Pay for Performance Part III: How Overconfidence Hinders Pay Plan Effectiveness

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

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 why performance pay plans fail can be found in the psychological mindset of your employees. They are not always rational and clear-thinking beings. They fall prey to distracting emotional impulses.

My views on the failures of pay-for-performance compensation plans have found recent support in the work of Harvard Business School Professor Ian Larkin and others in an article titled The psychological cost of performance pay, 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, and others.; “Psychologists and decision research scholars have long noted that people tend to be overly confident in their own abilities and overly 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 in relation to others.

“Recent research has shown that overconfidence is not so much an individual personality trait as a bias that affects most people,” the authors say, “depending on the task at hand. In general, people tend to be overconfident in their ability in tasks they perform very frequently, find easy, or are familiar with Conversely, we tend to be underconfident in tasks that are difficult or rarely performed This has big implications for overconfidence in work environments, 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. Since performance-based pay is supposed to cause employees to “self-select” into jobs that best match their skill set, overconfidence leads them to overshoot. Therefore, performance-based pay may not efficiently classify workers by skill level, compromising that goal. “Psychologists have argued that overconfident workers will tend to select performance-based compensation systems, particularly preferring individual-based performance pay,” the authors say.

Here are some other effects of this misalignment between skill set and job:

• These employees will underperform and not earn as much as they thought, increasing dissatisfaction. Again, this is the opposite of the desired impact of the compensation plan!
• They will compare themselves to their peers more favorably than is warranted, and when they fail to earn equal pay, they perceive “pay inequality” rather than lack of performance on your part. This generates even more dissatisfaction.
• The company will experience increased turnover, as people move in and out of jobs for which they are not qualified.
• I love the example cited in Larkin’s study: In a survey of the sales force of a large enterprise software vendor in 2000, each salesperson was asked how much they 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 overconfident in their sales skills and resulting compensation. The average churn rate for enterprise software vendors at the time was nearly 30% per year, and the average tenure level was only about two years, “suggesting that a vendor’s failure to meet with your expected pay level inflated it may cause you to go to another company.Since sales cycles in the industry are a year or more, and relationships are so critical to sales success, high attrition rates from vendors are extremely expensive for software vendors (Sink, 2006)”.
• How do you offset the effects of overconfidence?
• Twenty years of solving this problem for clients helps me to sum this up at its core:
• Start by gaining a better insight into employees’ real skills and contributions through appraisal, and more actively observe (track) their performance. Then, use the knowledge gained to rank your talent to best match the skill set to the job title, and therefore compensation.
• At the individual level: Assess each person’s current skill levels, access to necessary resources, and cultural mindset. Create action plans to permanently fix problems.
• At the team level: Assess relative skill sets. Relate them to the needs of the team. Shift tasks to the appropriate people. Focus interactions on actions and results with a vision of the future.
• At the management level: Clearly the reference jobs, not the people in them. Involve employees in this process, as they have information about performance requirements that managers do not. Match employees’ available skill sets to jobs, reassigning people as needed. Keep involving people in the process, asking for feedback and reporting on progress.
• Actively share goals and the corporate thinking behind them.

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

In short, seek the truth of what is happening and what needs to happen, so that everyone gets the right seat on the bus. They better understand and accept the role they must play, and contribute more productively to meeting their shared business objectives.

Knowledge is Power: Once you improve your ability to see what’s really going on in your workplace, you’ll be better able to 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 truth-seeking, crafting compensation plans that truly motivate employees to maximize their contributions becomes much more difficult. easier.

All of this is hard work and should be a central part of every manager’s day. Total employee engagement is “job first,” to borrow an old Ford advertising slogan, and is the foundation of excellence that solves many of today’s workforce problems.