researchsuggests that across firms, pay dispersion among top managers is positivelyrelated to firm performance, consistent with tournament theory, and thatthis relationship is stronger in firms with strong governance (Lee, Lev, &Yeo, 2008). Other research finds that the effects of dispersion on perfor-mance are moderated by organizational context. For example, the pay gapbetween the CEO and other members of the highly paid executive group isnegatively associated with performance in multinational firms, especially infirms with a stronger international presence (Carpenter & Sanders, 2004).Similarly, pay disparities among top managers are negatively associatedwith performance in high technology firms but not in low technology firms(Siegel & Hambrick, 2005).

To conclude, pay differentials between executives and non-executives(e.g., front-line employees) and between executives at different levels is oftenseen as having performance consequences. One view is that larger differen-tials induce perceptions of unfairness, which could harm performance. Thisview is most often raised in discussions of differentials between executivesand front-line employees and some firms apparently accept this logic, giventhat they have placed restrictions on at least the base salary component ofexecutive compensation. However, there is little empirical research onemployee reactions to differentials or the effect of policies restricting differen-tials. An alternative view, consistent with tournament theory, is that paydifferentials serve a motivational purpose by encouraging the performancenecessary to progress up the ranks to higher paying jobs (where such progres-sion is possible). Some empirical evidence seems to support this hypothesis,although it appears to depend on contextual factors.



Summary

Agency theory emphasizes the use of PFP contracting schemes as a means ofcontrolling agency costs. Empirically, this suggests that we should observeboth that PFP exists, and that firms with PFP (or that execute it moreeffectively) will perform better (unless the vast majority of firms are already atoptimal PFP levels). On the first point, the management literature is skeptical,while the economics/finance literature generally takes the relationshipbetween executive compensation (mainly the stock-based portion, whichaccounts for the largest part) and shareholder wealth as a given. Our readingof the evidence concurs with the latter view. On the second point, evidencehas been slow to accumulate. Skepticism regarding the existence of PFP hascontributed to a search in the management literature for other explanationsfor executive pay, such as sociopolitical factors. The challenge for researchersis to more successfully determine the relative importance of PFP, sociopoliti-cal, and other factors in explaining executive pay. Such evidence has greatpotential for influencing PFP design in organizations, regulatory actions and,perhaps, the motivation and performance of other executives and employeesin organizations.

Conclusion and Suggested Research Directions

In the opening of this chapter, we identified several issues of interest regardingPFP: conceptual mechanisms; empirical evidence on effectiveness of differentprograms such as merit pay or group incentives; the risks and challenges thatare often encountered in using such programs; and the case of PFP amongexecutives. We also saw in the opening of our chapter that there are strong(and conflicting) opinions regarding what the empirical evidence says aboutthe existence and effectiveness of PFP. Some of our most important conclu-sions are as follows.

First, as we stated earlier, “one best way” advice (e.g., do or do not useindividual PFP plans) or “sound-bite” conclusions (e.g., pay does or doesnot motivate) are rarely valid, but rather depend on the circumstances.Pfeffer and Sutton (2006, p. 133), in emphasizing the importance of evi-dence-based management, state that “the use of financial incentives is asubject filled with ideology and belief—and where many of those beliefshave little or no evidence to support them” and that “consultants, gurus,and executives charge ahead with assumptions and practices that reflect areckless disregard for the evidence”. As we saw earlier, Pfeffer (1998, pp.214–215) has argued that “Literally hundreds of studies and scores of sys-tematic reviews of incentive studies consistently document the ineffective-ness of external rewards”. Although we agree on the importance ofevidence-based management, we disagree that such a simple and clear-cutinterpretation of the effectiveness of PFP is correct, based on the evidencewe have reviewed.



Second, while there are several longstanding theories of compensation andmotivation, most of these concentrate on the effect that PFP has, holding theemployee population constant, something we describe as the incentive effect.This overly narrow focus has resulted in management research largely over-looking one of the most important mechanisms by which PFP can have animpact. Increasingly, however, scholars have recognized that PFP may changethe employee population and its attributes. This sorting effect can be as (ormore) important than the incentive effect in some circumstances. We believethat future research should strive to do a better job of incorporating and esti-mating the magnitude of sorting effects, as well as incentive effects. An espe-cially interesting area for future research is the interplay between incentiveand sorting effects in group and organization-based plans where both cooper-ation and strong individual contributions are needed.

Third, the empirical evidence demonstrates that the use and intensity ofPFP programs is typically associated with better individual, group, and orga-nization performance. However, as with many areas of managementresearch, whether the causality of this relationship has been established to thedegree necessary to confidently advise organizations is something that can bequestioned. Certainly, what is beyond question is that PFP can and does fail,both in the case of executives and nonexecutives. Thus, there is a risk/returntrade-off. PFP can be a major positive influence on effectiveness, but can alsoharm it. Better evidence on survival, success, and failure of PFP plans wouldbe helpful. Another area of recommended attention is merit pay. Althoughwidely used, we continue to have remarkably little good evidence on itseffects and encourage researchers to “circle back” to more thoroughly exam-ine this important issue. One aspect of merit pay for which we found some-what more evidence concerns the question of how much PFP in the form ofmerit pay actually exists. Although the strength of merit pay likely variesfrom organization to organization, our review finds that merit pay is oftendefined too narrowly (e.g., excluding other consequences of merit ratingssuch as promotion, inter-organization mobility, and associated pay growth),thus probably leading to an overly pessimistic view of its strength andpotential impact.

Fourth, any discussion of whether PFP “works” must, to be practicallyuseful, provide some sort of cost–benefit or ROI analysis (Sturman, Trevor,Boudreau, & Gerhart, 2003). For almost any job, there will likely come apoint where increasing incentive intensity (PFP) will change behavior.Whether it is worthwhile to do so depends on what the value of the changein behavior is and what it costs to achieve it. Cost includes not only thehigher cost of compensation, but also potential unintended consequencessuch as the use of undesirable means to achieve the ends and lessened atten-tion to objectives not emphasized in the PFP plan.21 Such a “devil is in thedetails” approach is, of course, not as straightforward as saying that PFP



either works or does not work, but it is more realistic and thus necessary foreffective decision making.

Fifth, we devoted significant attention to the special case of executive PFP.Executives are unique in terms of the impact they can have on organizationperformance and the public nature of their earnings. Because of what somebelieve to be no meaningful relationship between firm financial performanceand pay among executives, the validity and relevance of agency theory hasbeen increasingly challenged and supplemented with alternative theories. Ourreview, however, suggests that the field of management has gone too far in itsskepticism, largely dismissing the existence of PFP in executive pay and focus-ing almost exclusively on the role of “mischief” (Dalton et al., 2007). Althoughthere certainly is mischief in executive pay, it is not the whole story. Weencourage researchers to more carefully consider how to define and estimatethe magnitude of PFP among executives in their research and whether currentconventional wisdom in the management literature is consistent with the fullrange of evidence available in related fields. To us, it seems that the manage-ment literature on executive compensation—as well as PFP among non-executives—has done a thorough job of documenting all of the things that cango wrong. While that line of research is important, it is most useful to thedegree that it also incorporates the role of performance, thus providing insightinto the relative importance of performance and non-performance factorsunder varying conditions.

We have seen that the use and effectiveness of PFP, both for executives andnonexecutives, is viewed with skepticism in parts of the management litera-ture (Dalton et al., 2007; Hitt, 2005; Pfeffer, 1998; Pfeffer & Sutton, 2006).Some degree of skepticism is always healthy, as long as it is based on facts. Inthis vein, we saw that Pfeffer and Sutton (2006) warned against the influenceof “ideology and belief” and called for evidence-based management instead.However, ideology and belief can perhaps help explain some of the skepticismregarding PFP. A series of articles bemoans the influence of economic ideas inmanagement (Ferraro, Pfeffer, & Sutton, 2005; Ghoshal, 2005; Pfeffer, 2005).Pfeffer (2005) says that “economics is indeed taking over management andorganization science” and that some aspects of this influence “can be harmful”(p. 96). Further, a question is raised as to the evidence base for this influence.Ferraro et al. (2005), in talking about the influence of economics, state that“theories can ‘win’ in the marketplace for ideas, independent of their empiri-cal validity, to the extent that their assumptions and language become takenfor granted and normatively valued, therefore creating conditions that makethem come ‘true’” (p. 8). One of their two examples to make this argument,that (economic) theories can “win” despite a lack of solid evidence is “theincreasing reliance on contingent, extrinsic incentives” (p. 18). In contrast,our view is that any increased reliance on contingent, extrinsic incentives isnot necessarily “independent of their empirical validity”. Rather, our reading



is that there is rather strong empirical evidence showing that PFP can improveperformance.

One concern we have is that management scholars may be too focused ondifferentiating what they do from what is done in other business school disci-plines, especially those grounded in economics. Differentiation is good, aslong as it is based on solid logic and carefully generated empirical evidence.However, differentiation does not require showing that the other disciplinehas got it all wrong. In the case of compensation, management research hasbeen of great value in showing how economic principles of incentives and PFPcan be informed by other social science perspectives (Gerhart & Rynes, 2003).Nevertheless, doing so does not require (nor does the evidence in our viewsupport) almost blanket dismissals of the effectiveness of PFP or the impor-tance of the role it plays in determining the pay—and performance—ofemployees and, especially, executives.

One of the areas that management research has identified as important andunder-researched, and one that it should be uniquely qualified to study, iswhether executive pay has indirect effects on firm performance by influencingemployee behaviors. Do employees pay attention to the amount of moneypaid to executives in their organizations? Do they care? Do they act differentlyas a result? Do their reactions depend on how the company has performed?There is much opinion on these questions, but little evidence that we couldfind. This is certainly an area where management scholars are well-positionedto provide some valuable insights.

Finally, we encourage researchers to pay more attention to the reportingand interpreting of effect sizes in compensation research. We continue to seeexamples where only the statistical significance of results is discussed with nointerpretation or discussion of regression coefficients or variance explained.In an area like compensation, where key variables (compensation, financialperformance) are measured in inherently meaningful ratio-level scales, suchinterpretations should take center stage. Knowing, for example, that perfor-mance and/or sociopolitical factors have a relationship with executive pay thatis likely to be non-zero (i.e., statistically significant) is not very interesting byitself. As argued earlier, the magnitude of such relationships needs to be thefocus, both for evaluating theories and for drawing practical implications.

Endnotes1. Further, in some areas of compensation, such as executive compensation, the way

it is managed can also have wider repercussions, with employees, shareholders,the public, and regulators all taking an interest (and sometimes action) inresponse.

2. Nonmonetary rewards are also relevant to employee motivation, but we limit ourdiscussion here to financial/monetary rewards which, by themselves, constitute avery large literature.



3. The d statistic is defined as the difference between the dependent variable meanfor Group A versus Group B, divided by the pooled standard deviation of GroupsA and B. Thus, it gives the difference between Group A and B in terms of standarddeviation units.

4. For a discussion of empirical work on the importance of monetary rewards rela-tive to other rewards, see Gerhart and Rynes (2003) and Rynes, Gerhart, andMinette (2004). For a discussion of evidence on the relationship between mone-tary rewards and intrinsic motivation (in work settings), see Gerhart and Rynes(2003) and Rynes, Gerhart, and Parks (2005).

5. There appears to be some shift toward the use of merit bonuses, where, unlikemerit pay, performance awards do not become a (permanent) part of base salary,thus limiting growth of fixed costs.

6. Single-loop suggestions are those that do not question fundamental proceduresor assumptions; double-loop are the opposite.

7. There were two likely reasons for this change. First, Microsoft is no longer agrowth company, making stock price appreciation, and thus growth in employeewealth via increased stock option value, a less powerful PFP program. Second,changes in accounting standards (from intrinsic value to fair value) have madestock options more costly for companies to use.

8. Although some authors (Katzenbach & Smith, 2003) make a distinction betweengroups and teams, in this review we use the terms interchangeably to mean “inter-dependent collections of individuals who share responsibility for specificoutcomes” (Sundstrom, DeMeuse, & Futrell, 1990).

9. Executives, unlike most rank-and-file employees, are also prohibited from short-selling stock in their own companies, and must publically disclose their sales,transfers, and investment hedging transactions involving company stock.

10. To interpret these PFP sensitivities, consider that in 2007, the median Fortune500 company had a market value of $10 billion and the 50th company on the listhad a market value of $57 billion. Using the Jensen and Murphy (1990) estimateof $3.25, a 10% increase in market value would imply $3.25 million and $18.53million higher executive compensation, respectively. Using the Aggarwal andSamwick (1999a) estimate of $14.53, a 10% increase in market value would imply$14.53 million and $82.8 million higher compensation, respectively.

11. Indeed, it seems that one consequence of the agency theory idea that executivesshould be encouraged to act in the best interests of owners has been a concertedeffort by organizations over time to have executives hold significant amounts ofstock and stock options.

12. In addition, stock options ordinarily have vesting requirements, meaning thatthey cannot be exercised immediately. Executive stock options are also not trad-able, meaning that option pricing models likely overstate their value.

13. Consider the example of Richard Fairbank, the CEO of Capital One, as reportedin the annual Wall Street Journal/Mercer CEO Compensation Survey (April 13,2006). According to the Survey, in 2005, shareholders of Capital One earned a 1-year total return of 2.7%. Over 5 years, shareholders earned an (annualized) totalreturn of 5.8%. Under the column, Total Direct Compensation Realized, the



Survey reported that Fairbank received $249.3 million from Capital One in 2005.This apparent lack of alignment between shareholder return and CEO compen-sation was reported widely in the popular press. Less widely reported, however,was the fact that most of the $249.3 million received by Fairbank resulted from hisstock ownership, specifically his exercise of stock options granted to him in 1995(and that would have expired in 2005 if they had not been exercised), and thatshareholder wealth increased by $23 billion between 1995 and 2005 for a cumu-lative shareholder return of 802%.

14. One type of severance payment that has received much attention is the goldenparachute, which refers to the provision typically found in CEO employmentcontracts that provides an often sizable severance payment to the CEO uponchange in control (e.g., when there is a takeover of the company). Critics questionthe logic of paying a large sum of money to a CEO who facilitates a sale of thecompany and then leaves, especially where other stakeholders such as employeesare adversely affected (e.g., by the lay-offs that often happen in such cases). Thestated rationale for a golden parachute is that it prevents a CEO from being soentrenched as to be unwilling to facilitate a sale of the company, even if it is a gooddeal for shareholders, for fear of losing his/her position.

15. An alternative view, expressed by Milton Friedman, is that “the social responsi-bility of business is to increase profits” (Friedman, 1970). In Friedman’s view, asingle-minded focus on business goals can be seen as a moral imperative becausemanagers have a fiduciary duty under the principal-agent relationship to maxi-mize the wealth of shareholders.

16. Age or time to retirement can also be a contingency factor. For executives whoreceive pensions, as retirement approaches, a larger proportion of overall wealthis in the form of debt (their accrued pension benefit) rather than equity, which isin turn related to more conservative behavior (Sudaram & Yermack, 2007).

17. One challenge in studying the firm performance consequences of mergers andacquisitions is the potential for unobserved heterogeneity if firms that engage inthis activity differ in their performance prospects from firms that do not. Forexample, mergers and acquisitions that take place in declining industries may befollowed by poorer firm performance. However, one does not know what perfor-mance would have been in the absence of the merger or acquisition.

18. Typically, when options are issued, the strike price (i.e., the price at which stockcan be purchased in the future) is set equal to the current stock price. For exam-ple, if the options are issued on June 15 and the stock price is $20/share, the strikeprice would also be $20/share. Then, if the stock price increases in the future (andprior to the expiration of the option) to, for example, $30/share, the holder canexercise the option and make a profit of $30–$20=$10/share. In contrast, backdat-ing occurs if the option is actually issued on June 15, but the date of issue isreported as an earlier date when the stock price was lower, giving the option morevalue. For example, if the stock price had been at $10/share on February 10 of thatyear and February 10 (instead of June 15) is the date that is reported, then theoption holder has already realized a profit of $10/share on June 15 when theoptions are (actually) granted.



19. The Sarbanes-Oxley Act also has a clawback provision, but its coverage is limited.20. Whole Foods’ pay multiple has increased from 10 in 1999 to 14 in 2000–2005 to

19 today (www.wholefoodsmarket.com/investor/proxy08.pdf, retrieved March22, 2008), suggesting that the definition of internal equity changes periodically,or, more likely, as was the case with Ben and Jerry’s, the realities of the externallabor market override the desire for internal equity (Laabs, 1995).

21. Also, at a meta-level, it would be very helpful not only to know the averageexpected ROI on PFP plans of different types, but also the variance of such ROI,which serves as a measure of the risk of using such plans (Gerhart et al., 1996).Another challenge is to estimate the mean and variance of return in the face ofselection bias (i.e., where only plans with some minimum level of success survivelong enough to be observed).

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