7 Pay-for-performance is an illusion

The corporate governance scandals and the financial crisis have tempered the enthusiasm for performance-related pay. Even the most fervent supporters of pay-for-performance have had to admit that there is more than enough evidence for the drawbacks inherent in this approach, while at the same time there is a significant lack of empirical evidence for the positive effect of financial incentives. The current remuneration practice appears to depend mainly on the intuitive attractiveness of this approach. It is openly accepted that financial incentives influence executives and encourage them to achieve the performance goals that have been set in advance. In practice it is clear that ‘companies get what they pay for’. Unfortunately, it appears that what companies get is not always what is in their best interests.

This observation has resulted in two views of pay-for-performance. Supporters of one view are of the opinion that the many negative examples do not cancel out the positive effects of performance-related pay. As long as the performance agreement is drawn up correctly, performance-related pay will indeed lead to better performance. Supporters of the other view base themselves on evidence from social psychology and believe that humans are simply not capable of being guided in a positive way by financial incentives. My research indicates that this second view is correct. The inherent weaknesses that have been revealed about the pay-for-performance approach and the unavoidable use of imperfect performance measures ensure that it is impossible to draw up a performance agreement without unintended incentives. This fact, combined with the complex social-psychological processes surrounding the introduction of financial incentives, ensures that the promise of pay-for-performance is an illusion. The research has even revealed that the creation of powerful financial incentives for executives of listed companies based on predetermined, objective and measurable aims runs the risk of achieving the exact opposite of what was intended. This is why the promise of pay-for-performance in order to create ‘alignment’ between the personal financial interests of the executives and the interests of the company cannot be realised.