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Management

Pay-for-Performance Compensation Undermines Performance

MIT Sloan study shows that target-independent compensation systems can be superior

Published: Monday, May 2, 2022 - 13:48

(MIT Sloan: Cambridge, MA) -- A new study released by MIT Sloan Management Review argues that compensation systems that do not link sales target achievement to individual incentives bolster intrinsic motivation, satisfaction with pay, and ultimately, employee performance, while pay-for-performance (PFP) compensation systems can undermine the performance of modern, collaborative work teams.

“Organizations may have more to lose by failing to move beyond pay-for-performance (PFP) compensation systems,” says co-author Jonas Solbach, market reach strategy manager at Hilti Group. “After conducting a large-scale experiment with a target-independent compensation system, the results point to a strong case for leaving PFP behind.”

Liechtenstein-based Hilti Group, which offers products and services to the construction industry, is a family-owned business that employs more than 30,000 people, 70 percent of whom sell its products and services directly to contractors on construction sites in 120 countries. Hilti has a decentralized structure, and the country organizations maintain their own sales forces. The authors ran an experiment in which they replaced a PFP compensation system with a target-independent system in the direct sales force of a country organization of Hilti Group, beginning in January 2019.

The results suggest that target-independent compensation systems can be superior to PFP systems in organizations that rely heavily on knowledge work and collaboration.

While PFP systems focus narrowly on defined outcomes (such as the number of sales closed), they ignore the ways in which outcomes are produced, often undermining the performance of work that requires people to explore complex problems, develop creative solutions, and achieve qualitative results that cannot be fully specified in advance. PFP remains focused on extrinsic motivation of financial reward but ignores powerful and beneficial intrinsic motivators, such as the joy of the task itself, sense of contributing and belonging to a team, and personal development.

“Intrinsic motivation seems to provide access to the vast untapped potential of employees, boosting both performance and well-being. Target-independent pay schemes serve as a lever to transform the focus of leaders from computational command-and-control to behavior-driven performance management,” adds Klaus Mӧller, professor of controlling/performance management at the University of St. Gallen.

The payoffs were clear at Hilti: A target-independent pay scheme bolstered intrinsic motivation, satisfaction with pay, and ultimately, employee performance, without giving rise to free-riding, ugly competition, cost challenges, and layoffs in times of crisis. Organizations that have attained a certain level of cultural maturity and are performance-driven are best suited to see similar success with a target-independent system. Successful implementation requires full support of senior leaders and must be aligned with all current programs and processes. Management must communicate extensively to convey its trust in employees and its performance expectations.

The experiment

The compensation experiment took place at a country organization in Eastern Europe beginning in January 2019. At the time, the company’s 190 salespeople received 65 percent of their salary in fixed compensation and 35 percent in variable compensation. The new sales compensation system did not link rewards to preset targets. Under the new system, the pool for fixed sales compensation increased to 97 percent of the average total payout for the entire sales force in the previous two years.

A change such as this was intended to signal greater trust in salespeople; to better support the stretch targets, operations, and practices necessary to exploit the full potential of a sales territory; and to encourage knowledge-sharing and long-term strategic behaviors. It also expanded the structure of advancement from three levels to seven levels to give a longer-term career path. The organization also extended the use of gamelike competition from individuals to teams.

“The new pay scheme should address increasing complexity in sales jobs with more service and digital solutions sales content as well as longer sales cycles, a context which characterizes not only Hilti sales jobs nowadays but can be observed also in more and more industries,” Franz Wirnsperger added from a practitioner’s perspective.

The results

The results speak for themselves—the country organization outperformed the market by a factor of 1.4 in 2019 (fully twice the rate of 2018). Turnover within the sales force decreased by more than 4 percent under the new pay scheme in 2019. Satisfaction with compensation within the sales force increased by 19 percent, compared with a 9 percent increase across the entire workforce. A slackening in sales efforts did not materialize.

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