If you run a company, stop increasing pay based on performance reviews. No, I’m not taking advantage of all that newly legal weed in my state (Washington). I know this challenges a belief as old as business itself. It challenges something that seems so totally obvious that you’re still not convinced I’m not smoking something. But hear me out.
This excellent post in the Harvard Business Review Blog, Stop Basing Pay on Performance Reviews, makes a compelling case for this. It won’t take long, so please go read it. Here’s an excerpt.
If your company is like most, it tries to drive high performance by dangling money in front of employees’ noses. To implement this concept, you sit down with your direct reports every once in a while, assess them on their performance, and give them ratings, which help determine their bonuses or raises.
What a terrible system.
Performance reviews that are tied to compensation create a blame-oriented culture. It’s well known that they reinforce hierarchy, undermine collegiality, work against cooperative problem solving, discourage straight talk, and too easily become politicized. They’re self-defeating and demoralizing for all concerned. Even high performers suffer, because when their pay bumps up against the top of the salary range, their supervisors have to stop giving them raises, regardless of achievement.
The idea that more pay decreases intrinsic motivation is supported by a lot of science. In my one year at GitHub post I highlighted a talk that referred to a set of such studies:
I can pinpoint the moment that was the start of this journey to GitHub, I didn’t know it at the time. It was when I watched the RSA Animate video of Dan Pink’s talk on The surprising truth about what really motivates us.
Hint: It’s not more money.
I recommend this talk to just about everyone I know who works for a living. I’m kind of obsessed with it. It’s mind opening. Dan Pink shows how study after study demonstrate that for work that contains a cognitive element (such as programming), more pay undermines motivation.
More recently, researchers found a neurological basis to support the idea that monetary rewards undermine intrinsic motivation.
This rings true to me personally because of all the open source work I do for which I don’t get paid. I do it for the joy of building something useful, for the recognition of my peers, and because I enjoy the process of writing code.
Likewise, at work, the reason I work hard is I love the products I work on. I care about my co-workers. And I enjoy the recognition for the good work I do. The compensation doesn’t motivate me to work harder. All it does is give me the means and reason to stay at my company.
Not to mention, should the company dangle a bonus to improve my performance, there’s some questions to ask. Why wasn’t I already trying to improve my performance? Where will this new performance come from? Often, the extra performance comes from attempting to work long hours which backfires and is unsustainable.
So what’s the alternative?
Pay according to the market
This is what Lear did, emphasis mine:
In 2010, we replaced annual performance reviews with quarterly sessions in which employees talk to their supervisors about their past and future work, with a focus on gaining new skills and mitigating weaknesses. We rolled out the change to our 115,000 employees across 36 countries, some of which had cultures far different from that of our American base.
The quarterly review sessions have no connection to decisions on pay. None. Employees might have been skeptical at first, so to drive the point home, we dropped annual individual raises. Instead we adjust pay only according to changing local markets.
They pay according to the market.
This makes a lot of sense when you consider the purpose of compensation:
- It’s an exchange of money for work.
- It helps a company attract and hire talent.
- It helps a company retain talent.
It’s not a reward. You wouldn’t go to your neighborhood kid and say, “Hey, I’ll pay you 50% of what the market would normally offer you, but I’ll increase it 4% every year if you do a really good job.” The kid would rightfully give you the middle finger. But companies do this to employees all the time. Don’t believe me?
Staying employed at the same company for over two years on average is going to make you earn less over your lifetime by about 50% or more.
Keep in mind that 50% is a conservative number at the lowest end of the spectrum. This is assuming that your career is only going to last 10 years. The longer you work, the greater the difference will become over your lifetime.
Let that sink in.
If your employees act rationally, they’d be stupid to stay at your company for longer than two years watching their pay drop over the years in comparison to the market for their skills. And if they wise up and leave every two years, the turnover is very costly. The total cost of turnover can be as high as 150% of an employee’s salary when you factor in lost opportunity costs and the time and expense in hiring a replacement.
So even if you decide to continue on a pay for performance system, market forces necessitate that you adjust pay to market value. Or continue selling your employees a story about how they should stay out of “loyalty”. This story is never bidirectional.
And what should you do if someone tries to take advantage of the system and consistently underperforms? You fire them. They are not upholding their side of the exchange. Most of the time, people want to do good work. Optimize for that scenario. People will have occasional ruts. Help them through it. That’s what the separate performance reviews are for. It provides a means of providing candid feedback without the extra charged atmosphere that money can bring to the discussion.
The Netflix model
This is one area where I think the Netflix model is very interesting. They try to pay top of market for each employee using the following test:
- What could person get elsewhere?
- What could we pay for replacement?
- What would we pay to keep that person (if they had a bigger offer elsewhere)?
After all, when you hire someone, the offer is usually based on the market. So why stop adjusting it after that? This also solves the problem I’ve seen companies run into when the market is hot, they’ll hire a fresh college grad for more than a much more experienced developer makes because the developer’s performance bonuses haven’t kept up with the market.
Keep in mind, this is good for employees too. If an employee wants to make more money, they will focus on increasing their value to your company and the market as a whole. This aligns the employee’s interest with the company’s interest.
Another cool feature of the Netflix model is they give employees a choice to take as much or as little of that compensation as stock instead of cash. I think that’s a great way to give employees a choice in how they invest in the company’s future.
If you insist on continuing to believe that bonuses for performance is the right approach, I’d be curious to hear what science and data you have that refutes the evidence presented by the various people I’ve referenced. What do you know that they don’t? It’d make for some interesting research.
UPDATE: Based on some comments, there’s one thing I want to clarify. I don’t think the evidence suggests that all companies should pay absolute top of Market. That’s not what I’m suggesting. Many companies can’t afford that and offer other compensating factors to lure developers. For example, a desirable company that makes amazing products might be able to get away with paying closer to the market average because of the prestige and excitement of working there.
The point is not that you have to be at 99%. The point is to use the market value for an individual’s skills as your index for compensation adjustments. When it goes up, you raise accordingly. When it flatlines or goes down, well, I’m not sure what Lear does. I certainly wouldn’t lower salaries. I’d just stop having raises until the market value is above an individual’s current pay. I’d be curious to hear what others think.