Compensation and incentives

Managing compensation: A map of concepts and tools

(Baker, Jensen & Murphy’ 88)

▪ Compensation level where people work: recruitment, turnover

▪ Compensation composition the value (cost, utility) of a certain level

▪ Compensation function performance

Compensation level

▪ = Value of “job package”:♦ effort, money, term, human capital, specificity, fringe benefits, etc.

▪ How to set up? Multidimensional, lack of prices Look at:♦ turnover ♦ queues of qualified candidates♦ costs and benefits of turnover

▪ Job rating systems (“Hay” plans) aggravates bureaucracy

▪ “Efficiency wages” = higher than market wages Two origins:♦ Market compensation level or function?♦ Regulation rent seeking

Compensation composition

▪ Should not trigger conflict between parties▪ Effects on labor relations

♦ Self-selection: e.g., health plans, deferred low subjective discount rate

♦ Moral hazard: paying with product discourages theft♦ Self-control: pensions, work safety

▪ Effects on other relations♦ Adverse selection: reduces transaction costs by grouping: health

insurance♦ Moral hazard: e.g., easily-to-enforce credit to employees♦ Tax avoidance by paying in kind

▪ Growing demand for flexibility: ♦ Demographic variety and change ‘Flexible compensation’

▪ Marketing view of compensation package: selling jobs

Compensation function (1)

▪ How compensation level depends on performance

▪ Basic types of variable compensation♦ Piece rates, commissions, bonus plans, etc.♦ BUT not only money, not only short term:

• Task allocation between subordinates

• Promotions and salary revisions

• Firing and penalties

• Non-vested pensions and deferred compensation

Compensation function (2). Effects and limitations of pay for performance

▪ Big problem in economics literature, small in real life: “inefficient” risk allocation (principal-agent model)

▪ Main real problem: produces harder effort and smarter effort—BUT poses measurement problems: ♦ Gap between performance and contribution to firm value♦ Quality: Moscow taxis; MBO and killings of civilians in Viet Nam ♦ Gaming: reallocation of performance between periods or units ♦ Externalities:

• Sabotage of others in relative performance, between shifts Pay compression useful to enhance cooperation

• Damage to clientele: reputation effects Important to group together activities in which performance can

be measured in a similar way

Uncertainty Performance

IncentivesObservable performance

Effort

Firm value

Verifiable performance

3rd party enforcement

2nd party enforcement

1st party enforcement

3rd party, judicial enforcement

Compensation Function (3). Group or individual?

▪ Key issue: relative advantage of specialized versus mutual performance evaluation

▪ Larger group size makes specialization relatively preferable

▪ Greater within-team interactions make mutual systems preferable

Compensation Function (4). Puzzles in variable compensation

▪ Short term not predominant, even in the US—but long-term variability hard to estimate

▪ Asymmetric use of prizes and punishments: wage reduction damages morale and is seen as unfair better to dismiss underperformers

▪ Use of ceilings —to avoid aberrant effects? Aberrant results, exogenous risk, equality.

▪ Use of minimums despite causing reallocation (e.g., in sales, public works)—as insurance?

Compensation function (5). Performance evaluation

▪ Objective evaluation♦ Objective aberrations♦ Contractual problems: standards

tricky to set and move• Employees self-protect through social

norms stipulating a certain effort

• Difficult to change: ‘ratchet’ effect with piece rate: moving standards

– Factors: technical change, trust

– Famous ‘Lincoln Electric’ case Next

Working / Careers at Lincoln Electric(http://www.lincolnelectric.com/corporate/career/openings.asp)

▪ “Both entry-level and skilled positions require working a rotating shift on either a two or three shift basis. In addition, most plant operations positions pay on a piecework basis. That means pay is based directly on output.

▪ All of these positions offer excellent opportunities for quality-conscious, productivity-minded individuals who are interested in being rewarded for their excellent performance.

▪ Incentive Performance - A Cornerstone of Our Culture. The Incentive Performance System primarily attributed to James F. Lincoln has been in place at Lincoln Electric since the early twentieth century. It has resulted in one of the oldest "pay-for-performance" systems in the country, and is frequently used for benchmarking by other businesses and studied by academics around the world.

▪ The Incentive Performance System in place in the U.S. Lincoln operations features:

♦ An elected Advisory Board for direct and open communication with senior management since 1914.

♦ Piecework incentive rewards for all production work. ♦ A profit-sharing Bonus Plan for employees paid annually at the discretion

of the Board of Directors since 1934. ♦ Guaranteed Employment after three years of service. The company has

not exercised its layoff options in the U.S. operations since post war 1948. ♦ 401(k) plan offering the employee a variety of pre-tax investment options. ♦ Competitive compensation and other benefits. ♦ A Financial Security Program which includes company contributions based

on years of service from 4 - 10%. ♦ An attractive vacation package based on comparable years of service.”

“Through this well-defined group of incentives, Lincoln encourages and compensates individual initiative and responsibility. Employees work together to reduce costs and improve quality. These individual and cooperative efforts create a more profitable company, the success of which each person shares according to his or her own contribution.”

Compensation function (5). Performance evaluation

▪ Objective evaluation

▪ Subjective evaluation♦ Corrects objective aberrations (Baker/Gibbons/Murphy QJE ‘94)♦ Requires relational contracting, 2nd party enforcement♦ Causes subjective aberrations

• Systematic and unintentional failures Questionnaires

• Rent-seeking ( “influence”) activities

♦ Rejected by middle managers (b/c we value ourselves too bad / too good in absolute / relative terms) Important: amounts & expectations

▪ Frequency of evaluation: ♦ Cost: Measurement + Rent seeking

• E.g., promotions in Japanese firms, entry in Civil Service

♦ Value: before specific investments

Compensation function (6). Careers & deferred compensation

▪ Compensating labor in the long term

▪ Examples: Seniority, non-vested pensions, pantoufles, audit firm’s partners, professions with entry barriers, etc.

▪ Long term investment expropriation risk if specific

Compensation function (7). Deferred compensation—Main issues

▪ Why? ♦ Performance unobservable in the short run (e.g.,

quality, professionals)♦ Also: “specific” human capital (e.g., info required

for coordination); employees’ risk aversion (?)

▪ How?♦ Compensation through quasi-rents: deferred

compensation

Compensation function (7). Consequences of deferred compensation

▪ Self selection of people with low discount rate more fraud-adverse? Lower expected turnover

▪ Stronger effort, if future compensation is not vested (threat of losing quasi-rents) ♦ What happens with professionals’ regulation?

▪ But quasi-rents can be expropriated Might be better to determine promotions and deferred

compensation by seniority than by evaluating performance Vested compensation still self-selection, but not

stronger effort: e.g., Civil Service, promotions in Japan

Compensation function (8)How to contract careers

▪ Mandatory law♦ Permanent employment: dismissal triggers established

indemnity 3rd party, judicial enforcement parties cannot opt out legally

• May trigger workers’ opportunism

• Less incentive for employers to contract

• More careful and personal selection, high capital intensity, unemployment,

▪ Enabling law♦ Idem unless parties contract out, agreeing e.g. on

termination at will♦ Employer performs “quasi-judicial” function often with the

help of workers’ boards (e.g., Japan, Lincoln Electric)

Compensation function (9)More issues on careers

▪ Mandatory retirement ♦ Japan: 54 years for “permanent” employees ♦ Needed in final years b/c compensation > disutility of work

▪ Promotions as a reward system♦ Careful evaluation controls for long term performance♦ Matching problem (“Peter’s Principle”): also appointment:

better when same abilities required in different ranks Otherwise, does not motivate technical, salespeople, etc. Two tracks needed

▪ More

Compensation function (&10)Still more issues on careers

▪ Tournaments ♦ Prizes fixed in advance, allocated through relative performance♦ Spread between prizes is the motivating factor♦ When luck is more important, more spread needed for same effort♦ Advantages (M&R, 384): Ordinal information, Prize pool set in advance♦ Compensation of “Stars”

▪ Tenure & Up or Out♦ Common in consulting and professional firms and universities♦ Explicit tenure helps recruiting good candidates: current workers do not feel

threatened • (implicit tenure may result from the fact that matching improves with seniority.

Institutional constraints very important in Europe (not in Japan)♦ “Up or out”

• fresh ideas• eliminates incentives to cheat by unfairly denying promotion: difference of gaps

needed to encourage employees to invest and employers to promote employees• less costly for “producers” of non-specific human capital: good outside Jobs

Managing our incentives