Pay-For-Performance Part III: How Overconfidence Hinders Pay Plan Effectiveness

In recent articles, I have been exploring the disconnection between corporate compensation strategies and the realities of the workplace. It is a critical issue, because compensation plans play a starring role in retaining talent and promoting increased employee productivity. They also have a secondary goal of encouraging people to “find the right seat on the bus,” self-sorting themselves into jobs that offer the financial risk/reward ratio that makes them most comfortable (and best matches their skill set.)

In theory, well-structured compensation plans that emphasize incentives, such as pay-for-performance, should work. In practice, unfortunately, these grand plans often miss the mark, wasting corporate resources and reducing productivity.

The reasons pay-for-performance plans fail can be found in the psychological mindsets of your employees. They are not always clear-thinking, rational beings. They fall prey to distracting emotional impulses.

My opinions on the failings of pay-for-performance compensation plans have found recent support in the work of Harvard Business School Professor Ian Larkin and others in a paper titled The Psychological Cost of Pay-for-Performance, in which they cite three key areas of psychological interference in compensation plans: Social comparison, overconfidence and risk aversion.

In this third article, let’s explore “overconfidence” and its impact on the effectiveness of performance-based pay. According to Larkin, et al.; “Psychologists and decision research scholars have long noted that people tend to be overconfident about their own abilities and too optimistic about their future.”

Overconfidence takes at least three forms:

• Individuals consistently express unwarranted subjective certainty in their personal and social predictions.
• They often overestimate their own ability.
• They often overestimate their ability relative to others.

“Recent research has shown that overconfidence is not as much an individual personality trait as it is a bias that affects most people,” say the authors, “depending on the task at hand. In general, people tend to be overconfident about their ability on tasks they perform very frequently, find easy, or are familiar with. Conversely, we tend to be under-confident on difficult tasks or those we seldom carry out. This has large implications for overconfidence in work settings, since work inherently involves tasks with which employees are very familiar.”

This overconfidence affects an employee’s perception of what they should be paid for their effort. Given that performance-based pay is supposed to get employees to “self select” into positions that best match their skill set, overconfidence drives them to shoot too highly. So, performance-based pay may fail to efficiently sort workers by skill level, compromising that goal. “Psychologists have argued that overconfident workers will tend to select into performance-based compensation systems, particularly preferring individual-based pay-for-performance,” say the authors.

Here are some other effects of this mis-alignment between skill set and job:

• These employees will under-perform, and not make as much as they thought they would, increasing dissatisfaction. Again, this is the opposite of the desired compensation plan impact!
• They will compare themselves against peers more favorably than is justified, and when they fail to earn equal pay, they perceive “pay inequity” rather than lack of performance on their part. This engenders even more dissatisfaction.
• The company will experience higher turnover, as people cycle in and out of jobs they are not qualified to fill.
• I love the example cited in the Larkin study: In a survey of the sales force of a large enterprise software vendor in 2000, each salesperson was asked how much he expected to earn in commissions that year. The survey median of $800,000 was nearly eight times the actual median compensation, suggesting that these salespeople were highly overconfident about their sales abilities and resulting compensation. The average attrition rate of enterprise software salespeople at the time was nearly 30% per year, and average tenure level was only around two years, “suggesting that a salesperson’s failure to meet his inflated expected pay level may cause him to leave for another firm. Since sales cycles in the industry are a year or more, and relationships are so critical to sales success, high salesperson attrition rates are extremely costly to software vendors (Sink, 2006).”
• How do you compensate for the effects of overconfidence?
• Twenty years of solving this problem for clients helps me boil this down to its essence:
• Start by getting better insight into actual employee skill and contribution through assessment, and by more actively observing (tracking) their output. Then, use the knowledge gained to sort your talent to better match skill set to job position, and therefore to compensation.
• At the individual level: Assess current skill levels, access to needed resources and cultural mindsets of each person. Create action plans to cure issues permanently.
• At the team level: Assess relative skill sets. Relate them to team needs. Shift tasks to appropriate people. Focus interactions on forward-thinking actions and results.
• At the managerial level: Clearly benchmark jobs, not the people in them. Involve the employees in this process, as they have information about performance requirements that managers don’t. Match available employee skill sets to jobs, reassigning people as needed. Keep engaging people in the process, asking for feedback and reporting progress.
• Actively share goals and the corporate thinking behind them.

A well-run assessment process will help make employee interactions and decision-making more objective. You then use the assessment results to launch better, sustained ongoing engagement based on true two-way communication that builds and maintains trust, and focuses on actionable tasks and results.

In short, pursue the truth of what is happening, and what has to happen, to get everyone on the right seat on the bus. They better understand and agree to the role they need to play, and contribute more productively towards fulfilling your mutually shared business goals.

Knowledge is power: Once you improve your ability to observe what is really occurring in your workplace, you can better match people to jobs, and compensation to jobs. Once the subjectivity that employees bring to the workplace is marginalized by true communication and a corporate culture that rewards the pursuit of truth, crafting compensation plans that truly motivate employees to maximize their contributions becomes a lot easier.

All of this is hard work, and needs to be a central part of all managers’ days. Full employee engagement is “Job One,” to borrow an old Ford advertising slogan, and is the Foundation of Excellence that solves so many of today’s workforce problems.