has pay for performance had its day.pdf

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had its day?performance

ay for performance has these days achieved the status of a manage-

ment mantra. A generation of executives, motivated by performance-

measurement systems linking their actions to results and, ultimately, to

compensation, has embraced the creed and practice of making assets

sweat. To continue flourishing, however, companies need to innovate as

well as to exploit their existing assets. Yet most find it very hard to motivate

Jonathan D. Day, Paul Y. Mang, Ansgar Richter,

and John Roberts

The way to get your employees to focus on both the present and the future

is to adjust your culture and to weaken your financial incentives.

P

Has pay for

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47

their people to develop new business

ideas and, simultaneously, to

manage current performance.

The natural reflex might be that

people should receive higher pay for innovat-

ing effectively. But our research1 suggests otherwise. Surprisingly, the secret

of persuading people to focus simultaneously on developing new businesses

and managing current operations may be to rely less on pay for performance.

In fact, companies that achieve both objectives de-emphasize performance

pay or use it in a more nuanced, less intense manner. Crucially, they combine

it with an unusually inclusive culture. In these companies, employees feel

that their interests and those of the business are much the same, so they nat-urally try to do what is best for its current and long-term welfare, just as

they do for themselves in their personal lives. Pay for performance may still

have an important job to do in such a culture, but as a supplemental boost

rather than a primary driving force.

1This article is based on McKinsey research, starting in January 2000, on the determinants of corpo-

rate adaptiveness. We looked at companies (such as Charles Schwab, GE, Hewlett-Packard, Nokia,

and 3M) that have a record of success in both developing new businesses and sustaining the perfor-

mance of existing ones.


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Encouraging growth and performance

With few exceptions, corporate incentive schemes encourage managers to

concentrate either on executing current tasks or on developing and imple-

menting new business ideas to fuel future growth, but not both. Most such

schemes are designed to motivate current performance: retail organizations,

for example, tie rewards to current sales, manufacturing companies to pro-

duction costs and volumes. In such companies, the need to meet perfor-

mance targets leaves people with little time to innovate. As one harried

manager in a global industrial company put it, We are very welcome to doinnovative stuffafter 11:30 PM.

Incentive mechanisms emphasizing current performance tend to be more

common because measuring the familiar tasks that boost itthe exploita-

tion that leverages existing competenciesis so much easier than measuring

the exploration and experimentation that may lead to future growth.2 So, for

example, a company that wants to motivate its sales representatives to sell

more goods or services will track how many contracts its agents close, adjustthe scores for differences beyond their control (such as the number of cus-

tomers in each area), and reward them accordingly. Effort and score are usu-

ally clearly linked, so the company can expect agents to work hard if high

scores are well rewarded.

But the achievements of these agents would be a lot harder to measure if the

company wanted them to bring back ideas for new product offerings based

on the changing needs of its customers. A simple tally wouldnt do, since it

might be years before an ideas real value could be assessed. The company

would also have to adjust for more elusive factors, such as the willingness

of customers to provide information about their preferences. All this is so

difficult to quantify that to use formal incentives effectively a company

would have to monitor, in minute detail, the way each sales agent actually

behaved with customers.

And performance in highly exploratory tasksbiochemical research, for

instance, or scenario planningcant really be measured at all. Who knows,in advance, which experiments will yield fruitful results or which scenarios

will yield valuable insights? Proxy measurements can give a rough idea in

some contexts. Management consultants, for example, who often work in

teams, use peer observation to assess one anothers ability to come up with

new ideas. But few companies have a performance-management system that

48 THE McKINSEY QUARTERLY 2002 NUMBER 4

2James G. Marchs terminology contrasts exploration and exploitation as two fundamentally differ-

ent types of activity. See James G. March, Exploration and exploitation in organizational learning,

Organization Science, Volume 2, Number 1, 1991, pp. 7187.


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assesses how well employees deal with growth-oriented tasks as accurately

as it assesses their current performance.

Some companies try to get around the problem of measuring exploratory

activities by promising a big, one-off bonus to anyone who comes up with

an idea that is later commercialized. But these arrangements can prove diffi-

cult to operate. In 1964 Peter Roberts

developed an innovative socket

wrench as an employee of Sears,

Roebuck. For the rights to thepatent, Sears paid him $10,000, a

handsome sum to the 18-year-old

inventor. Five years later he sued

Sears, claiming that it had deliber-

ately underestimated the tools sales potential, which had proved to be in the

millions of dollars. Roberts received an award of more than $8 million and,

after Sears appealed the judgment, settled for an undisclosed sum.

The problem of measuring performance in exploratory tasks makes it hard

to design effective financial-reward systems that motivate innovation. It is

doubly difficult to design incentive schemes that induce people to pay proper

attention to current performance as well as exploration.

Who should multitask?

Of course, not everyone, or even every manager, must allocate time between

both. Quite the contrary, the benefits of having some people concentrate

exclusively on one or the other can be enormous. To this end, some com-

panies actually put exploratory and current activities in different business

unitsan approach known as cocooning.3 But even in these companies,

some people need to allocate scarce resources between current and future

activities.

Cocooning tends to shift the burden of balancing growth and performance

upward: top managerssometimes CEOsmust select the new ideas thatare pursued, drive promising ideas to fruition, ensure that current assets are

sweated effectively, and get rid of businesses that have passed their sell-by

date. In the extreme version of cocooning, everyone other than the CEO

would have only one task: to find new ideas for the company or to expand

existing businesses.

49H A S P AY F O R P E R F O R M A N C E H A D I T S D AY ?

3See Clayton M. Christensen, The Innovators Dilemma: When New Technologies Cause Great Firms to

Fail, Boston: Harvard Business School Press, 1997; and Mehrdad Baghai, Stephen Coley, and David

White, The Alchemy of Growth: Practical Insights for Building the Enduring Enterprise, Cambridge, Mas-

sachusetts: Perseus Publishing, 1999.

The problem of rating per formance

in exploratory tasks makes it hardto design effective financial-rewardsystems to motivate innovation


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In practice, this approach is unworkable except in the smallest companies. In

larger ones, top managers are generally too far from the places where ideas

are generated to be effective judges and motivators. Weak ideas may get too

much attention because the boss happens to like them, while great ideas

can end up outside the business as frustrated employees leave. Moreover,

if the trade-offs between growth and performance are pushed upward, the

result can be bottlenecks at the top of the organization and frustrated senior

executives who are overloaded with

information but still need to make

timely decisions.

The better practice is to have man-

agers at many levels pursuing new

business ideas and better current

performance simultaneously. This

approach keeps innovation alive and ensures that new ideas are linked to the

companys customers and markets. But how can top management motivate

people at a number of levels to pursue the seemingly conflicting objectivesof encouraging future growth and, at the same time, improving current per-

formance? How can these people most effectively be persuaded to divide

their time between the two?

The rule of balanced incentives

To encourage any activity, companies can use either high- or low-powered

incentives. High-powered incentives offer people big financial rewards for

good performance and penalties or much lower rewards for poor perfor-

mance. Top athletes on professional sports teams, for example, have high-

powered incentives. Their performance is easy to observe. Those who do

well receive vast sums of money; bad performers leave the game. By contrast,

with low-powered incentivessuch as financial bonuses linked to the for-

tunes of a group or an entire corporationindividual differences in per-

formance have less impact on the rewards employees receive. Still more

low-powered are the kinds of rewards that confer recognition and status

rather than pay. In some jobs (those of judges and the clergy may be exam-ples), it is perfectly normal to offer little or no financial incentive for perfor-

mance, even when it is measured.

High-powered incentives call for a relatively clear and sure link between

actions and results, which is why companies tend to award strong incentives

for current performance and weaker incentives for exploration. But with two

disparate tasks to perform, people naturally turn to the task they think will

bring them the greatest reward relative to the risks. So if companies follow


Weak ideas may get too muchattention merely because the bosshappens to like them, while greatideas end up outside the business


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the natural pathgiving high-powered rewards where they can and less

intense ones where they musttheir people will probably respond by focus-

ing on the well-rewarded tasks.4

Clearly, companies need to balance the incentives they attach to familiar

and exploratory tasks if they want people to do both in equal measure.

This imperative may mean going against the vogue of pay for performance;

indeed, it may require companies to reduce the power of the incentives they

use to encourage their employees to undertake the more easily measured,

familiar tasks. The incentive encouraging the least easilymeasurable task then becomes the standard for all

activities. If a retailer, for instance, wants its

salespeople to spend more time exploring the

needs of its customers, the best course may be to

lower the incentives for selling until they are com-

parable to those for gathering information.

Many managers think that the logic of relaxing payfor performance in this way is counterintuitive. Yet

with a few exceptions, a system of low-powered incen-

tives balanced between exploitative and exploratory

tasks will probably work better than either balanced

but high-powered incentives or the mismatched incentives

that many organizations use today.

A balance of high-powered incentives is rarely appropriate, for two reasons.

One of them is the fear of risk: high-powered incentives for undertaking

exploratory tasks may create a higher degree of financial uncertainty than

many employees can bear. Since it is hard for any one person in the orga-

nization to control the factors that make exploratory activities successful

and recognized, employees might be penalized indeed even firedfor

events that they couldnt influence. Few line managers will be able or willing

to accept financial risk.

The disputes that erupt over sharing the upside of innovation are the secondproblem. A company that installs a system of balanced high-powered incen-

tives must often give much of the value it generates back to employees in

compensation not just for their contribution but also for the extra risk they

assume. Shareholders too will naturally want a piece of the cake, but there

may not be enough left to satisfy them. Partnerships in professional-service


4See Steven Kerr, On the folly of rewarding A, while hoping for B,Academy of Management Executive,

Volume 9, Number 1, 1995, pp. 714; Bengt Holmstrm and Paul Milgrom, Multitask principal-agent

analyses: Incentive contracts, asset ownership, and job design, Journal of Law, Economics, and

Organization, Volume 7, special issue, 1991, pp. 2452.


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firms actually can afford to offer their people high-powered incentives for

undertaking both routine and exploratory tasks, partly because the senior

employees of these firms also happen to be the shareholders. But few other

companies are in a similar position in this respect.

It is therefore unlikely that a balance of high-powered incentives will suit

many companies that want to encourage their people to pursue routine and

exploratory activities simultaneously. A more promising approach would be

to orchestrate a system of weak though balanced incentives. But then the

incentive system doesnt give employees much reason to go the extra mileand exert the extra effort that is so valuable to companies. The solution lies

in their culture.


Founded just over 30 years ago, Charles Schwab,the San Franciscobased financial-services firm,

is now a leader in the US private-brokerage

market. It has consistently managed to develop

new businesses and business models, without

having to sacrifice operational efficiency in the

process.

Schwabs major breakthrough came in the

mid-1990s, when it introduced World Wide

Webbased on-line brokerage services. The

underlying technology had not been developed at

Schwab, and substantial innovation in its busi-

ness system was needed to give its customers

the ability to switch seamlessly between branch

and on-line channels. The employees of the

branches would, for example, have to support

customers on-line, over the phone, and face-to-face. Obviously, however, the new on-line chan-

nel would threaten those very employees. What

would motivate them to support on-line trading?

Would they be willing to help on-line customers?

Wouldnt they sabotage the channel for fear of

being cannibalized?

Schwab had to ensure that opening the newchannel was the employees goal as much as

the companys. Three principles were critical to

winning such a commitment:

1. Developing a joint vision. First, the company

needed to unite all its employees behind its

vision of exemplary customer service. This had

been Schwabs aim from the startbut people

in the branches, and not just their managers,

had to see its implications in the context of the

new channel. Everyone in the company had to

believe that customers must be supported both

on- and off-line. To bring this basic principle

home to employees, management not only had

to understand how it would look from their per-

spective but also needed to convey the mes-

sage in person. A large team of managers atSchwabs headquarters went out to the

branches and discussed with their employ-

eessometimes in late-evening sessions

the meaning of seamless service across

channels for customers, the staff, and the

company as a whole. Schwab found that abso-

Schwabs way


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Beyond incentives: Fostering a high-commitment culture

The companies that most effectively motivate their employees to pursue

future growth and, at the same time, to concentrate on current performance

use weak, balanced incentive structures but take care to supplement them

with unusually inclusive and motivating corporate cultures. At a company

of this kind, employees see a close fit between its long-term interests and

their own. Consequently, they are better motivated not only to work dili-

gently and creatively with relatively low levels of explicit incentive pay but

also to divide their time between exploratory and predictable tasks in a waythat serves the business well. In such companies, the culture and incentive

schemes serve to reinforce each other.


lutely nothing could replace no-questions-

barred conversations for building and maintain-ing a high-commitment corporate culture.

2. Living the values. Installing the technology

for on-line brokerage services would put

employees of Schwabs branch network at

risk. Schwab countered their understandable

anxiety by appealing to its established values

of fairness and empathy: it promised that it

would not eliminate jobs and would give its

people enough time to adjust to the new order.

Nonetheless, Schwab didnt relax its commit-

ment to individual and collective accountability.

People could still be fired if they failed to per-

form up to standard.

3. Using balanced incentives. Finally, to make

certain that the branch employees wouldntjust tolerate the new channel but would instead

do everything they could to make it work,

Schwab tried to ensure that all of them could

share in its fortunes, by shifting the companys

compensation system toward low-powered

incentives based on the performance of groups

and of the company as a whole. As an

employee said, Designing a system thatenhanced team spirit was hard because, tradi-

tionally, brokers have such an individualistic

culture and performance ethic. On the other

hand, team spirit and teamwork are really part

of our values. But how do you design a program

that encourages teamwork and also absolutely

rewards those who contributed the most?

In the end, Schwab adopted a system that

required an entire branch to hit its target before

any branch, group, or team bonuses were

awarded. Once the branch did so, the bonuses

of employees would vary according to their indi-

vidual performance, up to a ceiling of 25 percent

of their base salaryenough to make a differ-

ence but far below what other companies in the

sector offered at that time.

The success of Schwabs move to on-line trading

actually helped secure the jobs of employees in

the branch network, which was enlarged because

the new on-line customers wanted services at

branches as well.


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By contrast, employees in many companies dont feel that their personal

interests are aligned with those of the organization. Thus they need explicit

incentives to work as hard as the company wants them to and dont auto-

matically divide their time between predictable and exploratory activities.

Such companies go to great lengths to motivate employees and allocate their

efforts wisely.

In private life, people usually manage the trade-offs between executing their

daily routine tasks and preparing for the futureplanning their chil-

drens schooling, for example, or moving to a new apartment.By pursuing their own perceived interests, they make the

right choices because they themselves directly reap the

benefits and pay the costs of their actions.

But in most companies, the chain linking the perfor-

mance of an individual to a consequence for him or her

is much more cumbersome. Managers must identify each

useful activity they want an employee to perform, tie an incen-tive to it, measure the employees performance, and grant or withhold

the reward. A company that relies strictly on such formal incentives to shape

employee preferences must construct these chains with exquisite care and

accept the risk that they will fail to measure performance accurately and will

thus motivate employees to do the wrong things.

However, a company that creates and nourishes a culture in which its

employees identify its interests with their own increases the odds that they

will strike the right balance in their allocation of effort, without any strong

explicit incentives, just as they do in their private lives. A few companies

have evolved such cultures over time.5 Generally, their dominant values are

service to customers, fairness, empathy with the concerns of employees, and

open access to information. The key element of such a culture is the way it

promotes the employees sense of belonging to, or identity with, the com-

pany. Although we dont thoroughly understand how companies can build

such a culture, our research has shown how it promotes simultaneous inno-

vation and current performance when combined with balanced low-poweredincentives (see sidebar, Schwabs way, on the previous spread).

Managers seeking to encourage high performance on current tasks and, at

the same time, innovative thinking about future opportunities ought to look


5To describe such a culture, human-resources scholars use the term high commitment, referring to

the mutual commitment of employee and company. See, for example, James N. Baron and David M.Kreps, Strategic Human Resources: Frameworks for General Managers, New York: Wiley, 1999.


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beyond simple pay-for-performance formulas and instead try to create a

proper balance among the formal incentives that are used to promote both

of these goals. Those incentives can be even more effective if they are sup-

ported by a culture that aligns the interests of a company with those of its

employees.

Jonathan Day is a principal in McKinseys London office; Paul Mang is an associate principal in

the Chicago office;Ansgar Richter, an alumnus of the Frankfurt office, is currently an assistant pro-

fessor at the European Business School, in Oestrich-Winkel, Germany; John Roberts is senior

associate dean and the John H. and Irene S. Scully professor of economics, strategic manage-ment, and international business at the Stanford University Graduate School of Business.

Copyright 2002 McKinsey & Company. All rights reserved.


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