Does Performance Pay Work?

Reputability, the UK reputational risk firm, has a new blog post about an empirical study of performance pay that demonstrates that performance pay does not result in higher share prices.  The study is spot on and reinforces the points I make in my forthcoming book, Indispensable and Other Myths:  Why the CEO Pay Experiment Failed and How to Fix It (University of California Press, forthcoming 2014).  (I cite an earlier version of the study there.)  Michael J. Cooper, Huseyin Gulen, and P. Raghavendra Rau performed a careful analysis of the impact of various forms of performance pay.  They concluded that paying CEOs more — generally in the form of performance pay structures such as stock options, restricted stock, and bonuses — resulted in worse, not better share price performance.  Unsurprisingly, stock options had the strongest negative effect, while guaranteed salaries had no impact at all on stock price, positive or negative.

Cooper, et. al argue that the reason performance pay does not produce better corporate performance is that it encourages executives to make acquisitions, and acquisitions tend to be decrease companies’ value.  Reputability’s Anthony Fitzsimmons does not dispute this, but adds that the problem may be linked to the concept of “dominant” CEOs.  CEOs who are paid more than their peers may be “dominant,” and this characteristic may lead to poor management such as refusal to consider alternative viewpoints.

There is actually an extensive social science literature on why performance pay does not work for the type of high-level cognitive tasks performed by CEOs.  I analyze that literature extensively in Indispensable and can’t really do it justice in a short blog post.  (There are also other reasons not rooted in social science for the failures of performance pay, but these have more to do with the type of performance pay companies tend to use than with the concept of performance pay itself.  I discuss these other problems in the book as well.) 

One issue psychologists have honed in on is that performance pay is inherently distracting.  Think about shooting a free throw at the park,with no one you know around.  With nothing much to take your attention away, you can focus on the task at hand, sinking the ball into the basket. Then imagine trying to make that same shot with a $50,000 prize available if you hit five in a row.  Does the shot become easier or harder with a considerable sum of money on the line?  Performance pay may have a similarly distracting effect on CEOs’ ability to manage their companies.  With such a vast personal fortune on the line, to what extent can CEOs really focus on the task at hand and ignore the pecuniary consequences of success or failure?  The empirical data from studies such as Cooper, et. al‘s suggest that money is as highly distracting for CEOs as it is for the rest of us.

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