Culture & Engagement

The odd relationship between compensation and performance

HR system integration

The relationship between compensation and performance is a little bit like the relationship between two people. They both rely on each other to function, but it’s hard to predict how an action by one might influence the other.


Yes, it’s a complex relationship. But it’s an important relationship to understand – especially if you care about building a happy and productive environment. So today, I’m going to inspect the way in which compensation can influence performance – and how you can use this information to build a stronger workforce.

The logic doesn’t add up – more money does not always mean better performance


Money is the driving factor that gets most people working. If it wasn’t, we’d all be volunteering full-time at the local soup kitchen. So wouldn’t it be logical to conclude that more money equals better performance?


Well, yes it would. But it doesn’t always work like that.


Image by Mark Yuill / Shutterstock, Inc


“When people first approach me, they tell me they need to earn X because they have to pay their bills” says Owen Morgan, Director of Intoo UK & Ireland. “But once cost bases are covered, financial elements tend to disappear from the equation. Performance is then influenced by other factors like recognition or an engaging workload.”


Owen’s input definitely carries some weight – he has worked in career development and talent management for over 15 years. But this isn’t just a casual observation. In fact, Owen’s notion is supported by a popular scientific theory called “The Two-Factor Theory” (or “Herzberg’s Motivation-Hygiene Theory”).

Compensation is a hygiene factor – not a motivator


Herzberg’s theory does not look directly at performance. Rather, it looks at job satisfaction. But his study is still relevant, because job satisfaction is closely linked to performance. For example, Taylor & Francis (2013) found a positive correlation between job satisfaction and some financial indicators of organisational performance.

Herzberg’s theory


Now, according to Herzberg’s theory, there are two independent factors that influence job satisfaction. These are:


1, Motivators – these have a positive influence on job satisfaction.

2, Hygiene factors – these prevent job dissatisfaction.


Essentially, Herzberg is saying that the motivators will give employees the drive they need to work harder. The hygiene factors will simply keep them content with their job overall.


According to his theory, financial benefits are hygiene factors. In other words, compensation doesn’t actually improve performance – rather, it secures the fort against employees feeling unhappy in their roles, and helps you boost retention rates.

Money might not always motivate, but it sure as hell prevents churn


George Elfond, CEO of Rallyware, takes a very analytical approach to how compensation and retention interact. His company helps employers to on-board, train and engage their people, and he’s noticed a number of interesting patterns emerging from the data he’s been collecting.


“Having worked with many companies to boost their employee retention levels” he says, “we have seen the direct impact compensation has on retention. Companies that proactively evaluate compensation have a 43% higher level of retention.”

Companies that proactively evaluate compensation

Image by Pressmaster / Shutterstock, Inc


But what does retention have to do with performance? Well, a lot of things, actually. Constantly having to replace your workers is not only expensive, but it is inefficient. Some institutes estimate that it can take up to 26 weeks for a new hire to reach their full productivity! And what would you do if you started losing your top performers? Just keep replacing them with more? Because chances are, if you’re bad at keeping top performers, you’re probably bad at finding them, too.

Attract top performers from the start by offering competitive pay rates


On the subject of hiring top performers, it’s worth noting that the relationship between compensation and performance starts long before it comes to annual appraisals or quarterly bonus calculations. Yes, it starts during recruitment. And if you’re not offering the right compensation for new vacancies, then you’re not going to be attracting the top performers.

Attracting the top performers


According to Morgan from Intoo, “people will always look for a role that they feel is fairly paid. Yes, it’s a matter of perception – but the best performers tend to have a more demanding perception of how much they’re worth! You can’t just dress a bad salary up and hope nobody will notice. You need to set a rate that reflects what people think their skills are worth.”


Of course, good recruiters already know this. Good recruiters don’t try to advertise posts at 75% of their average market value. Good recruiters know how to set salaries that will attract top performers – while bad recruiters block top performers from even considering applying.

Attention to compensation helps you build a stronger performance profile


So what do we know about the relationship between compensation and performance so far? Well, we know that:


 * Setting the right levels of pay can help you attract better performers

 * Regularly reviewing compensation improves retention

 * However, more money doesn’t necessarily equal better individual performance


So by paying close attention to the compensation you’re paying, you might not be increasing individual performance. But you’ll be raising the overall performance profile of your organisation.


But something still doesn’t feel right. If money doesn’t drive individual performance, then why do so many companies still use performance related pay? Well, it’s because sometimes, money really does motivate.

Sometimes, cash can drive performance like crazy


Charlie Trevor is professor and department chair for management and human resources at the Wisconsin School of Business. According to Charlie, more than 90% of firms are using some sort of pay-for-performance program to boost productivity, and there’s a strong argument for doing so.


But while his research has revealed that performance related pay is associated with future employee performance across all organisational levels, it also shows that it is most effective when applied to roles where performance is more easily measured – such as sales jobs.

Performance pay it is most effective when applied to roles where performance is more easily measured

Image by chainarong06 / Shutterstock, Inc


“There are two main types of performance related pay” says Charlie. “Merit pay, and a lump sum bonus. While merit pay offers incremental increases to salary year on year, a lump sum bonus has a stronger impact, because of the immediacy of the windfall.”


However, Charlie warns that firms should not simply abandon merit pay, as this could lead to problems attracting and retaining high quality employees.

Money motivates, but its effects are short-lived


Have you ever wondered why sales targets are calculated quarterly, monthly, weekly or even daily? Well, it’s because money isn’t a long-term solution. Yes, it can improve performance, but its effects usually work in short bursts.


In 1993, Harvard Business Review published a paper titled “Why Incentive Plans Cannot Work”. In their paper, they stated that rewards do not create a lasting commitment – they merely, and temporarily, change what we do.


This is probably why most money-driven job roles offer regular, short bursts of extra income, such as weekly or monthly sales commissions. It keeps injecting that temporary boost in motivation and performance.

Getting the right balance is crucial


So, now we’ve learned that compensation is important for both motivation and retention. It therefore plays a very important role in performance. But while we’ve talked about what can happen if you set compensation levels too low… what happens when you set them too high?


A few years ago, the BBC compiled research about the impact of money on performance. In one study, they found that the greater the financial reward becomes, the worse performance gets. This is possibly because the increased pressure impairs a person’s ability to carry out tasks effectively.

nearly half of all junior bankers quit within three years.

Image by BlueSkyImage / Shutterstock, Inc


You can see this in playing out in real life, as well as in the research lab. For example, EFC says that nearly half of all junior bankers quit within three years. They add that while there is lots of money to be made, the toll it takes on health and social life forces many people away from the job.


Yes, too much money can have the opposite effect!

So what exactly does the relationship between compensation and performance look like?


We’ve covered a lot of information in a short amount of time. I’d love to explore these areas in more detail some time, but the point of today’s post was not to deliver a lecture – rather, I wanted to introduce you to the way this odd relationship works.


So let’s summarise the key points in brief:


 * Compensation is more of a safety blanket than a motivator. Setting appropriate salaries might not improve individual performance, but it will help you to attract and retain the best workers.

 * Performance-related pay is more effective in roles where performance is easily measured. Bonus payments can be very effective in roles such as sales, where it is easy to pin payments to achievements. However, this still only seems to work as a temporary performance booster.

 * Too much money can drive performance down. The pressure of working for a bigger “prize” can often lead to worse performance, and high attrition.


The relationship between performance and compensation is indeed complicated. But let’s not overthink things. Why? Well, because everybody is different. You could compile statistics all day long, and you’d never create a single rule that applied to every single person in your organisation.


Everybody is different. You won’t create a single rule that works for everyone. Take an agile approach, and learn how each of your people work.


So rather than over analysing everything, wouldn’t it be more effective to simply ensure that people are compensated fairly for the work they do, and then spend more energy on more meaningful areas of business? Like engagement, physical health, and emotional wellbeing?


Yes, you should benchmark salaries to make sure you’re paying a decent wage. Yes, you should talk to employees regularly to make sure they feel they are being paid fairly. And yes, offer performance-related payments and bonuses! But none of this is the be-all and end-all of performance. You’ve got to take an agile approach, and you’ve got to learn how each of your people works.


If you have an opinion to add to this article, please add a comment by logging into Disqus below (it’s free). Or, to discuss this topic in more detail, head over to our Facebook discussion group, People Talk – you’ll find like-minded HR professionals and business leaders putting the world to rights over morning coffee!