Economists have traditionally stressed the importance of performance pay to align employees’ behavior with the objectives of employers. However, organizations also adopt non-monetary practices to guide the behavior of employees. In particular, in recent years many larger companies have revised their practices to manage employee performance – often reducing the role of individual rewards and focusing more on establishing regular conversations about performance between supervisors and subordinates.
In a recent IZA discussion paper, Kathrin Manthei, Dirk Sliwka and Timo Vogelsang study whether introducing regular conversations about a specific outcome variable can indeed raise performance, and how the effect of these conversations compares to and interacts with effects of performance pay tied to the same outcome variable. The research team analyzed the supervision between district managers and their store managers of a nationwide retailer, operating discount supermarkets in Germany.
The key result is that performance reviews indeed increased profits by approximately 7-8 percent. Yet, this positive effect of the performance reviews vanished when it was accompanied by performance pay, which alone had no significant effect on profits. Thus, in contrast to the researchers’ expectations, performance pay did not only reduce the marginal effect of introducing performance reviews – it even reduced the absolute effect of this practice.
Performance pay undermines reputational incentives
The authors explain that the use of monetary rewards can reduce the power of the “reputational incentive” mechanism, especially when reputational incentives are strong. Performance reviews generate more transparency about the managers’ activities to raise profits, facilitating the signaling of motivation which leads to higher powered incentives. Performance pay, on the other hand, may undermine the reputational incentives triggered through the review meetings and, in turn, can affect the quality of the interaction between supervisor and subordinate.
On a broader level, these results show that different organizational practices may interact in non-trivial ways. The performance effect of introducing a specific management practice may be contingent on the use of other practices. Whether and how specific practices interact depends on the interplay of different economic motives and behavioral mechanisms.