Gerhart PFP

This article was downloaded by: [University of Bath]
On: 07 October 2014, At: 10:56

Publisher: Routledge
Informa Ltd Registered in England and Wales Registered Number: 1072954
Registered office: Mortimer House, 37-41 Mortimer Street, London W1T 3JH,
UK
The Academy of Management

Annals
Publication details, including instructions for
authors and subscription information:
http://www.tandfonline.com/loi/rama20
6 Pay and Performance:

Individuals, Groups, and
Executives
a b
Barry Gerhart , Sara L. Rynes & Ingrid Smithey
c
Fulmer
a
School of Business , University of
Wisconsin‐Madison ,
b
Tippie College of Business , University of Iowa ,
c
College of Management , Georgia Institute of
Technology ,
Published online: 05 Aug 2009.
To cite this article: Barry Gerhart , Sara L. Rynes & Ingrid Smithey Fulmer (2009)
6 Pay and Performance: Individuals, Groups, and Executives, The Academy of
Management Annals, 3:1, 251-315, DOI: 10.1080/19416520903047269
To link to this article: http://dx.doi.org/10.1080/19416520903047269
PLEASE SCROLL DOWN FOR ARTICLE
Taylor & Francis makes every effort to ensure the accuracy of all the
information (the “Content”) contained in the publications on our platform.
However, Taylor & Francis, our agents, and our licensors make no
representations or warranties whatsoever as to the accuracy, completeness,
or suitability for any purpose of the Content. Any opinions and views
expressed in this publication are the opinions and views of the authors, and
are not the views of or endorsed by Taylor & Francis. The accuracy of the
Content should not be relied upon and should be independently verified with
primary sources of information. Taylor and Francis shall not be liable for any
losses, actions, claims, proceedings, demands, costs, expenses, damages,
and other liabilities whatsoever or howsoever caused arising directly or
indirectly in connection with, in relation to or arising out of the use of the
Content.
This article may be used for research, teaching, and private study purposes.
Any substantial or systematic reproduction, redistribution, reselling, loan,
sub-licensing, systematic supply, or distribution in any form to anyone is
expressly forbidden. Terms & Conditions of access and use can be found at
http://www.tandfonline.com/page/terms-and-conditions
Downloaded by [University of Bath] at 10:56 07 October 2014
The Academy of Management Annals
Vol. 3, No. 1, 2009, 251–315
6
Pay and Performance:
Individuals, Groups, and Executives
BARRY GERHART*
School of Business, University of Wisconsin-Madison
SARA L. RYNES
Tippie College of Business, University of Iowa
INGRID SMITHEY FULMER

College of Management, Georgia Institute of Technology
Abstract
Academy
10.1080/19416520903047269
RAMA_A_404899.sgm
1941-6520
Original
Taylor
3102009
bgerhart@bus.wisc.edu
BarryGerhart
000002009
and
&Article
Francis
of(print)/1941-6067(online)
Francis
Management Annals
In this chapter, we address three pay for performance (PFP) questions. First,
what are the conceptual mechanisms by which PFP influences performance?
Second, what programs do organizations use to implement PFP and what is
the empirical evidence on their effectiveness? Third, what perils and pitfalls
arise on the way from PFP theory to its execution in organizations? We
address these questions in general terms, but also highlight unique issues that
arise in PFP for teams and for executives. We highlight the fact that research
and practice in the area of PFP requires one to deal with a number of trade-
offs. For example, strengthening PFP links can generate powerful motivation
*Corresponding author. Email: bgerhart@bus.wisc.edu
ISSN 1941-6520 print/ISSN 1941-6067 online

© 2009 Academy of Management
DOI: 10.1080/19416520903047269
http://www.informaworld.com
251
252 • The Academy of Management Annals
effects, but sometimes these are in unintended and unanticipated directions,

resulting in undesirable effects. In addition, there are also trade-offs in decid-
ing the degree of emphasis to give to individual versus team performance and
to results versus behaviors in PFP plans. What all this means is that, as in
other areas of management, “one best way” advice (e.g., do or do not use indi-
vidual PFP plans) or “sound-bite” conclusions (e.g., PFP does not exist; PFP
does or does not motivate) are rarely valid, but rather depend on the circum-
stances and the organization. In the realm of executive pay, we question the
current conventional wisdom in the management literature that there is little
or no PFP. We close the chapter with a discussion of our key conclusions and
suggestions for what we think would be the most interesting and useful future
research areas. We encourage the management literature, which has increas-

ingly become interested in the concept of evidence-based management, to
execute this concept more effectively in its research and when talking or writ-
ing about pay.
Introduction
Literally hundreds of studies and scores of systematic reviews of incen-

tive studies consistently document the ineffectiveness of external
rewards. (Pfeffer, 1998, pp. 214–215)
Money is the crucial incentive because, as a medium of exchange, it is
the most instrumental… No other incentive or motivational technique
comes even close to money with respect to its incremental value.
(Locke, Feren, McCaleb, Shaw, & Denny, 1980)
The link between pay and performance [of executives] has increased
nearly tenfold since 1980. (Hall, 2000)
Research shows only a small relationship between executive compensa-
tion in any form and firm performance. (Hitt, 2005).
On average, the single largest operating cost for an organization is employee

compensation (Blinder, 1990; European Parliament, 1999; Bureau of Labor
Statistics, 2001). An organization’s success depends not only on the magni-
tude of this cost, but also on what it gets in return for its investment.1 Yet, as
the opening quotes suggest, there is considerable disagreement about both the
existence, and the effects, of pay for performance (PFP) among employees and
executives. In this chapter, we hope to shed some light on which claims are
best supported by research evidence.
Compensation (also called pay or remuneration) can be defined to
include “all forms of financial returns and tangible services and benefits
employees receive as part of an employment relationship” (Milkovich &
Newman, 2008, p. 9).2 However, in this chapter, we focus on one dimension
Pay and Performance • 253
of compensation—PFP. Although there are multiple dimensions of compen-

sation (e.g., pay level, pay structure, benefits), our decision to focus primarily
on PFP stems from its potential both as a basis for organization differentia-
tion from competitors and as a potentially powerful driver of performance.
In addition, PFP is a strategic compensation decision where organizations
appear to have more discretion than in other areas such as pay level, which
is more constrained by labor and product market parameters (Gerhart &
Milkovich, 1990; Haire, Ghiselli, & Gordon, 1967). Also, PFP is of special
interest because when it “works”, it seems capable of producing spectacularly
good results and when it does not work, it can likewise produce spectacularly
bad results (Gerhart, 2001). Thus, it seems to be an area where organizations
can choose to be different in an effort to achieve high performance, but in

doing so, also run higher risks (Gerhart, Trevor, & Graham, 1996). PFP is
also of interest because such plans (in one form or another) not only con-
tinue to be prevalent in the private sector, but also seem to be making
inroads into sectors of the economy where they have not historically been
prevalent (e.g., the public sector, health care, education). Apparently, there is
a growing belief that PFP can be used to improve effectiveness in these sec-
tors as well.
In this chapter, we focus first on three general issues related to PFP. First,
what are the conceptual mechanisms by which PFP influences performance?
Second, what programs do organizations use to implement PFP and what is
the empirical evidence on their effectiveness? Third, what perils and pitfalls
arise on the way from PFP theory to its execution in organizations? Finally, we
devote a separate section to PFP for executives. The issues in executive PFP
are similar in some ways to the three general issues covered in our broader
discussion of employee PFP. At the same time, however, executive compensa-
tion is unique in important ways (its magnitude, the key role of stock plans,
the amount of public interest and regulatory scrutiny), suggesting the value of
a separate discussion. We close the chapter with a discussion of our key con-
clusions and suggestions for what we think would be the most interesting and
useful future research areas.
We highlight in this chapter the fact that research and practice in the area
of PFP requires one to deal with a number of trade-offs and conundrums.
Strengthening PFP links can generate powerful motivation effects, but some-
times these are in unanticipated and undesirable directions. Similarly, the
relative emphasis given to results-based and behavior-based measures of
performance may contribute to too much or too little focus on certain perfor-
mance objectives. In like fashion, the relative emphasis given to individual and
group/organization performance in PFP plans may be beneficial for some
objectives, but detrimental to others. What all this means is that, as in other
areas of management, “one best way” advice (e.g., do or do not use individual
PFP plans) or “sound-bite” conclusions (e.g., pay does or does not motivate)
are rarely valid, but rather depend on the circumstances. This, of course, is
what makes the field so interesting. In the case of executive compensation, the
large sums of money involved, questions about its appropriateness and
disagreement regarding the degree to which it is determined by performance
versus less legitimate factors only adds to that interest.
Conceptual Issues
Incentive and Sorting Effects
Several social sciences, but particularly psychology and economics, have
offered a variety of theories to explain the impact of pay in organizations.
These include reinforcement, expectancy, equity, utility, agency, efficiency
wage, and tournament theories (for reviews, see Bartol and Locke (2000) and
Gerhart and Rynes (2003)). To simplify greatly, these theories suggest that pay
operates on motivation and performance via two different mechanisms—
incentive effects and sorting (Gerhart & Milkovich, 1992; Gerhart & Rynes,
2003; Lazear, 1986).
First, there is the potential for an incentive effect, which is the impact of
PFP on performance via its impact on current employees’ motivational states.
In other words, the incentive effect is how pay influences the level or intensity
of individual and aggregate motivation, holding attributes of the workforce
constant. More so than sorting effects, incentive effects have been the focus of
the great majority of theory and research in compensation.
The most direct evidence of the power of incentive effects comes from
meta-analytic summaries of empirical work on individual incentive programs.
This research aims to isolate the impact of individual contributions an objec-
tive measures of performance. For example, in a meta-analysis of potential
productivity-enhancing interventions in actual work settings, Locke et al.
(1980) found that the introduction of individual pay incentives increased pro-
ductivity by an average of 30%. These results are particularly compelling
because the authors only included studies that were conducted in ongoing
organizations (as opposed to laboratories), that used either control groups or
before–after designs, and that used objective performance measures (e.g.,
physical output). A second meta-analysis by Guzzo, Jette, and Katzell (1985)
likewise found that financial incentives had a large mean effect on productiv-
ity (d=2.12).3 More recent meta-analyses (Jenkins, Mitra, Gupta, & Shaw,
1998; Judiesch, 1994; Stajkovic & Luthans, 1997) also provide similarly strong
support for the impact of PFP incentives. In short, in contrast to Pfeffer’s
(1998) assertion, there is strong evidence that PFP produces incentive effects
that are very strong under certain conditions (e.g., individually-based with
objectively measureable outcomes).4
Second, PFP may also produce higher performance through sorting
effects, which reflect the impact of pay on performance via its impact on the
composition of the workforce (Gerhart & Milkovich, 1992). That is, different
types of pay systems may cause different types of people to apply to and stay
with (i.e., self-select into) an organization. For example, individuals attracted
to different types of pay systems may vary on the basis of ability (Trank,
Rynes, & Bretz, 2002), responsiveness to PFP (Stewart, 1996), risk seeking
(Cable & Judge, 1994), trait-like motivation (Amabile, Hill, Hennesey, &
Tighe, 1994; Judge & Ilies, 2002), or other productivity-related attributes.
Organizations too may differentially select and retain employees, depending
on the nature of their pay level and/or PFP strategies. The self-selection
aspect of sorting and its application to the effects of pay is based primarily on
work in economics (Lazear, 1986), but the idea is also consistent with
Schneider’s (1987) attraction–selection–attrition (ASA) model in the applied

psychology literature (Bretz, Ash, & Dreher, 1989). Critics of PFP, including
Pfeffer (1998), tend to ignore this effect.
As with incentive effects, there also is rather compelling evidence of sorting
effects associated with PFP. For example, Lazear (2000) reported a 44%
increase in productivity when a glass installation company switched from
salaries to individual incentives. Of this increase, roughly 50% was due to exist-
ing workers increasing their productivity (an incentive effect), while the other
50% was attributable to less productive workers quitting and being replaced by
more productive workers over time (a sorting effect). Another study, a field
experiment by Bandiera, Barankay and Rasul (2007), demonstrated that when
managers were switched from straight salaries to a PFP system where their pay
depended on the productivity of workers they managed, the managers
increased worker productivity both by hiring more productive workers (sort-
ing) and by pushing existing workers (incentive) to be more productive.
Cadsby, Song, and Tapon (2007) likewise found that both incentive and
sorting effects explain the positive impact of PFP on productivity. Their study,
set in the laboratory, was designed so that subjects went through multiple
rounds of a task. In some rounds, they were assigned to a PFP plan, in others,
to a fixed salary plan. In yet other rounds, they were asked to choose between
fixed salary or PFP. By the last rounds in three experiments, the PFP condition
generated 38% higher performance than the fixed salary condition, and the
sorting effect (less risk averse and more productive subjects being more likely
to select the PFP condition) was approximately twice as large as the incentive
effect in accounting for the performance difference.
Further evidence suggests that PFP is more attractive to higher performers
than to lower performers. For example, Trank et al. (2002) found that the
highest-achieving college students place considerably more importance
on being paid for performance than do their lesser-achieving counterparts.
Likewise, people with higher need for achievement (Bretz et al., 1989; Turban
& Keon, 1993) and lower risk aversion (Cadsby et al., 2007; Cable & Judge,
1994) also prefer jobs where pay is linked more closely to performance.
Other research shows that high performers are not only more likely to seek
out PFP, but they are also more likely to quit and seek other employment if
their performance is not sufficiently recognized with financial rewards
(Nyberg, 2008; Salamin & Hom, 2005; Trevor, Gerhart, & Boudreau, 1997).
Conversely, low performers are more likely to stay with an employer when pay–
performance relationships are weaker (Harrison, Virick, & William, 1996).
Finally, we should note that to the degree sorting effects operate, it may
appear as though the PFP relationship is weak because selectivity in hiring by
employers (and/or self-selection by applicants), combined with the use of
selection procedures having predictive validity, will result in not only higher
mean performance, but also restricted within-organization variance in perfor-
mance (Brogden, 1949). Under such range restriction, the observed PFP rela-
tionship will be attenuated, but it would be a mistake to conclude that PFP is
unrelated to performance. In any event, prior research has convincingly
shown that PFP can have substantial positive effects on performance, and that
these effects occur through both incentive and sorting mechanisms.
Defining and Measuring Performance

A major decision in the design and success of PFP programs is likely to be the
choice of how to define and measure performance. We focus on two key
choices here. First, how much emphasis is placed on results-oriented/objective
performance measures (e.g., number of units produced, profitability) relative
to behavior-based ones (e.g., supervisory/merit evaluations of effort or qual-
ity)? Second, how much emphasis is placed on individual contributions
relative to collective contributions?
Behavior-based (subjective) versus results-based (objective) measures.

Behavior-oriented measures (such as traditional merit ratings) offer a number
of potential advantages relative to results-based measures (Eisenhardt, 1985a,
1989; Gerhart, 2000; Holmstrom, 1982; Lawler, 1971; Ouchi, 1979). First, they
can be used for any type of job. Second, they permit the rater to factor in vari-
ables that are not under the employee’s control, but that nevertheless influ-
ence performance. Third, they permit a focus on whether results are achieved
using acceptable means and behaviors. Fourth, they generally carry less risk of
measurement deficiency, or the possibility that employees will focus only on
explicitly measured tasks or results at the expense of broader pro-social behav-
iors, organizational citizenship behaviors, or contextual performance (Arvey
& Murphy, 1998; Lawler, 1971; Milgrom & Roberts, 1992; Wright, George,
Farnsworth, & McMahan, 1993).
On the other hand, the subjectivity of behavior-oriented measures can limit
their ability to differentiate employees (Milkovich & Wigdor, 1991). Meta-
analytic evidence has found a mean inter-rater reliability of only 0.52 for
performance ratings (Viswesvaran, Ones, & Schmidt, 1996), making it difficult
for organizations to justify differentiating employees based on such error-

laden performance measures, especially if a single rater (usually the immediate
supervisor) is the source. Moreover, even if subjectivity could be sufficiently
controlled and performance reliably and credibly differentiated, managers
may be reluctant to differentiate because of concerns about adverse conse-
quences for workgroup cohesion, pro-social behaviors, and management–
employee relations (Heneman & Judge, 2000; Longenecker, Sims, & Gioia,
1987). Finally, behavior-based measures are not applicable in situations where
either the opportunity to observe behaviors or the ability to judge behaviors is
not feasible.
At first blush, objective measures of performance, such as productivity,
sales volume, shareholder return, and profitability, would seem to provide the
solution to the aforementioned problems. However, relevant objective
measures are not available for most jobs, especially at the individual level.
Moreover, agency theory (which we discuss more fully in our section on exec-
utive compensation) emphasizes that results-based plans—at least those that
seek to replace some part of fixed salary with an incentive component—
increase risk-bearing among employees (Gibbons, 1998). Because most
employees derive the bulk of their income from employment, they cannot
diversify their employment-related earnings risk, making them more risk-
averse than others (e.g., investors) who can diversify their investments. Thus,
employees prefer fixed pay to incentives, unless there is a compensating
differential (Cable & Judge, 1994; Weitzman & Kruse, 1990). This, then, is the
classic trade-off between designing plans that maximize incentives while keep-
ing the negative effects of risk (in the form of negative employee reactions)
under control.
Risk aversion is less of a problem where objective measures are seen as
credible and performance on such measures is high, providing significant pay-
outs to employees. However, poor performance on such measures (and thus
decreasing or disappearing payouts)—especially if attributed to factors
employees see as beyond their own control (e.g., poor decisions by top execu-
tives or a sinking economy)—often results in negative employee reactions
(Gerhart & Milkovich, 1992). In such cases, there will almost inevitably be
pressure to revise (e.g., the experience at GM’s Saturn division (Gerhart,
2001)) or abandon the plan (DuPont (Gerhart & Rynes, 2003)).
Another issue is that even though objective measures are possibly more
reliable, they may also be more deficient. Lawler (1971) warned that “it is
quite difficult to establish criteria that are both measurable quantitatively and
inclusive of all the important job behaviors”, and “if an employee is not evalu-
ated in terms of an activity, he will not be motivated to perform it” (p. 171).
This is similar to the equal compensation principle from economics, which
states that if an employee’s allocation of time or attention cannot be moni-
tored by the employer, then marginal rates of return to employees for desired
activities must be at least equal to or greater than rates of return to activities

that are not desired, or they will receive little or no time or attention
(Milgrom & Roberts, 1992).
Finally, results-oriented measures often have a higher degree of incentive
intensity (Gerhart, 2001). Two potential consequences, one good, one bad, of
higher incentive intensity are: (a) higher motivational intensity; and (b) a
higher risk that this intensity will cause unintended consequences as these
highly motivated employees use their “ingenuity” to find new ways to earn
large payouts. We return to this concern later.
Individual and group (or collective) performance measures. Criticisms have

been leveled at organizations for focusing too much on individual perfor-

mance and rewards (Deming, 1986; Pfeffer, 1998; Pfeffer & Sutton, 2006). For
example, Deming (1986) argued that management’s “excessive” focus on indi-
vidual performance ignores the fact that differences in individual performance
often “arise almost entirely from the system that (people) work in, rather than
the people themselves” (p. 110). Regarding teamwork, Deming cautioned that
under individual PFP, “Everyone propels himself forward, or tries to, for his
own good… The organization is the loser” (Deming 1986, p. 110).
While the potential pitfalls of individually-based PFP are important, the lit-
erature is quite clear that group-based plans also have their own potential
drawbacks. One is that most employees (at least in the US) prefer that their
pay be based on individual rather than group performance (Cable & Judge,
1994; LeBlanc & Mulvey, 1998). Another is that, as noted earlier in the section
on sorting, this preference appears to be stronger among more productive
applicants and employees, suggesting that group-based PFP might, on aver-
age, be prone to unfavorable sorting effects.
Another concern has to do with the weakening of incentive effects (or “line
of sight”) under group plans (Schwab, 1973), particularly as group size
increases. Individuals are less likely to see a clear link between their effort and
their pay when the PFP plan uses group or organization-level performance
measures, which are influenced by a host of factors other than employee effort
and many of which are beyond workers’ immediate control. In addition, there
is a concern that co-workers will not contribute equally to group performance,
but nevertheless will receive the same level of rewards. Although Pfeffer (1998,
p. 219) claims that evidence regarding the importance of the “so-called free-
riding problem” is “surprisingly meager”, major reviews of team incentives
conclude that the free-rider problem is indeed an important phenomenon
requiring considerable attention if it is to be mitigated (Albanese & Van Fleet,
1985; Cooper, Dyck, & Frohlich, 1992; Shepperd, 1993).
Summary. A major issue in designing PFP plans is how to define and

measure performance. Two principal decisions are the relative emphasis to be
placed on results- versus behavior-based measures and on individual versus

group/collective performance. As we have seen, there are trade-offs involved
in each decision. In practice, many organizations fashion PFP plans that
combine different types of performance measures, perhaps in the hope of
obtaining positive motivation intensity (and sorting) effects, while at the same
time focusing employee motivation on multiple objectives (Gerhart et al.,
1996; Gerhart & Rynes, 2003). However, too much complexity in a PFP plan
can also be a drawback by undermining line of sight.
Risk/Return and Fit/Misfit

The preceding discussion, especially that dealing with potential incentive and
sorting effects, focuses primarily on the mean (i.e., average) and main (i.e.,
noninteractive) effects of PFP programs. Of course, to focus only on average
and main effects is to oversimplify reality. Even if PFP has a positive effect on
average, any organization considering a particular PFP program should also
be interested in the variance of the effect across organizations, which can be
interpreted as a measure of risk (Gerhart et al., 1996). In addition, perspectives
on fit, alignment, and contingency seek to understand contextual factors (e.g.,
business strategy, national culture, organization size, and HR practices other
than compensation) that may further influence (strengthen or weaken) the
success of PFP plans (for reviews, see Gerhart (2000, 2007), Gomez-Mejia and
Balkin (1992) and Milkovich (1988)).
Empirical Evidence on Individual and Group PFP Plans

In practice, organizations use specific PFP programs at the individual and/or
group level (e.g., merit pay, profit-sharing, and so forth) in an attempt to
enhance and support organization effectiveness. Thus, we organize our review
of the evidence on specific PFP plans by whether the plans are individual-based
or group/organization-based. Within each of these sections, we also segment
research according to results-based versus behavior-based performance
(Table 5.1). Although not explicitly included in Table 5.1, a third factor, incen-
tive intensity, is implicitly included in that it tends to be stronger for results-
based plans. We conclude with a discussion of risk/return and fit issues.
Table 5.1 Pay for Performance (PFP) Programs, by Level and Type of Performance Measure
Level of performance measure
Type of performance
measure Individual Facility/plant Organization
Behavior-based Merit pay Merit pay for
executives
Results-based Individual incentives Gain-sharing Profit-sharing
sales commission stock plans
Despite the fact that we describe each PFP program separately, it should be
kept in mind that people are often paid using a combination of programs.
Moreover, successful PFP programs (such as those at Lincoln Electric, Nucor
Steel, Whole Foods, Southwest Airlines, and General Electric, to name just a
few) come in many different formats, with varying degrees of relative empha-
sis on individual, group/unit, and/or organization level performance.
Individual-Based PFP Plans

Individual incentives. Individual incentives provide results-based (rather
than behavior-based) rewards. These can, for example, be in the form of piece
rates (where production workers get paid on the basis of the number of pieces
produced) or sales commissions, where pay is based on revenue produced. As

shown earlier, much of the meta-analytic evidence on PFP comes from studies
of individual incentive plans. This research has shown substantial positive effects
for PFP (Locke et al., 1980; Guzzo et al., 1985; Jenkins et al., 1998). However,
because incentive systems cannot be applied in the absence of valid measures
of objective performance, their feasibility is limited for most job categories.
In addition, if used exclusively, individual incentive plans can cause unin-
tended consequences (overly narrow motivational focus, ethical shortcuts to
achieve results). Lawler (1971), for example, warned that “it is quite difficult to
establish criteria that are both measurable quantitatively and inclusive of all
the important job behaviors” and that “if an employee is not evaluated in
terms of an activity, he will not be motivated to perform it” (p. 171). Similar
concerns are raised by Milgrom and Roberts (1992). Even where individual
incentives start out working well, problems often eventually arise if manage-
ment begins to feel that the production standard is set too low and, as a result,
increases the amount of production needed to earn the same incentive payout.
If such rate-cutting is perceived to be unfair, workers may restrict their output
and management’s credibility may be irreparably harmed (Lawler, 1971; Roy,
1952). Finally, individual incentive plans alone will not motivate cooperative
behaviors. As a consequence of such challenges, merit pay is a more common
PFP system.
Merit pay. Merit pay is by far the most common PFP program, being
used in roughly 90% of US organizations (with managerial and professional
employees most likely to be covered; Cohen, 2006), as well as in many other
countries (Heneman & Werner, 2000). Merit pay is typically defined as an
increase to base salary (often on an annual basis) that is based on (subjective)
performance appraisal ratings, usually by an employee’s supervisor.5 Merit pay
can be said to exist objectively when performance ratings validly differentiate
employees on the basis of performance and these differences are positively
and meaningfully correlated with salary increases in a particular year (and,
over time, with salary levels).
Although merit pay policies are very common, both employers and
employees are often less than satisfied with their results. One problem
encountered in many organizations is that merit ratings have a high mean and
little variance (Heneman, 1992). Without sufficient differentiation in merit
ratings (and thus, merit increases), it is easy to understand why many employ-
ees are skeptical about the existence of genuine PFP in merit pay systems. In a
HayGroup (2002) survey conducted in 335 companies, employees were asked
whether they agreed with the statement, “If my performance improves, I will
receive better compensation”. Only 35% agreed, while 27% neither agreed nor
disagreed, and 38% disagreed with this statement.
Given these challenges with merit rating programs, an entire literature
arose that sought to estimate the extent of rating “errors”. These errors include
leniency (overly favorable ratings) and central tendency (not using the low
and high ends of the scale), both of which result in a lack of differentiation in
merit ratings. Researchers have also studied the effectiveness of potential solu-
tions to these errors, such as rater training and re-design of performance
appraisal instruments to reflect behaviors rather than traits. However,
Murphy and Cleveland (1995) argue that this approach views performance
appraisal too narrowly—“as a measurement process” (p. 30)—and thus has
not been very fruitful because many so-called rater errors “are consciously
made and that failure to discriminate among persons…is often a highly adap-
tive behavior” (p. 28). For example, very high ratings are likely to require
greater justification because they result in higher salary costs, while low rat-
ings may require difficult conversations with the ratee or even more difficult
decisions, such as termination. Arvey and Murphy (1998) conclude that rating
errors such as central tendency, halo, and leniency, “which occupied so much
research space, are [now] thought to be relatively unimportant, trivial, and
due to understandable factors” (p. 163). They also “find a trend in increased
optimism regarding the use of supervisory ratings”.
Rather than studying and controlling rating “errors”, a more straightfor-
ward and aggressive approach to achieving greater differentiation is to use a
forced distribution policy, such that a certain percentage of employees must
fall into each of the performance rating categories. For example, rather than
having a distribution (using a four-point scale with 4 being high) that often
comes out to be in the neighborhood of 5% rating a “1”, 25% “2s”, 55% “3s”,
and 15% “4s”, a forced distribution policy might require a distribution more
like 20% “1s”, 30% “2s”, 40% “3s”, and 10% “4s”. A number of companies have
instituted these forced distribution systems (Scullen, Bergey, & Aiman-Smith,
2005). Some (e.g., General Electric) have continued to use them over time, while
others have encountered problems having to do with employee morale and/or
equal employment opportunity, leading them to discontinue or modify their
systems (e.g., Ford and Pfizer; even GE seems to have tempered their system
recently). In addition, there are concerns about perceived unfairness and effects
on cooperation among employees. However, to the degree that such systems

are used to identify and discharge low performers (and reward high perform-
ers), there are, as might be anticipated, potentially important sorting effects
(Scullen et al., 2005).
Moreover, even where PFP does exist in an objective sense in merit pay
systems, process issues may serve to either clarify or obscure this fact. Gomez-
Mejia and Balkin (1992), for example, highlight the role of policy choices such
as pay disclosure versus pay secrecy (Colella, Paetzold, Zardkoohi, & Wesson,
2007) and participative versus authoritarian pay system design. Where there is
PFP, anything that increases employee awareness and understanding should
increase line of sight (and thus, motivation). For example, Shaw and Gupta
(2007) reported that PFP was more strongly associated with lower turnover
among higher performers to the extent that there was strong pay system com-
munication, thus enhancing sorting effects.
Without in any way minimizing the challenges to PFP administration, it
can be argued that merit pay is stronger than usually believed for a number of
reasons (Gerhart & Rynes, 2003), a few of which we highlight here. First, as
discussed, merit pay can have important sorting effects, even where the
within-organization incentive effects of PFP appear to be small due to possible
range restriction. Second, “merit pay” is often defined too narrowly. Merit rat-
ings influence not only annual salary increases, but also promotions (Gerhart
& Milkovich, 1989). The average pay increase due to promotion is in the range
of 8–12% (Milkovich & Newman, 2008, p. 363), which is considerably larger
than the average within-grade merit increase (roughly 3% in recent years in
the US). Moreover, the pay increase due to promotion is considerably larger at
top management levels, often more than 70% (Gerhart & Milkovich, 1990).
Consider one example of how different the PFP estimate can be, depending
on how promotion is treated. Konrad and Pfeffer (1990) concluded that,
across 200 colleges and universities, the relationship between research pro-
ductivity and faculty pay was “small”. Specifically, they reported that a one
standard deviation increase in research productivity was associated with only
a $400 increase in faculty pay. (The mean faculty pay in their study, which
used data collected in 1969, was $11,782 with a standard deviation=$4533.)
However, their model included controls for faculty rank/level, meaning that
they estimated the within-rank, PFP relationship, or the direct effect of
research productivity, excluding the (indirect) effect of research productivity
on faculty salary via more productive faculty being more likely to be pro-
moted. Konrad and Pfeffer’s (1990) Appendix Table A.2 shows that the corre-
lation between research productivity and faculty salary was 0.493, which
provides an estimate of the total (direct + indirect) effect of research produc-
tivity on salary. This 0.493 correlation indicates that a one standard deviation
increase in productivity (without controlling for rank or other variables) was
associated with pay that was higher by 0.493 salary standard deviations, which
works out to an increase of $2234, an effect that is more than four times as
large as the $400 estimate emphasized by Konrad and Pfeffer (1990). Consider
then that a faculty member one standard deviation above the mean of perfor-
mance would have an expected salary of $14,016, compared to $9548 for a fac-
ulty member one standard deviation below the mean, a difference of 47%.
This does not strike us as a “small” PFP relationship.
Other studies, all using data on exempt employees in a wide range of jobs,
also show that recognizing the promotion-related aspect of PFP results in
larger estimates of total PFP in merit pay systems. For example, Trevor et al.
(1997) found that at one standard deviation below mean performance
(mean=2.74, SD =0.66), mean salary growth over a 3-year period was $1705,
compared with $2695 for performance at one standard deviation above the
mean, a difference of 58%. Gerhart (1990) reported that over a 5-year period,
each one point increase in performance was associated with a 16.1% higher
salary. Gerhart and Milkovich (1989) found that promotions, which play a
major role in salary growth (Milkovich & Newman, 2008), were influenced
importantly by performance. In the case of men, for example, those 1 point
above the mean on a 4-point performance scale received 48% more promo-
tions over a 6-year period than those with performance at the mean.
There has been surprisingly little empirical research on the influence of
merit pay on worker performance, particularly in recent years. However, what
research does exist is primarily positive. For example, in a review of merit pay
research, Heneman (1992) found that reported relationships between merit
pay and performance ratings are almost always positive, though not always
statistically significant. Kopelman and Reinharth (1982) conducted a 3-year
study of 10 branch offices of a financial services organization. They examined
the average size of the performance rating/merit pay increase relationship in
each branch and then correlated the size of these PFP relationships with aver-
age performance ratings in each unit, both concurrently and lagged by 1 and
2 years. They found that “the stronger the performance–reward tie, the higher
the level of subsequent performance” (p. 34). Greene and Podsakoff (1978)
examined changes in production workers’ individual performance ratings and
satisfaction after removal of a merit pay system from a unionized paper plant.
Relative to a control plant, average performance ratings dropped dramatically
after the removal of merit pay, as did satisfaction with pay and supervision for
those who had been rated as high performers.
In a contrary finding, Pearce, Stevenson and Perry (1985) reported that
performance in 20 Social Security branch offices did not significantly improve
after the switch to a (nominally) merit pay system. However, there were a
variety of problems with the study that made it a test of the effects of merit
pay. For example, 8 of the 12 before-and-after tests were conducted at the start
of the program, before any merit increases had actually been distributed. In
addition, there was “evidence that the implementation of this federal merit
pay program was flawed in several ways” (Pearce et al., 1985, p. 271), and the
amount of money tied to merit was very small. As such, to the extent that a
“merit system” was implemented at all, it appears to have been done in a very
weak fashion.
In summary, despite considerable skepticism about merit pay (Konrad &
Pfeffer, 1990; Pfeffer, 1998), the actual evidence on merit pay is primarily
positive. Specifically, performance ratings are nearly always statistically sig-
nificantly related to merit raises (Heneman, 1990), units with stronger merit
pay programs have higher subsequent performance (Kopelman & Reinharth,
1982), and removal of merit pay can result in lower subsequent performance,
as well as lower satisfaction among top performers (Greene & Podsakoff,
1978). High performers are less likely to leave (Trevor et al., 1997) and high-
achievers are more attracted (Trank et al., 2002) to organizations where PFP
is strong. Thus, as with individual incentive systems, there appear to be both
incentive and sorting effects associated with merit pay. In addition, merit
ratings are clearly associated with probabilities of promotion, which in turn
are associated with considerably higher rewards than “regular” merit
increases and result in significant accumulations over time. Although more
research would certainly be welcome, a comprehensive look at the existing
research suggests that merit pay exists in many organizations, and that it can
positively influence performance.
Rewards at the Supra-individual Level: Group- and Organization-level PFP Plans

Over the past two decades, organizations have increasingly moved toward
evaluating and rewarding performance at plant, division, and corporate levels.
There are a variety of reasons for this trend. One is that more jobs and projects
are being designed in such a way that success is dependent on the cooperation
of multiple employees (Hollenbeck, DeRue, & Guzzo, 2004). Another is that
when jobs are designed independently and employees rewarded only on the
basis of their individual performance, aggregated individual performance may
not add up to optimal organizational performance (Schuster, 1984). Yet
another reason, as previously noted, is that influential management gurus
(Deming, see Gabor (1992) and Pfeffer (1998)) have touted the superiority of
team- or group-based systems, arguing that individual reward systems cause
employees to compete with one another, attaining personal success at the
expense of other employees or the larger organization.
In this review, we examine the evidence with respect to group-based plans.
We begin with plans focused on relatively large units of analysis such as gain-
sharing, profit-sharing, and employee stock ownership plans. We begin there
because these plans have a longer history and a much stronger research base,
particularly in ongoing employment settings. We then turn to reward systems
for small work groups or teams, where evidence (particularly outside of the
laboratory) is scarce, and the results much less clear.
Gain-sharing. Gain-sharing is a results-based program that generally

links pay to performance at the facility level. Theoretically, gain-sharing
programs are expected to be less motivational than individual incentive
programs, given that outcomes are dependent on other workers as well as
broader environmental factors (e.g., economic downturns or entry of new
competitors). However, they also have a number of expected advantages. For
example, they can be customized to target multiple objectives in addition to
productivity, such as schedule attainment, safety, or customer satisfaction. In
addition, goals are generally both objective and based on historical stan-
dards—factors that are likely to facilitate employees’ goal acceptance (Case,
1998). The various potential advantages of gain-sharing led Milkovich and
Wigdor (1991, p. 86) to suggest that it might:

provide a way to accommodate the complexity and interdependence of
jobs, the need for work group cooperation, and the existence of work
group performance norms and still offer the motivational potential of
clear goals, clear pay-to-performance links, and relatively large pay
increases.
Indeed, the empirical evidence on gain-sharing appears to be quite favorable
(Gerhart & Milkovich, 1992; Lawler, 1990; Welbourne & Gomez-Mejia,
1995). For example, one 5-year study of 28 sites found positive effects of a
variety of gain-sharing plans on productivity (Schuster, 1984). Another study
(Hatcher & Ross, 1991) found that changing from individual incentives to
gain-sharing resulted in a decrease in grievances and a fairly dramatic
increase in product quality (defects per 1000 products shipped declined from
20.93 to 2.31). Arthur and Jelf (1999) examined gains (in labor costs, costs of
maintenance materials, perishable tools, scrap, rework, and supplies) from a
5-year gain-sharing plan in an auto parts manufacturing company with 1600
employees. They found a total of $15 million in savings over the 5-year
period, as well as a decrease of 20% in absenteeism and 50% in grievances. In a
follow-up study, Arthur and Aiman-Smith (2001) reported an increase (from
40% to 60%) in the ratio of “double-loop” to “single-loop” suggestions6 from
workers over a 4-year period—a phenomenon that they interpreted as
evidence of increased organizational learning.
In another study with positive results, Wagner, Rubin, and Callahan
(1988) found a substantial increase in productivity (103.7%) under a
foundry gain-sharing plan, as well as statistically significant decreases in
labor costs and grievances. An interesting feature of this particular study is
that in contrast to most gain-sharing plans (McAdams, 1995), the evaluated
plan did not have a strong worker participation feature. Despite this, the
authors also reported greater employee concern for cooperative behaviors
as well as co-worker “policing” of quantity and quality to assure equitable
contributions.
Similarly, Banker, Lee, Potter, and Srinivasan (1996) compared results

from 15 stores of a major retailer with store-level incentives against results
from another 19 stores without incentives. Time-series analyses showed that
stores with the incentive plan had 4.9% higher sales, 3.4% higher customer
satisfaction, and 4.4% higher profit than stores without the incentive plan. In
addition, there were three contextual variables that proved to be important
(positive) moderators: tough market competition, upscale customer profiles,
and low ratios of supervisors to sales associates.
Petty, Singleton, and Connell (1992) compared one division of an electric
utility company that implemented a gain-sharing plan to another division that
did not. The gain-sharing division performed better on 11 of 12 objective per-
formance measures, providing an estimated savings of somewhere between

$857,000 and $2 million. In addition, there were also positive differences in
employee perceptions of teamwork, fairness, employee involvement, and
other attitudes.
Despite this generally positive evidence, gain-sharing plans are not without
their problems. For example, the program studied by Petty et al. (1992) was
subsequently discontinued due to a breakdown in union negotiations over
how to distribute the gain-sharing pie among employees. Based on the initial
success of the gain-sharing unit, unionized employees in other divisions
pressed to be covered by the plan and to share in the payouts. However, man-
agement wanted the bonus to be distributed as a percentage of worker salaries
while the union wanted identical (flat) bonuses for all employees. The impasse
over this issue resulted in the entire plan being discontinued.
Gain-sharing programs can also come under pressure in years when there
is no bonus payout. For example, a plan at DuPont’s Fibers Division was dis-
continued, and one at Saturn substantially watered down in terms of the vari-
able pay component (Bohl, 1997) over this issue. In fact, program
discontinuation seems to be relatively common. For example, Kaufman
(1992) found that of 104 companies that had implemented a particular kind of
gain-sharing program (Improshare) between 1981 and 1988, 23% had discon-
tinued the plan by the time of his study. In addition, another 163 companies
that were known to have implemented Improshare plans during the period
did not return the survey, so it is likely that the discontinuation rate was
higher than the one measured.
As discussed earlier, another potential concern is a negative sorting effect.
For example, a study by Weiss (1987) at AT&T found that extreme performers
(at both the top and bottom) were more likely to leave under a gain-sharing
plan. More generally, as we have noted, high performers have been found to
be highly sensitive to relative rewards and more favorably inclined toward
individual (versus group) PFP (Trevor et al., 1997; Trank et al., 2002).
Finally, the returns from gain-sharing programs appear to dwindle with
increasing plan size. For example, Kaufman (1992) reported that doubling the
number of employees covered by Improshare from around 200 to 400 was

associated with a reduction in the average productivity gain of nearly 50%. In
addition, Zenger and Marshall (2000) found that incentive intensity in group
and organization plans was negatively associated with the administrative unit
level of the plan (e.g., department or work team versus entire organization)
and unit size. As such, it appears that organizations’ incentive design deci-
sions are consistent with theory and research on the negative relationship
between group size and incentive effects. Thus, while Pfeffer (1998) claims
that the “evidence for the effectiveness of various group incentives is compel-
ling, while the empirical evidence for free-riding is sparse” (p. 219), the evi-
dence in fact indicates that as group or organization size increases, the
effectiveness of group/organization-based PFP plans becomes weaker. (See

also the studies by Kruse (1993) and Blasi, Conte and Kruse (1996) in the
following two sections.)
Profit-sharing. Profit-sharing plans pay out based on meeting a profit-

ability target (e.g., return on assets or net income). Profit-sharing can be either
deferred (i.e., to fund retirement) or paid in cash, while payouts may be either
formula-based (e.g., a fixed percentage of net income) or discretionary. In
terms of employee attitudes, Weitzman and Kruse (1990) reported generally
positive employee attitudes toward profit-sharing, although this was
“tempered…by the risk of fluctuating income” (p. 123).
Several researchers have provided estimates of the effect of profit-sharing
on productivity. Weitzman and Kruse (1990) estimated the mean effect at 7.4%,
and the median at 4.4%. A meta-analysis by Doucouliagos (1995) of 19 studies
and 32,752 firms reported a correlation between profit-sharing and productiv-
ity (generally measured as value added or sales per employee) of r=0.05.
However, the correlation was significantly higher in employee-managed firms
(r=0.26) than in more traditional firms (r=0.04). We note, however, that
Doucouliagos’ definition of profit-sharing included other plans such as gain-
sharing. Thus, it is possible that plans covering smaller numbers of employees
(such as gain-sharing) may have partly driven the results.
In perhaps the most extensive study to date, Kruse (1993) surveyed 275
firms employing a total of approximately 6 million employees. Kruse found
that productivity growth in profit-sharing companies was 3.5–5.0% higher
than in companies not using profit-sharing. However, there were some
important contingency factors. For example, cash plans exhibited substan-
tially higher productivity growth than deferred plans, particularly in within-
industry models. Size was also an important contingency factor, with annual
productivity growth of 11–17% in companies having fewer than 775 employ-
ees versus 0–6.9% growth in companies with more than 775 employees. A
third contingency factor, formula versus discretionary, indicated an advantage
for discretionary plans, particularly using within-industry models. Kruse
speculated that such plans probably require trust and a positive employee rela-
tions climate in order to be effective.
Research on profit-sharing, like research on gain-sharing, suffers from a
number of limitations (Kruse, 1993). For example, both research streams are
likely to suffer from selection bias (i.e., successful profit-sharing plans are
more likely to be studied because unsuccessful plans are less likely to survive
or be written about). Secondly, because most studies have used cross-sectional
data, there is the possibility of reverse causality (i.e., gain- and profit-sharing
plans may be more likely to be adopted by companies that are more produc-
tive or profitable in the first place). For example, when Kim (1998) used a
simultaneous equations model to control for reverse causality and profits, the
positive effect of profit-sharing on profits disappeared. Third, the effects of

both gain-sharing and profit-sharing programs may be confounded with
other positive management practices that are not measured or controlled.
Finally, the typical measure of productivity in profit-sharing research is
value added (the extent to which the price of a product exceeds the cost of the
factor inputs such as labor and capital), rather than a measure of physical pro-
ductivity (e.g., units produced). Obviously, the price of a product can be influ-
enced by many factors other than productivity, such as industry trends and
marketing (Gerhart & Rynes, 2003). Thus, finding a relation between profits
distributed per worker (profit-sharing) and value added does not necessarily
mean that profit-sharing causes higher productivity.
For these reasons, the following factors should be kept in mind with
respect to the modestly positive results summarized previously. First, profit-
sharing appears to be associated with higher overall labor costs (Kim, 1998;
Mitchell, Lewin, & Lawler, 1990), a finding consistent with agency theory pre-
dictions that workers will require a compensating differential for accepting
the risk involved in variable compensation programs. Second, even where
profit-sharing has been found to have a positive relationship with productiv-
ity, it is not clear whether the relationship is causal. Third, the hoped-for
advantage of making labor costs variable in relation to profitability will be
realized only if profit- or gain-sharing plans survive years when no payouts
are made.
Stock plans. According to the National Council on Employee Ownership

website, as of February 2008, 11.2 million employees owned company stock
worth more than $928 billion via employee stock ownership plans (ESOPs),
stock bonus plans, or profit-sharing plans invested in stock. Another
1.5 million employees held $133 billion in stock via 401(k) plans. In addition,
9 million employees participated in broad-based stock options plans, while
another 11 million participated in stock purchase plans. Thus, approximately
33 million employees, or about one-third of all private sector employees,
appear to have some degree of ownership in their employing companies.
Moreover, partial employee ownership has grown from an estimated 1% of

corporate equity in the 1920s to almost 5% (Blasi, Kruse, Sesil & Kroumova,
2003). However, these same authors indicate that “significant” employee
ownership (20% or more of a company’s stock) is mainly associated with small
and medium-sized family and independent businesses.
Another prominent feature of stock plans is that different types of plans
tend to be used for different employee groups. For example, stock purchase
plans and provision of company stock through 401(k) plans are roughly
equally prevalent across employee categories. In contrast, stock options,
outright stock grants, and phantom stock plans (where pay is linked to stock
performance, but with no actual option or ownership) are still heavily
weighted toward officers and executives. As such, these latter plans will be dis-
cussed primarily in our coverage of executive compensation.
With that said, it is worth noting that stock option plans have frequently
been used as a major attraction and retention strategy for non-executives of
high-tech companies and small start-up firms. Microsoft, for example, created
more than 10,000 millionaires through its stock option program (although it
has now been discontinued, in favor of stock grants instead).7 Also, in one of
the few studies of stock options focused below the executive level, Gerhart and
Milkovich (1990) examined the relationship between the percentage of top
and middle level managers (within six levels of the Board of Directors) eligible
for stock options in a firm and the firm’s return on assets. Their results sug-
gested that a company having 20% of managers eligible for stock options had
a predicted return on assets of 5.5%, as compared with a predicted return on
assets of 6.8% (or roughly 25% higher) for companies having 80% of managers
eligible. However, because these findings pertain to relatively high-level and
highly paid managers, results might be weaker for plans covering a broader
range of employees, particularly in larger firms (Oyer & Schaefer, 2005).
Turning to stock ownership plans (as opposed to options), it is generally
assumed that whatever effect ESOPs might have on firm performance is likely
to be mediated through employee attitudes. Klein (1987) hypothesized that
ESOPs might affect employee attitudes and motivation in three ways: (1)
through a “pride in ownership” effect, regardless of financial benefit; (2)
through the financial benefits yielded by the plan; and (3) through improved
two-way communication between employees and managers. She tested these
hypotheses on data from 2804 employees in 37 ESOPs. In addition, she also
obtained data from key managerial respondents in each firm pertaining to the
extent to which the ESOP was a core part of management’s philosophy, as well
as the resources devoted to ESOP communication.
Klein’s findings did not support the first hypothesis (mere pride of own-
ership), but did support the second and third. Specifically, the R2 between
size of employer financial contribution and organizational commitment was
0.17, and the R2 with turnover intention was 0.25 (higher contributions were
associated with lower intentions). Adding the management philosophy and

ESOP communication variables increased the R2 to 0.30 for organizational
commitment, and 0.39 for turnover intentions. There was also support for a
relationship between perceived worker influence on decisions and employee
commitment, but not with turnover intentions.
In a study of “psychological ownership”, Wagner, Parker and Christiansen
(2003) examined how the 401(k) participation of employees and their percep-
tions of organizational climate related to: (a) attitudes toward ownership (e.g.,
beliefs that individual employees should share both the financial successes,
and setbacks, of their employer); (b) ownership behaviors (e.g., trying to cut
costs, making suggestions for work improvement, and seeking information
about their employer’s financials); (c) attitudes toward the organization; and
(d) financial performance (sales per square foot, net sales, and ratio of net
sales to planned sales). They examined these relationships at the group level of
analysis, studying 204 work groups from 33 stores in a large retail organiza-
tion. (Employees had the option of investing their 401(k) contributions in
company stock or mutual funds, whereas company matching contributions
were in the form of company stock). Their results showed that participation in
401(k) plans and working in a climate supportive of self-determination were
related to attitudes toward ownership, ownership behaviors, and attitudes
toward the organization. In addition, ownership behaviors were positively
related to group financial performance. Thus, both Klein (1987) and Wagner
et al. (2003) suggest that employee attitudes are important determinants of the
effects of employee ownership.
Most other studies of ESOPs have examined their effects on productivity or
financial outcomes, rather than attitudes. Overall, the results of these studies
suggest very modest benefits to stock ownership. For example, Blasi et al.
(1996) examined 562 Employee Ownership Firms (EOFs) and compared their
financial performance (profitability and price/earnings ratios) to 4716 firms
without such plans. Overall, they found no main effect for EOF on firm per-
formance. Instead, the relationship between EOF and performance depended
to a “striking” (p. 75) degree on firm size. Specifically, Blasi et al. (1996) found
that for the smallest quartile on firm size (maximum firm size=1015), EOF
firms were 1.3 percentage points higher on ROA, and 1.5 percentage points
higher on price/earnings (P/E) ratio. In contrast, in the quartile where firm
size ranged between 3014–12,700 employees, EOF firms had ROAs that were
1.9 percentage points lower, and P/E ratios that were 1.6 percentage points
lower. Thus, the coefficients generally revealed a declining pattern of returns
by firm size. Similarly, Doucouliagos (1995) conducted a meta-analysis based
on 17 studies and 31,323 firms and found a weighted mean correlation
between employee ownership and productivity of only r=0.03. Thus, this
study also suggests that the typical effects of ESOPs on firm productivity are
very modest.
More recently, Blasi et al. (2003) report that, based on seven large-sample
studies, “we observe at least neutral and generally positive effects of employee
ownership on firm performance” (p. 908). However, they indicate that few
employers (probably less than 1%) use stock ownership in a way that would be
expected to generate large incentive effects (i.e., in combination with high
goal-setting, active employee participation, and strong two-way communica-
tions between workers and management). Rather, most companies adopt such
plans for their financial, tax, or takeover defense advantages—or as substitutes
for defined benefit pension plans—rather than as motivational plans designed
to induce employees to “act like owners”. Nevertheless, results from Klein
(1987), Blasi, Conte et al. (1996) and Blasi, Kruse et al. (2003) and Wagner
et al. (2003) suggest that ESOPs can have a positive impact on firm perfor-
mance under the right conditions (e.g., in smaller firms, in firms where own-
ership improves communication and employee attitudes, and in firms having
greater financial success).
Compensation for small groups and teams. In small group or team-based

systems,8 conflicting reward objectives come to the forefront. “One objective is
to foster member cooperation and cohesiveness in executing team projects
and assignments. The other is to recognize individual differences in the
contribution members make toward team accomplishments. While the first
objective is compatible with extending reward payouts to members as equal
shares, the second objective argues for members receiving equitable reward
payouts in proportion to their relative contribution” (Weinberger, 1998,
p. 18). Or, as Hollenbeck et al. (2004, p. 362) put it: “The degree to which
teams should operate and be rewarded for behaving as cooperative or compet-
itive systems is at the heart of the debate on reward structures for teams”.
Unfortunately, extant research does not provide a great deal of advice to
managers on how to deal with this conflict. Although there have been a large
number of studies of group rewards (not always pay) in laboratory settings,
findings from field settings are very scarce. In addition, existing laboratory
studies often employ subjects and manipulations that are considerably differ-
ent from those observed in employment settings. Perhaps not surprisingly,
then, an extensive review of this literature by DeMatteo, Eby and Sundstrom
(1998) presented few clear conclusions about the likely effects of different
ways of compensating teams in ongoing organizations. We turn now to pro-
viding our own updated review.
In one of the few field studies of small-group reward systems, Wageman
(1995) examined the effects of implementing individual, group-based, and
“hybrid” (mixed individual and group) rewards on intact groups of technicians
at Xerox’s Customer Service Division. Wageman sought to identify managers
who would be highly motivated to implement alternative reward structures
(which in the past had been primarily individually-based). Specifically, she
identified five district managers “who expressed strong interest in participat-

ing and were willing to alter the ways in which rewards were distributed in
their districts” (p. 155). In addition, she recruited two additional district man-
agers who agreed to continue rewarding employees on an individual basis (i.e.,
the status quo). Participation of these 7 districts yielded 60 groups (353 tech-
nicians) in the group outcome condition, 77 groups (398 technicians) in the
hybrid outcome condition, and 55 groups (369 technicians) in the individual
outcome condition.
All groups in a given district implemented the same type of reward condi-
tion. Prior to implementation, all first-line managers received a one-day
training session in “planned spontaneous” reward practices. In addition,
managers developed monthly plans for delivering rewards to groups and/or

their members. Furthermore, as the study progressed, managers recorded all
rewards delivered each month and sent the list to the author. Three types of
outcomes were measured: (1) archival data on group performance; (2) survey
and archival measures of group interactions; and (3) survey measures of indi-
vidual motivation and satisfaction. In addition, an extensive measure of pre-
implementation group interdependence (assessed via such things as the
extent to which groups actively coordinated the queuing of service calls or
managed their expenses collectively) was developed. This served as a “before”
measure for assessing change in group interdependence as a result of the
reward implementation.
Although Wageman (1995) reported a variety of results, the most notable
was that pure group or pure individual systems were associated with better
performance than hybrid systems:
Findings showed that the work performed by the technicians in this
study can be done well in two different ways: independently and inter-
dependently…. By contrast, a look at the dynamics of hybrid groups
shows that both the independent and the interdependent processes
were barely half-fueled in the hybrid-task/hybrid-outcome condition.
Hybrid tasks required groups to act sometimes as groups, sometimes as
individuals. While the individual part came naturally, acting as a group
did not. Individuals perceived the introduction of group-level elements
to their work and rewards as an add-on, not a fundamental change in
the work, and it undermined attention to the basic aspects of the task.
(Wageman, 1995, p. 173–175)
In assessing the likely generalizability of Wageman’s findings, it is impor-
tant to note that beyond praise and recognition from managers, the only
money managers distributed under the system came from their discretionary
budgets, which were not connected to annual merit increases. In addition,
only one type of job was studied. Moreover, Wageman only observed perfor-
mance over a 4-month period (although some individual difference variables
were measured eight months later), and those months did not include the
end-of-the-year annual salary increase. Still, Wageman reported that: “the
intervention produced significant differences in the reward practices of partic-
ipating districts…and it created three distinct levels of outcome interdepen-
dence—group, hybrid, and individual” (p. 160). As such, at the very least, her
study suggests that the move from individual to hybrid systems may be
fraught with danger—perhaps more danger than moving to a more extreme
(i.e., completely interdependent) system.
The balance between group and individual rewards was also addressed in a
study reported in a short research summary by Katz (2001). She was interested
in how to design group incentives that might encourage high performers to
help weaker members, while simultaneously increasing weak performers’

desire to improve their own performance. To do this, she tested 35 three- or
four-member teams in an interactive simulation that provided opportunities
for team members to both cooperate with and compete against one another.
Thus, “although the simulation did not re-create a management setting per se,
it did involve many of the conditions that characterize one: dispersed
information, time pressures, easily evaluated performance, and the need for
collaboration” (Katz, 2001, p. 22).
Teams were compensated via one of five different structures: pay equality
(all members received the same pay); pay equity (members were compensated
based on individual performance) and three hybrid methods: group threshold
(pay rose after the team as a whole reached a certain target); individual thresh-
old (pay increased after every member of the team hit an established target),
and relative ratio (team members were paid for individual performance, but
once the highest paid earned twice as much as the lowest paid, some of the
highest performer’s earnings were transferred to the poorer performers).
Results showed that the two threshold schemes were better at keeping
high performers motivated than the equality scheme, and better than the
equity scheme at encouraging high performers to share information with
others. In addition, the individual threshold scheme created a strong drive
among lower performers to improve their performance. In contrast, the rel-
ative ratio scheme was the least effective because it placed a cap on rewards
and made groups members constantly concerned about how they were per-
forming relative to others. Katz concluded that group and individual thresh-
old systems might be most applicable, particularly in situations when group
outputs are quantifiable, when members’ roles are not highly differentiated,
when highly skilled workers are not enough to “carry” a whole team, and
when there is sufficient time for high performers to teach less effective
members.
Because small-group compensation research is not yet plentiful, it is possi-
ble that future meta-analytic studies will reveal a number of main effects or
generalizable advice for compensating small groups or teams. At the present
time, however, the effectiveness of small-group compensation systems appears

to be affected by multiple contingency variables (DeMatteo et al., 1998).
For example, one variable (in addition to group size—see our earlier dis-
cussion) that has long been hypothesized to moderate the effectiveness of
incentive plans is the extent to which tasks are truly interdependent. For
example, Shaw, Gupta and Delery (2002) found that in an industry where
tasks are mostly independent (long-distance trucking), firm accident rates and
time spent out-of-service were lowest (i.e., performance was best) when there
were high individual pay incentives and high pay dispersion across drivers. In
contrast, in a second study in the concrete pipe industry, they found that
safety performance was poorest when high pay differentiation was coupled
with high task interdependence (measured via the existence of self-managed

teams).
However, some theoretical models have suggested that the relationships
between task interdependence, reward systems, and performance may be even
more complicated than suggested by Shaw et al. (2002). For example, Siemsen,
Balasubramanian and Roth (2007) used mathematical logic to argue that the
appropriate team reward system depends on the nature of the dependency
(i.e., for output-, help-, or knowledge-sharing). Similarly, Siggelkow (2002)
proposed that appropriate rewards depend on whether team outputs are com-
plements, or substitutes, for one another. Chillemi and Gui (1997) suggested
that employers’ optimal responses to individual salary demands by team
members also depend on how much team turnover the group can afford.
Empirical laboratory studies, too, have suggested that things may be quite
complicated with teams. For example, Beersma et al. (2003) engaged 75 four-
person teams in a distributed decision making computer simulation task.
Although the task was interdependent, half the teams were told that they
would be rewarded based on individual performance (with the highest-
performing members winning $10 each), while the other half were rewarded
based on team performance ($40 to the highest-performing team). Each
team participated in 1.5 hours of training appropriate to its reward condi-
tion (i.e., teams rewarded on an individual basis received individual perfor-
mance feedback, while teams rewarded on a team basis received team-level
feedback).
Results showed that teams rewarded on an individual basis outperformed
others on speed, but under-performed on accuracy relative to those rewarded
on a team basis. In addition, there was an interaction between two personality
characteristics of team members and the reward system. Specifically, teams
with higher levels of extroversion and agreeableness performed relatively bet-
ter under the cooperative condition than did teams with lower levels of these
personality traits. Finally, analyses showed that the poorest individual
performers were more sensitive to the interaction of reward structure and
personality than were the highest-performing individuals.
In a subsequent study, Johnson et al. (2006) extended the findings of

Beersma et al. (2003) by putting 80 student teams through two rounds of a
similar computer simulation, utilizing four conditions. In one condition,
teams were rewarded competitively (i.e., on the basis of individual perfor-
mance) in both rounds (competitive/competitive); in a second condition, they
were rewarded cooperatively (based on team performance) in both rounds
(cooperative/cooperative). For the other teams, the reward systems were
switched between rounds, resulting in a competitive/cooperative condition
and a cooperative/competitive condition.
Results from this two-phase experiment showed that teams in the cooper-
ative/competitive condition performed similarly in the second (competitive)
round to teams that were competitively rewarded all along. In contrast, com-
petitive/cooperative teams performed quite differently from teams that were
cooperatively rewarded in both rounds. Specifically, in the second (coopera-
tive) round, instead of being higher on accuracy than on speed (as were coop-
erative/cooperative teams), they were higher on speed than accuracy.
Moreover, competitive/cooperative teams slowed down at Time 2 but did not
improve on accuracy as compared to Time 1. In addition, cooperatively
rewarded teams shared significantly more information than competitively
rewarded teams, with information-sharing partially mediating the relationship
between reward structure and team accuracy. The authors concluded that their
results were more complicated than what would be predicted by simple con-
tingency theories, since performance in Time 2 was dependent on how teams
had been rewarded in Time 1. As such, team results appeared to be path-
dependent, as suggested by the resource-based view of the firm (Barney, 1991).
Summary
Every pay program has its advantages and disadvantages. Programs differ in
their sorting and incentive effects, their incentive intensity and risk, their use
of behaviors versus results, and their emphasis on individual versus group
measures of performance. Individual-based plans are likely to fit better where
work is independent and competition between individuals is encouraged, but
less well where there is interdependence and a greater need for cooperation.
Group and organization-based plans would seem to provide the solution in
the latter case. However, as we have seen, such plans have potentially weaker
incentive effects and may also have adverse sorting effects, particularly as the
number of employees covered increases. Results-based plans can achieve
strong incentive intensity, but a compensating differential for the increased
risk borne by workers is likely to make such plans more costly, unless expected
performance improvements actually materialize. Also, objectives not explic-
itly included in the plan may be ignored. Behavior-based plans can be better
on these dimensions, but it is typically more difficult to achieve strong incen-
tive intensity without objective performance measures.
Because of the limitations of any single pay program, organizations often

elect to use a portfolio of programs (e.g., merit pay combined with profit-
sharing) that focus on different objectives, which may provide a means of hedg-
ing the risks of particular pay strategies while still achieving most of the hoped-
for benefits (Gerhart et al., 1996). Of course, as the Wageman (1995) research
suggests, hybrid plans are not always superior, especially to the degree that there
are mixed or conflicting messages and the relative size of incentives tied to
different performance objectives is not consistent with the stated priorities.
There continues to be a need for research on PFP programs of all types,
with the most valuable research including measures of mediating variables (to
better understand causal processes), and longitudinal designs (to better
understand survival, sorting effects, and also to satisfy time precedence stan-
dards for understanding causal processes). In addition, given that most PFP
plans are combination or hybrid plans, it would be useful to see more research
that studies such plans as holistic entities, rather than studying only one aspect
(e.g., profit-sharing) and not measuring other co-existing PFP plans.
In the previous review, we have emphasized the fact that the empirical
evidence shows that PFP programs can “work”, and work quite well.
Nevertheless, we do not want to lose sight of the equally important fact that
PFP programs can also have unintended consequences that may negatively
influence effectiveness. (For example, executives at Enron were found to have
inflated earnings to increase the stock price and thus, their own compensa-
tion.) The recent financial industry “meltdown” is attributed by some to
overly strong and risk-inducing incentive plans. Thus, there is a risk to using
PFP programs, especially those with high-intensity PFP.
The empirical evidence on this point is less systematic and organized, yet it
is important to recognize. Often, the evidence comes from experiences of indi-
vidual organizations. Typically, the problem is that PFP motivates “too well”,
but in the wrong direction. Examples include mis-coding health conditions in
hospitals to get higher government reimbursement rates and auto repair shops
finding (non-existent) mechanical problems so they could sell more repairs
(Gerhart, 2001) In both cases, the incentive plans were designed to reward
employees for driving revenue. Both plans accomplished that, but employees
used unacceptable means to do so. (Our later section on executive PFP pro-
vides further examples of unintended consequences.)
PFP plans, particularly to the degree they rely on results-based perfor-
mance measures (e.g., profits), carry other risks as well. For example, PFP
plans are expected to increase labor costs, particularly in plans that add a PFP
component with no reduction in base salary. Indeed, companies with aggres-
sive PFP programs such as Whole Foods, Lincoln Electric, and Nucor Steel,
do have relatively high labor cost per worker. However, to date these higher
costs have been more than offset by higher productivity (i.e., fewer workers to
produce a particular level of output). So, the model is one of highly-paid,
highly-productive workers, but fewer of them. Of course, not all companies

have been able to execute their PFP programs as successfully.
In plans that use the PFP component as a replacement for some portion of
base pay, direct costs are more contained. However, employee relations prob-
lems are likely to arise in years when the PFP portion does not pay out, or
when management retrospectively decides that the performance hurdle for
payout is too low (Roy, 1952; Whyte, 1955). Consequently, in deciding on the
use and design of PFP programs, “One must consider whether the potential
for impressive gains in performance” from such plans is “likely to outweigh
the potential problems, which can be serious” and be aware that such plans are
best thought of as representing “a high risk, high reward strategy” (Gerhart,
2001, p. 222).
In other cases, the failure of PFP programs may be less dramatic, but still a
problem. How long a PFP plan remains in place is sometimes used as a measure
of its success. While a short-term gain in performance from a pay plan that
does not last long should not be dismissed (Gerhart et al., 1996), a plan that
generates longer-term performance gains is, of course, preferred. Also, chang-
ing plans too often can result in a counterproductive “flavor-of-the-month”
perception among employees (Beer & Cannon, 2004). So, survival is a useful
indicator. Evidence on survival is also important for estimating statistical effect
sizes of PFP plans because studying only plans that survive would result in a
biased sample (Gerhart et al.).
A recent paper by Beer and Cannon (2004) provides survival information
on 13 PFP experiments conducted at Hewlett-Packard in the mid-1990s. In 12
of the 13 cases, the programs did not survive, in part, Beer and Cannon con-
clude, because of a perceived lack of fit with H-P’s high-commitment culture
at the time. In the H-P case, the PFP initiatives had unintended consequences
and managers eventually decided that performance could be more effectively
improved “through alternative managerial tools such as good supervision,
clear goals, coaching, training, and so forth” (Beer & Cannon, 2004, p. 13).
They note that: “This decision [did] not imply that managers believed that pay
did not motivate or that it could not be used effectively in other settings” (Beer
& Cannon, 2004, p. 13). Rather, managers decided that at H-P, there were bet-
ter alternatives. As Ouchi (1979), for example, pointed out, “control systems”
can take many forms other than PFP (e.g., careful selection of committed
employees, socialization, as well as rituals and ceremonies to reward those
who display attitudes and values seen as leading to organization success).
Moreover, to the degree that it is difficult to measure both performance
outcomes and the behaviors that lead to performance outcomes, it may prove
difficult to use PFP and greater emphasis on alternative control systems may
be required (Ouchi, 1979; Williamson, Wachter, & Harris, 1975).
The high failure rate of this one set of PFP plans at H-P warrants a few addi-
tional comments. First, the particular PFP programs that Hewlett-Packard
experimented with appear to have been mostly team-based programs (Led-

ford, 2004). Although these did not survive, H-P has for many years used and
continues to use other PFP programs such as broad-based stock options and
profit-sharing (Beer & Cannon, 2004). Second, the fact that managers decided
to “experiment” with PFP plans may indicate the influence of what other orga-
nizations were doing, as opposed to what would best fit H-P. Benchmarking is
a standard and necessary practice in compensation, but as in any area of man-
agement, it can devolve into following fads and fashions. Certainly, we know
that institutional forces play a role in compensation policies and practices
(Conlon & Parks, 1990; Eisenhardt, 1985b; Gerhart et al., 1996). Third, PFP
programs may generate desirable sorting effects, and it is possible that some
perceived lack of fit with the pre-existing culture, resulting in dissatisfaction

among some employees is a necessary part of this process (Cannon & Beer
2004; Gerhart & Rynes, 2003). Finally, whenever the risk of implementing a
new PFP plan is discussed, it is also necessary to discuss the risk of not imple-
menting such a plan (Gerhart et al., 1996), since changes in PFP strategy can
sometimes pay off handsomely.
Executives and PFP

To this point, our discussion has dealt with PFP issues as they affect a wide range
of employee types. However, both employers and scholars recognize that, due
to their strategic importance to the organization—as well as the heightened
potential for conflicts of interest and associated regulatory scrutiny—certain
employee groups require special attention in the design and study of their pay
(Milkovich & Newman, 2008). Certainly, executives are one such group.
Executives, especially chief executives, are also unique, of course, in that their
pay levels are much higher than those of nonexecutives and represent a sizeable
percentage (roughly 6% according to Bebchuk & Grinstein, 2005) of net income.
According to the chief executive officer (CEO) Compensation Survey/2007
conducted by the Wall Street Journal and the Hay Group (Wall Street Journal,
2008), median CEO pay (defined as base pay, annual incentive/bonus, and the
value of grants of stock options, restricted stock, and other long-term incentives)
in 200 large US companies in 2007 was $8.85 million. However, the composition
of executive pay is also notable. Of the $8.85 million, only about $1.1 million,
or 12%, was in the form of base pay, with the remainder in the form of either
short-term (21%) or long-term (67%) incentives. In the great majority of
companies, the long-term incentive component is based on stock returns.
As will be seen, there is less research than might be expected on the effec-
tiveness of PFP programs for executives. However, there is more research on
the degree to which PFP exists among executives (enough to generate two
meta-analyses), as well as on the degree to which PFP intensity and use vary as
a function of contextual organizational factors. Other work examines how the
design of executive pay packages may influence the business objectives that
executives choose, which likely has implications for performance as judged by

shareholders. There is also research on the degree to which factors other than
performance (e.g., sociopolitical factors) influence executive pay. (By implica-
tion, the greater the role played by these non-performance factors, the smaller
the role played by PFP.) Finally, executive pay is also sometimes seen as influ-
encing how non-executives (and other executives) in an organization feel and
perform (Cowherd & Levine, 1992; Wade, O’Reilly, & Pollock, 2006). Thus,
executive pay not only has potential consequences for firm performance
through its effect on the performance of the executive, but also via its possible
impact on the performance of other employees.
There is also great public interest in the level of executive pay. Walsh (2008,
p. 30) observes that “Public concern about executive pay… is about fairness.
Taken-for-granted norms of fairness are essential to the health of the free
market system”. The question here is whether anyone, regardless of their per-
formance, deserves to be paid so much. Public interest in this question can be
seen to some degree in the congressional and regulatory attention given to
executive pay (see our later discussion). Most recently, it has been readily
apparent as struggling private sector companies ranging from financial ser-
vices institutions to auto manufacturers turn to the federal government for
financial assistance. The norm to date has been that any firm expecting to
receive such assistance must agree to restrictions on executive pay. (For exam-
ple, see our later discussion of the Troubled Assets Relief Program.)
We begin our review of executive PFP with a discussion of agency theory,
the dominant theoretical framework in the area.
Agency Theory
For non-executives, motivational theories such as goal-setting, expectancy
theory, reinforcement theory, and to some extent agency theory, have
grounded research and practice around performance-based pay. In the case of
executives, however, agency theory has overwhelmingly dominated the scene.
Agency theory starts from the observation that once an entrepreneur hires
his/her first employee, there is separation of ownership and control (Jensen &
Meckling, 1976). The entrepreneur (and/or others having ownership stakes, as
in larger firms) retains ownership, but now must deal with an agency relation-
ship, under which the owner (i.e., principal) contracts with one or more
employees (i.e., agents) “to perform some service on their behalf which
involves delegating some decision making authority to the agent” (Jensen &
Meckling, 1976, p. 308).
Agency costs: executives behaving badly. Agency theory posits that self-
interested, effort-averse, and relatively risk-averse managers (i.e., agents) may
sometimes fail to act in the best interests of shareholders (principals) due to
divergence of interests and information asymmetry (Fama & Jensen, 1983a,
1983b; Jensen & Meckling, 1976). As a result, shareholder welfare can suffer
due to such factors as suboptimal executive decisions, empire building,
gaming of incentive systems, shirking, sociopolitical activities, excess perqui-
sites extracted by executives, and so on. Dalton, Hitt, Certo and Dalton (2007)
provide a thorough review of the evidence on the existence of agency costs and
the challenges in controlling them. They describe “the central tenet of agency
theory” to be “that there is potential mischief when the interests of owners and
those of managers diverge” and that this may allow executives “to extract
higher rents than would otherwise be accorded to them by owners of the firm”
(Dalton et al., 2007, p. 2).
Although such costs are difficult to eliminate entirely, they can, under
agency theory, be reduced through contracting (i.e., PFP) schemes that are
based on monitoring of executive behaviors and/or presumed outcomes (e.g.,
firm performance) of such behaviors. Thus, boards of directors, acting on
behalf of shareholders, must decide the most efficient mechanism for aligning
the interests of the executive with those of shareholders. The costs of reducing
agency losses plus any remaining unmitigated agency losses are referred to
collectively as agency costs (Jensen & Meckling, 1976).
Because executive behaviors are difficult to specify in advance and costly to
measure due to unobservability, compensation that is contingent on firm-
level performance is commonly used to motivate executives to act in share-
holders’ interests (Eisenhardt, 1989; Gomez-Mejia & Balkin, 1992; Murphy,
1999). But outcome-based contracts involve shifting risk from the principal to
the agent, and the greater the uncertainty inherent in this risk-shifting, the
higher the overall cost of compensation. This trade-off makes it challenging to
specify the exact nature of the “optimal” compensation contract (i.e., “one that
maximizes the net expected economic value to shareholders after transaction
costs and payments to employees” (Core, Guay & Larcker, 2003, p. 27)). There
is also evidence that there is a “dark side” (Dalton et al., 2007, p. 18) to execu-
tive PFP in that it may motivate undesired or “untoward activities” (e.g., mis-
representation of earnings (Harris & Bromiley, 2007)) despite being designed
with the intent of aligning interests of executives with those of shareholders.
(As we saw earlier in this chapter, a similar challenge exists for nonexecutive
PFP plans.)
As noted, compared with most nonexecutive employees, executives have
a much larger percentage of their compensation is in the form of perfor-
mance-contingent pay. Executives are also unique in that they are generally
required to maintain a large personal equity stake in the corporation on an
ongoing basis.9 This effectively increases their own personal investment risk
through a lack of portfolio diversification, making the fundamental agency
theory challenge (the trade-off between incentives and risk) particularly
salient. These large-equity stakes usually come from stock and option hold-
ings that have accumulated over the years. Effectively, then, executive PFP
plans have long-term effects because they lead to equity accumulation, the
value of which is very sensitive to the firm’s stock performance (Nyberg,
Fulmer, Gerhart, & Carpenter, 2008).
Effects of Executive PFP: Empirical Evidence

Does PFP → performance?. In his review, Murphy (1999) concluded that
there was surprisingly little direct evidence on the effects of executive PFP
programs on firm performance. There is, however, plenty of evidence that
PFP design influences the goals and actions chosen by executives (see reviews
by Gerhart (2000) and Devers, Canella, Reilly and Yoder (2007)). Examples of
executive behaviors affected by PFP (usually defined in terms of the extent of
equity-related incentives) reported in these reviews include extent of diversifi-

cation, research/development and capital investment decisions, choice of
strategy, risk-taking, earnings manipulation, reaction to takeover attempts,
stock option backdating, and option grants being more likely in advance of
strong earnings. Although some of these outcomes of PFP are clearly undesir-
able and sometimes even illegal (as in the case of backdating options, which
we discuss later), in other cases, the alignment of actions with shareholder
interests can only be assessed after the fact. Most importantly, these studies, by
themselves, do not directly address the question of the net effect of such
incentives on financial performance.
Some early research suggested positive effects of PFP (defined in terms of
use of executive stock plans) on financial performance. For example, Masson
(1971) found that firms with greater emphasis on stock-based compensation
had higher shareholder return, while Brickley, Bhagat, and Lease (1985)
found that announcement of stock-based incentives was associated with an
abnormal (i.e., a deviation unpredicted by other variables) return to share-
holders of 2.4% during the period between the Board of Directors’ first meet-
ing to discuss the plan and the day that the Securities and Exchange
Commission (SEC) received the proxy statement describing the plan (mean
days in period=58.4). Similarly, Gerhart and Milkovich (1990) found that
incentive pay for middle and top managers (defined as eligibility for stock-
related incentives, but also as bonus/base ratio) was positively associated with
subsequent financial performance (Gerhart & Milkovich, 1990). Consistent
with agency theory’s focus on the trade-off between incentives and risk, how-
ever, firm risk seems to be a moderator of this relationship, with high-risk
firms performing more poorly when they emphasize incentive pay than when
they do not (Aggarwal & Samwick, 2006; Bloom & Milkovich, 1998).
It may be that Murphy’s conclusion about the lack of research on PFP con-
sequences reflected not only a judgment about the amount of research avail-
able on the topic at the time of his review, but also its credibility. The task of
credibly isolating the impact of PFP from the other determinants of firm per-
formance is a challenging one. Theory and research on this question is also
fragmented and often conflicting in its world views and inferences. For exam-
ple: “[t]here is presently no theoretical or empirical consensus on how stock
option and managerial equity ownership affect firm performance” (Core et al.,
2003, p. 34).
A recent study by Hanlon, Rajgopal, and Shevlin (2003) shows some of
the challenges in studying the PFP → performance question. They examined
the degree to which the Black–Scholes value of executive stock option grants
predicted future financial performance. Interestingly, rather than stock
returns, they used earnings (over 5-year periods) to measure financial perfor-
mance. (This was to avoid the complication of announcements of options
grants influencing stock price, see Brickley et al. (1985).) As discussed later,
earnings and stock returns show substantial convergence over longer time
periods like the 5-year period used here (but not over shorter periods), so this
is a viable study design. Hanlon et al. (2003) found that for each $1.00
increase in the value of stock option grants, earnings increased $3.71, a very
strong rate of return to shareholders. However, Hanlon et al. (2003) also
found that this return estimate depended on the functional form and the esti-
mation method. Using a linear model, there was actually a negative earnings
return (–$0.69) to stock option grants. Only when a nonlinear relationship
was specified, did the overall return estimate turn positive. In addition, the
$3.71 estimate was obtained using instrumental variables (in an effort to cor-
rect for simultaneity bias). Using ordinary least squares (with the nonlinear
function form) yielded an even higher estimate. Thus, the Hanlon et al.
(2003) study shows that the estimation of the PFP effect is not as robust as
one might wish across alternative specifications, limiting its ability to provide
a strong conclusion.
Still, the work that does exist generally seems to find that executive PFP is
associated with higher subsequent firm performance. Does this mean, then,
that firms should use more equity incentives, or are firms already generally
using an optimal level? Some researchers imply that firms can improve perfor-
mance by simply granting more equity (Morck, Schliefer, & Vishny, 1988),
while others researchers argue that since firms generally contract optimally,
observed equity ownership levels are likely to be efficient given a particular
firm’s own unique circumstances (Core et al., 2003), such as managerial risk
aversion and firm risk (Aggarwal & Samwick, 2006).
Does PFP actually exist for executives?. Although some evidence suggests
that PFP may positively influence performance, given the lack of research
consensus, scholars in both finance/economics and management have sought
to address the related question of whether PFP truly exists among executives.
If the answer is no, the key role of incentive alignment expected under agency
theory can be questioned and a search for alternative (e.g., sociopolitical)
explanations for observed CEO pay becomes more important. As we will see,
the fields of management and economics/finance have reached different

conclusions on this issue.
Agency theory-based empirical research hit its stride in the 1970s and
1980s. Yet, despite this relatively long history, agency-based research has yet
to yield a universal consensus on whether CEO pay is linked closely enough to
performance. Early studies showed mixed results, arguably due to differences
in methodology and choice of compensation and performance measures. For
example, Murphy (1985, p. 11), an economist, concluded that “executive
compensation is strongly positively related to corporate performance”, while
management scholars Kerr and Bettis (1987) reported no relationship
between shareholder returns and cash compensation.
In their seminal 1990 study, economists Jensen and Murphy lamented that
CEO incentive alignment had declined since the 1930s, with CEO wealth
(including equity holdings) increasing by an average of “only” $3.25 per $1000
increase in shareholder value, which they interpreted as a weak level of incen-
tives. Both of these conclusions have been challenged, particularly by research
in finance, accounting, and economics (Hadlock & Lumer, 1997; Hall &
Liebman, 1998; Haubrich, 1994). Specifically, subsequent studies in this liter-
ature have found larger performance–pay relationships (e.g., $14.53/$1,000 in
Aggarwal & Samwick, 1999a), while others have noted that both the Jensen
and Murphy and Aggarwal and Samwick estimates imply large changes in
executive compensation, given modest changes in market value, especially in
large firms (Gerhart & Rynes, 2003).10 It is not that these other literatures con-
clude that performance is the only factor in executive pay. To the contrary,
much research documents the existence of agency problems and the chal-
lenges in dealing with them. But, the important role of performance is also
recognized to a greater degree than in management.
In the management literature, however, many scholars still focus primarily
on Jensen and Murphy’s old (i.e., 1990) conclusion that the relationship
between organizational performance and pay among executives is “small”
(Tosi 2005; Dalton, Daily, Certo & Roengpitya, 2003; Dalton et al., 2007).
Further, empirical research in management is generally interpreted as being
consistent with this conclusion. Meta-analyses by Dalton et al. (2003) and
Tosi, Werner, Katz, and Gomez-Mejia (2000) report that variance explained
estimates (for the executive PFP relationship as defined in these studies) of
less than 1% and 4%, respectively. Based on these weak relationships, Tosi
compared those who continue to believe that US CEOs have strong PFP
incentives (Core, Guay, & Thomas, 2005) to those who resisted the idea that
“the earth is round, not flat” (p. 485–486). Hitt (2005, p. 963) summarizes this
literature as follows:
Research in economics, finance, and management… originally

supported the importance of equity ownership by managers and
directors. However, a recent meta-analysis concluded that no system-

atic relationship exists between ownership structure and firm perfor-
mance (Dalton, Daily, Certo, & Roengpitya, 2003). Stock options
became popular mechanisms for tying executive compensation to firm
performance and promoting executives’ equity ownership in firms.
However, anecdotal evidence and academic research suggest that they
have not been highly effective in meeting these goals. In fact, the
research shows only a small relationship between executive compensa-
tion in any form and firm performance. (Tosi et al., 2000)
Thus, different literatures have reached different answers to the question of

whether PFP exists among executives. (For a recent example, see the recent
debate between Walsh (2008) and Kaplan (2008).) What explains the differ-
ence? One major factor is that the economics/finance literature incorporates
the role of stock-based plans in achieving incentive alignment more fully than
does the management literature. It has been established that observed incen-
tive alignment (PFP) is much stronger when executive pay is defined and
measured to fully incorporate the value of stock and stock option holdings
accumulated over time and when researchers focus on how this value changes
with changes in shareholder wealth (Aggarwal & Samwick, 1999a; Hall and
Liebman, 1998; Jensen & Murphy, 1990).
To Murphy (1985), the relationship between the value of executive stock
holdings and the firm’s stock market performance is sufficiently obvious that
he described it as “mechanical” and later as “explicit” (Murphy, 1999). The
reason is that both executive and shareholder return are based on the value of
the same underlying asset, company stock (Conyon, 2006). By contrast,
accounting measures such as profitability or earnings are used primarily as
criteria in short-term (bonus) executive compensation plans, which account
for much less of total executive compensation. Over time, earnings measures
should also relate to total executive compensation, but that is primarily
because earnings should converge more closely with stock returns over longer
time periods (Dechow, 1994; Easton, Harris, & Ohlson, 1992; Warfield &
Wild, 1992). Murphy (1999, p. 2522) described this relationship between
earnings and CEO compensation over time as the “implicit” alignment with
shareholder interests, by virtue of the relationship between accounting mea-
sures and stock performance.
The importance of capturing the explicit part of CEO incentive alignment
can be seen by examining the annual survey of CEO pay published by the Wall
Street Journal. As we saw earlier, that survey reported that the majority (67%)
of CEO pay is based on what are commonly referred to as long-term incentive
plans, which include stock options and restricted stock (Ellig, 2002).11 In turn,
payouts to CEOs covered by these plans are typically based on shareholder
return (Kim & Graskamp, 2006; Ellig, 2002). By contrast, accounting measures
of performance such as net income are generally used for determining bonus
payouts under short-term incentive plans. Excluding stock-based payouts in
measuring CEO compensation or excluding shareholder return in measuring
firm performance is thus likely to lead to biased estimates of the strength of
overall incentive alignment (Hall, 2000). Indeed, Murphy (1999) states that
“virtually all of the sensitivity of pay to corporate performance for the typical
CEO is attributable to the explicit rather than the implicit part of the CEO’s
contract”.
Yet, most of the studies included in the Tosi et al. (2000) meta-analysis mea-
sured CEO compensation as salary plus bonus, and measured firm performance
in terms of accounting measures of profitability such as net income, return on
equity, or return on assets. In addition, these studies typically used short-term

(i.e., 1 year) time periods. Thus, the (central) role of stock in creating PFP was
not captured. Of the studies in the Dalton et al. (2003) meta-analysis that
included CEO equity as a measure of (long-term) CEO compensation, the
majority measured firm performance in terms of short-term accounting
profitability (e.g., return on equity, return on assets), rather than measuring
performance in terms of shareholder return or related measures. So, here stock-
based compensation was included, but its main driver, stock performance/
shareholder return, was not.
Yet another issue concerns the choice and timing of stock option measures.
Even though stock options are assigned an estimated value (e.g., using an
options pricing model such as Black-Scholes), their actual value is uncertain
and depends on what the stock price does in the future.12 If the stock price
does go up and options are later exercised, it can generate a sizable payout.
Some analyses (more often in the business press than in academic research)
have specified models where such payouts are counted toward a single year’s
compensation, and then highlighted cases where the large payout (e.g., in year
1) seems to be out of proportion with shareholder return in year 0. The prob-
lem with this approach is that the stock options exercised in year 1 and
counted entirely as year 1 compensation may have been granted many years
ago (e.g., in year –5). Shareholder return in year 0 may have been nothing spe-
cial, but it may have been high over one or more of the preceding years. In this
case, there would indeed appear to be little PFP if the correct choice of (rele-
vant) time period for measuring shareholder return is not made.13
So, is it really plausible that executive pay and performance are unrelated,
as now seems to be the conventional wisdom in the management literature? In
our opinion, the answer is “no”. One would have to argue that the alignment
between stock-based wealth of executives and shareholders is not relevant to
estimating the PFP relationship. But, as Hall (2000) argues, this is actually “the
most important component of the pay-to-performance link” (p. 123). A recent
empirical study (Nyberg et al., 2008) that seeks to better recognize the role of
company stock in PFP and also address other limitations of previous work
finds a much larger PFP relationship than previously reported in the manage-
ment literature, more consistent with earlier studies in the economics and
finance literatures (Aggarwal & Samwick, 1999a; Hall & Liebman, 1998).
Specifically, the addition of shareholder return (to measure performance) to
their CEO return equation (CEO return is analogous to change in CEO wealth
as percentage of beginning wealth level), after controlling for other determi-
nants, resulted in an increase in variance explained (adjusted R2) from 23% to
66%. Further, they found that a 1% change in shareholder return was associ-
ated with a nearly identical change in executive return. Thus, conventional
wisdom in the management literature, that there is little PFP among execu-
tives, may be largely a consequence of conceptual, specification, and measure-
ment problems.
However, some important caveats to this conclusion must also be noted.
First, there are clearly companies where PFP is not strong and, more disturb-
ingly, where executives have undertaken actions that not only destroyed
shareholder value, but were also illegal. Second, executives often have very
high compensation, even when their company performance is average or
below average, relative to industry competitors. Third, severance payments to
executives are often quite large and, on the face of it, largely independent of
firm performance (Alexakis & Graskamp, 2007).14 Until recently, the magni-
tude of these payments has been difficult to estimate and include in studies of
executive compensation. However, the SEC recently began to require more
stringent reporting in this area and it remains to be seen in future research
how incorporating these payments will affect the estimated PFP relationship.
Issues in Executive Compensation Research

Choice of financial performance measure: stock returns or earnings? Over
time, companies have moved toward greater reliance on market-based (i.e.,
stock return) measures, perhaps in an attempt to increase PFP and/or align-
ment with shareholders. As we saw in the preceding section, the choice of
performance measure can have a major impact on size of the estimated PFP
relationship among executives. Specifically, accounting-based measures such
as earnings, at least when measured over short time periods, are less strongly
related to executive pay than are market-based measures such as stock return.
Why is that the case?
Accounting-based measures of performance like earnings are backward-
looking in that they report what has already occurred. In contrast, stock prices
are forward-looking in that they reflect “publicly available information con-
cerning firms’ expected future cash flows” (Dechow, 1994, p. 12). In other
words, the greater the present value of future cash flows or dividends as esti-
mated by the market, the higher the stock price. Stock returns, in turn, are
based on stock price appreciation plus actual dividend payouts. The main
impact of earnings on current stock prices comes when earnings reports carry
new information (e.g., earnings above or below expectations) not already

impounded by the market in the stock price (Ball & Brown, 1968; Nichols &
Wahlen, 2004).
In the short run, an important potential drawback of using earnings as a
measure of performance is that “management typically have some discretion
over the recognition of accruals” and this can be used, for example “to oppor-
tunistically manipulate earnings” (Dechow, 1994, p. 5). Another problem with
using earnings to measure performance is that there is often a “recognition
lag” in accounting (Easton, Harris, & Ohlson, 1992; Warfield & Wild, 1992).
For example, for a loss due to an activity to be taken as an expense, the loss
needs to be both probable and estimable. As an example, consider a lawsuit
against a company. Typically, the expense of a lawsuit is not booked until it is

resolved. By contrast, the market will have already impounded (or recognized)
the estimated cost (albeit with varying degrees of accuracy that can only be
assessed after the fact) into the stock price in advance of the lawsuit’s resolu-
tion. Thus, earnings and shareholder returns may not track each other closely
during this period.
Over the long-run, however, earnings and stock returns are expected to
converge as recognition lag and other sources of divergence (e.g., possible
manipulation of earnings in the short run) cancel out and earnings estimates
become more statistically reliable. Indeed, empirical evidence provides strong
support for this hypothesis that earnings converge with shareholder return as
the time period of study increases (Dechow, 1994; Easton et al., 1992; Warfield
& Wild, 1992). For example, Warfield and Wild report the relationship
between earnings and stock returns over different time intervals as shown in
Table 5.2
Thus, what these results suggest is that the choice of whether to measure
performance in terms of earnings or stock returns is most consequential for
studies that use short time-frames. Our examination of research on executive
PFP in the management literature suggests that a short time-frame is the
norm, as is a preference for accounting-based measures of firm performance.
In our view, these design characteristics are likely to lead to incorrect infer-
ences regarding the PFP relationship and go a long way toward explaining
the different conclusions reached in the management and economics/finance
literatures.
Table 5.2 Relationship between Earnings and Stock Returns over Different Time Intervals as
Reported by Warfield and Wild (1992)
Time period Adjusted R2 Adjusted R
Quarterly 0.02 0.14
Annual (1 year) 0.09 0.30
Quadrennial (4 years) 0.40 0.63
In addition, from an agency theory standpoint, measuring performance

as stock returns would appear to provide a better fit with the theory. For
example, Devers et al. (2007, p. 1039) argue that “agency-theoretic argu-
ments strongly support the conclusion that shareholder wealth maximization
(e.g., market-based performance) should be the definitive criterion for com-
pensation research”. Agency theory states that shareholders are residual
claimants, meaning that they hold claims on (uncertain) “net cash flows for
the life of the organization” (Fama & Jensen, 1983b, p. 328) where “net”
means after other claims, expenses, and obligations are paid. The expected
value of those future cash flows is most directly reflected in the stock price.
Under agency theory (with imperfect information on agent performance),
the optimal contract to mitigate agency costs is one that also makes agents
residual claimants who will also participate in future net cash flows (up to
the point that agent risk-aversion allows). Thus, it would seem necessary to
fully incorporate stock-based measures of executive compensation in such
research.
Another issue in choosing a performance measure is whether it should be
adjusted for performance of competitors. For example, if the median share-
holder return in a particular industry is 30% over some time interval, then a
20% return for a firm in that industry would be, in relative terms, below aver-
age for the industry. Relative performance evaluation logic would then dictate
that executive pay also be lower than the industry median.
Despite theoretical arguments for the logic of rewarding market-adjusted
(or relative) rather than absolute firm performance (Holmstrom, 1979), most
studies find little or no evidence for the existence of explicit relative perfor-
mance evaluation (Aggarwal & Samwick, 1999b; Antle & Smith, 1986;
Gibbons & Murphy, 1990). Similarly, consulting firm data indicate that, of
the 250 largest US firms, less than 1% granted indexed (i.e., where relative
performance is used) options and only about 4% granted options that had
performance-contingent vesting requirements (versus time-based vesting)
(Alexakis & Graskamp, 2007). Thus, even if, as we believe the literature shows,
executive pay is related to shareholder return, this lack of relative performance
evaluation suggests that executives can earn large compensation for large
shareholder returns, even when these returns are arguably the result of an
entire industry performing well, rather than uniquely strong performance by
the firm (or executive). In addition, some evidence suggests that this relation-
ship is asymmetric, such that executives benefit in up-markets, but are not
penalized as strongly during down-markets (Garvey & Milbourn, 2006), pro-
viding further reason for concern with CEO pay.
Alternatively, others (Oyer, 2004; Rajgopal, Shevlin, & Zamora, 2006) sug-
gest that the lack of relative performance evaluation in up-markets is due to
CEO retention concerns. “If the supply of managerial talent is scarce and
hence inelastic, then increases in aggregate industry or market returns should
increase the equilibrium wage paid to CEOs” and “firms pay their CEOs
more simply to match their increased outside opportunities” in up-markets
(Rajgopal et al., 2006, p. 1818). In summary, while PFP is substantial among
executives, the theoretical arguments for and against the use of relative
performance evaluation in determining PFP, together with the empirical
evidence on this issue, continue to evolve.
Choice of performance measure: beyond financials. There has long been a

debate regarding whether firm performance can be evaluated using solely
financial measures. Although much of our discussion focuses on financial
measures of firm performance, the corporate social responsibility literature
emphasizes that financial performance is one of many goals that a firm may
pursue. In this view, businesses are responsible for outcomes related to all
areas of involvement with society (Wood, 1991).15 One influential approach
to corporate social performance is stakeholder theory, which recognizes that
firms have a number of constituencies (e.g., shareholders, customers, suppli-
ers, employees, society) and proposes that the successful management of the
sometimes conflicting needs of these constituencies is the key to firm
survival and success (Freeman, 1999). Intrinsic stakeholder theory suggests
that firms adopt stakeholder management practices as part of a normative
moral and ethical framework, where firm financial performance is not the
overriding goal, but rather is balanced with the goals of other stakeholders
(Freeman, 1999). In contrast, instrumental stakeholder theory (Jones, 1995)
singles-out financial performance as the most important objective, suggest-
ing that firms recognize and work to satisfy multiple stakeholders for the
purpose of improving financial performance. An empirical study by
Berman, Wicks, Kotha, and Jones (1999) examined the relationship between
firm performance and the degree to which firms acted positively in five key
stakeholder relationships: employee relations, diversity, local communities,
natural environment, and product safety/quality. Two of the five relation-
ships were statistically significant (and positive) in a return on assets equa-
tion: employee relations and product safety/quality. This finding—that
serving multiple stakeholders can ultimately benefit shareholders—is consis-
tent with evidence on the positive relationship between good employee rela-
tions and financial performance (Fulmer, Gerhart, & Scott, 2003) and with
the finding that corporate social performance and financial performance
were positively related (corrected r=0.36) in a meta-analysis of several
hundred studies (Orlitzky, Schmidt, & Rynes, 2003). It is also consistent
with research that shows higher shareholder return in firms that use both
financial and nonfinancial measures of performance in executive compensa-
tion (Said, HassabElnaby, & Wier, 2003).
In summary, it is important to recognize that firms can be evaluated on
performance dimensions other than financial performance. At the same time,
without adequate financial performance, the ongoing viability of a firm is in

doubt and, accordingly, its ability to serve the interests of multiple stakehold-
ers would also be in doubt.
Contingency factors, incentive alignment and monitoring. As research in

this area has matured, researchers have turned their attention to contingency
factors that affect incentive structure (or PFP). As noted previously, outcome-
based pay introduces an element of risk into the compensation contract that
may necessitate payment of a risk premium to the executive and higher overall
compensation costs (Eisenhardt, 1989; Garen, 1994). Similarly, if firm perfor-
mance is highly variable, this also introduces an element of risk that has been
shown to increase the overall required level of pay, reduce the use of incentive
pay, and/or result in weaker pay/performance linkages (Aggarwal & Samwick,
1999a; Bloom & Milkovich, 1998; Gray & Cannella, 1997; Miller, Wiseman, &
Gomez-Mejia, 2002). Aggarwal and Samwick (1999a) describe this hypothe-
sis—that incentive intensity (PFP) weakens as risk increases (i.e., the incen-
tives versus risk trade-off)—as the most central hypothesis of agency theory.
Thus, its strong support is viewed as important evidence of agency theory’s
validity.
Because CEOs have the broadest scope of responsibility and the most
direct accountability to shareholders, another agency theory-related hypothe-
sis is that CEO compensation will be more closely linked (than that of those
lower in the organization hierarchy) to shareholder return. Consistent with
this logic, Aggarwal and Samwick (2003) find that pay sensitivity to share-
holder wealth is higher for CEOs than it is for divisional managers, and that
divisional managers’ pay is also sensitive to divisional performance, particu-
larly when divisional performance measures are less “noisy” and therefore
more informative.
Individual differences, too, have begun to receive attention as another con-
tingency factor. This is because the motivational effects of performance-based
pay, particularly stock and options, can vary across individuals with differing
characteristics. In addition, depending on such variables as time to retire-
ment, previously accumulated equity in the firm, and other personal wealth,
executives may theoretically value the marginal stock and option compensa-
tion they receive differently from the value intended by the firm (Hall & Mur-
phy, 2002; Lambert, Larcker, & Verrecchia, 1991; Meulbroek, 2001).
Similarly, the fact that some executives choose to protect their personal wealth
through the use of hedging instruments that reduce their exposure to risk may
also alter the incentive effects of their pay packages (Bettis, Bizjak, &
Lemmon, 2001).16
The effect of incentives on subsequent performance may also depend on
the type of pay used to create the incentives. For example, compared to out-
right stock ownership, stock options are generally associated with subsequent
behavior that is viewed as riskier, such as corporate acquisitions (Sanders,

2001), and this riskier behavior may likewise result in greater variance in
financial performance (Sanders & Hambrick, 2007). Other research finds that
financial statement restatement, or “misreporting”, is predicted by the pay–
performance sensitivity of stock options, but not the sensitivity of other types
of pay, including restricted stock or other long-term incentives (Burns &
Kedia, 2006).
Governance. Under agency theory, incentives and monitoring are substi-

tutes. While some studies find that weak board governance is associated with
higher pay levels (Core, Holthausen, & Larcker, 1999), overall, the accumu-
lated research evidence is mixed on the effects of board governance on execu-

tive pay level, incentive alignment, and decisions to reprice underwater stock
options (Carter & Lynch, 2001; Chance, Kumar, & Todd, 2000; Gomez-Mejia,
Tosi, & Hinkin, 1987; Finkelstein & Hambrick, 1989; Pollock, Fischer, &
Wade, 2002). Moreover, even when focusing specifically on the compensation
committee, which has the most direct impact on executive pay, the evidence
for governance effects is relatively weak. Director fees paid to compensation
committee members are positively predictive of pay and negatively associated
with incentives in intial public offeing (IPO) firms (Conyon & He, 2004), but
board composition seems to have little effect. Independence of the compensa-
tion committee, the CEO’s presence on the committee, and the presence of
current and retired executives of other firms on the committee seems to have
no effect on pay level or incentives in US samples (Anderson & Bizjak, 2003;
Conyon & He, 2004; Daily, Johnson, Ellstrand, and Dalton, 1998), but the
existence of a compensation committee with a higher proportion of outside
directors was associated with stronger PFP as well as higher overall pay in the
UK (Conyon & Peck, 1998).
A firm’s ownership structure, which may also capture monitoring inten-
sity, seems to provide more meaningful constraints. The overall concentration
of ownership held by institutional investors is associated with greater incen-
tives and lower overall pay (Hartzell & Starks, 2003), although institutional
ownership by firms that are subject to influence (e.g., banks) is associated with
higher CEO pay (David, Kochhar, & Levitas, 1998). The presence of any large
outside blockholder (greater than 5% and not necessarily an institution) is
also associated with greater PFP and higher compensation risk (Gomez-Mejia
et al., 1987; Tosi & Gomez-Mejia, 1989).
Sociopolitical considerations in executive pay design. In part as a reaction

to the perceived lack of strong incentive alignment among top executives (à la
Jensen & Murphy, 1990), a body of research has emerged that departs from
the typical focus of agency theory, in that the effectiveness of incentive align-
ment and monitoring in controlling agency costs is fundamentally questioned.
(In another sense, though, it could be said to confirm the importance of

agency theory’s focus on the challenge of controlling agency costs.) Relying
heavily on theories of managerialism, organizational power and politics, and
social influence, research in this vein maintains that executive pay levels are
high and incentive alignment weak as a consequence of factors that diminish
the arm’s length, oversight relationship between boards of directors and top
executives (Bebchuk, Fried, & Walker, 2002). To the extent that this argument
is empirically supported on a broad scale, it calls into question the existence of
PFP among executives. As our review later indicates, there is ample evidence
documenting the influence of sociopolitical factors on executive compensa-
tion. However, that fact does not necessarily mean that sociopolitical factors
play a dominant role (Fulmer, in press).

Originally described by Berle and Means (1932), “managerialism” has been
widely applied in the executive pay context to describe motivations that man-
agers have for entrenchment (Shleifer & Vishny, 1989), for seeking to gain
influence over the board, and for increasing firm size in ways that are not
necessarily beneficial for shareholders (Tosi et al., 2000). Under this view,
increasing firm size provides a way for sympathetic boards to legitimate or
rationalize the pay of executives, rather than representing either a legitimate
job characteristic that requires a higher level of human capital or achievement
of a shareholder objective that should be rewarded with higher pay (Tosi et al.,
2000). For example, in a study of banks, Bliss and Rosen (2001) found that
whether growth in firm size occurred through mergers or non-merger growth,
CEO compensation increased with growth, even though stock price typically
declined after a merger announcement. As such, they suggest that mergers
represent “a fast way to increase the size of the firm” (Bliss & Rosen, 2001,
p. 110) and thus “an easy way to rapidly increase compensation”. Harford and
Li (2007) similarly found that mergers typically result in higher CEO compen-
sation, despite poor post-merger stock price performance. However, in
contrast to Bliss and Rosen, Harford and Li report that growth through merg-
ers has a larger effect on CEO compensation than does growth through other
means. Work by Lee, Shakespeare, and Walsh (2008) indicates that the story
could be more complex, as they found that CEOs engaging in both acquisition
and divestiture of assets (what Lee et al. (2008) describe as a churning strat-
egy) actually received higher compensation over time than CEOs following
only an acquisition (or only a divestiture) strategy. (All three strategies were
associated with higher CEO compensation than strategies involving no acqui-
sitions or divestitures.) Finally, other research reports that growth through
mergers and/or acquisition does carry some risk for CEOs (and have a PFP
element) in that they “pay a price, in the form of their jobs, for making acqui-
sitions that destroy [shareholder] value” (Lehn & Zhao, 2006, p. 1761).17
Theories of organizational politics and social influence have been used
to explicate the mechanisms of managerial entrenchment. Relationships are
cultivated over time as executives become entrenched in the organization

and perhaps even appoint members of the board; consequently, tenure and
CEO shareholdings are viewed as important levers for gaining influence
over boards of directors (Finkelstein & Hambrick, 1989; Hill & Phan, 1991;
Westphal & Zajac, 1995). Social cognitive theories have also been used to
explain CEO pay levels. For example, research finds that CEO pay is pre-
dicted by the external pay levels of the members of compensation commit-
tee—a finding that has been attributed to the existence of social
comparison processes (O’Reilly, Main, & Crystal, 1988), but that could also
reflect labor market factors if committee members are in similar industries
as the CEO. CEOs with higher social status relative to the chairs of their
compensation committees also receive higher pay, presumably in part

because of their ability to exert greater influence on lower-status chairs
(Belliveau, O’Reilly, & Wade, 1996). Social status, legitimacy, and resource-
dependence arguments have also been used to explain why CEO networks
of external board memberships are related to pay when firms are highly
diversified (Geletkanycz, Boyd, & Finkelstein, 2001). This influence may be
wielded by executives to increase their pay levels or to reduce the intensity
of PFP, or both.
Shareholder and regulatory influences on executive PFP. The separation of

ownership and control and the potential negative impact on firm financial
performance due to agency costs means that there is widespread interest in
whether PFP exists in executive pay (Bebchuk & Fried, 2004; Bebchuk et al.,
2002). There is little evidence that either negative press coverage (Core, Guay,
& Larcker, 2008) or greater financial statement transparency (now required by
the SEC as part of its ongoing effort to give shareholders better information to
evaluate and improve executive pay) has had much of an effect on the struc-
ture or level of executive pay. In recent years, shareholders have become
increasingly active in executive pay issues, with the number of shareholder
proposals related to executive pay approximately tripling between 2000 and
2004 (Loring & Taylor, 2006). Although executive compensation proposals
rarely receive a majority vote (Loring & Taylor, 2006), at firms that are targets
of proposals, subsequent CEO pay shows a slight tendency to increase more
slowly and to shift more toward cash and away from long-term pay (Thomas
& Martin, 1999).
SEC reporting requirements (and investigations) have, however, seem-
ingly had the effect of shutting down some of the ways of gaming PFP plans,
such as the practice of backdating stock option grants, which has an effect on
stock option valuation.18 Empirical evidence highlighting aberrant stock
return patterns around option grant dates during the period 1992–2002 sug-
gested a systematic problem with backdating of stock option grants (Lie,
2005, p. 802). Heron and Lie (2007) found that after August 2002, when the
SEC began requiring option grants to be reported within two business days,
these aberrant patterns had disappeared. Another important recent develop-
ment is the large growth in the use of “clawback” provisions in executive con-
tracts, which allow the Board to recover incentive payments made to
executives in the event that a subsequent restatement of financial results is
necessary due to misconduct by the executive. According to Equilar, more
than one-half of Fortune 100 companies had such a provision in 2007, up
from 18% in 2005.19
Federal tax policy since 1993 has attempted to shape the executive pay
landscape by limiting the deductibility (though not the payment) of non-
performance-contingent pay over $1 million (Internal Revenue Code Section
162[m]). Results are mixed on whether this policy has had the effect of
increasing the sensitivity of pay to performance for affected firms (Perry &
Zenner, 2001; Rose & Wolfram, 2002) but it has had virtually no effect on
overall pay levels, as the level of all pay components has increased since 1993
(Conyon, 2006). In addition, many firms simply choose to forfeit the deduc-
tion and pay non-performance-based pay over $1 million anyway (Balsam &
Yin, 2005).
The Emergency Economic Stabilization Act of 2008 provides “authority
and facilities that the Secretary of the Treasury can use to restore liquidity and
stability to the financial system of the United States”. A component of the Act,
the Troubled Assets Relief Program (TARP), places restrictions and require-
ments on executive compensation in financial institutions in which the
Treasury takes a debt or equity position. First, compensation that would
encourage executives “to take unnecessary and excessive risks that threaten
the value of the financial institution” is to be limited. Second, there is a
(clawback) provision stronger than that currently available (e.g., under
Sarbanes-Oxley) for the recovery of “any bonus or incentive compensation
paid to a senior executive officer based on statements of earnings, gains, or
other criteria that are later proven to be materially inaccurate”. Third, there
are restrictions on the use of golden parachute payments and additional limi-
tations on corporate tax deductibility (although not payment) of executive
pay. Thus, in return for government/taxpayer assistance, TARP seeks to limit
certain executive compensation practices.
Executive PFP and its potential effects on other employees. Executives are
unique in that their compensation—at least for the CEO, CFO, and the three
highest paid other executives in US corporations—is public, thus making it
possible for the way they are paid to influence not only their own perfor-
mance, but also that of others. Relative pay differences within firms, to the
degree they represent PFP, theoretically influence not only employees’ fair-
ness perceptions and willingness to cooperate (e.g., as predicted by equity
theory and relative deprivation theory), but also their motivation to work
hard to advance in the organization (e.g., as predicted by tournament theory

(Lazear & Rosen, 1981; Rosen, 1986)). Thus, large differentials in pay as a
function of job level can be seen as a positive from an incentive point of
view, or as a negative if believed to be so large as to be unjustified (Gerhart &
Milkovich, 1992). Indeed, the popular press, some politicians, and labor
organizations often argue that the pay differentials between executives and
rank and file workers are unfair and engender widespread worker resent-
ment. Although there is at least one study that reported a negative associa-
tion between size of pay differential between employees and upper-level
business unit managers (although not the highest-level executives) and
managers’ perception of product quality (Cowherd & Levine, 1992), the
study did not measure any employee perceptions (e.g., resentment toward
high executive pay, intention to decrease effort toward quality, etc)., so it is
difficult to tell if large pay differentials really caused lower quality via
employee reactions.
Because of concerns about employee reactions to high executive pay, a
handful of firms over the years have attempted to cap executive pay (usually
just the salary component) at some multiple of average worker pay (Ben &
Jerry’s Homemade; Laabs, 1995). At the time of this writing, Whole Foods
Market has a cap on executive base salary of 19 times average worker pay, or
$631,500 (Annual proxy statement dated January 28, 2008).20 Given that most
(88% in the Wall Street Journal/Hay Group survey) executive pay comes in
forms other than fixed salary (12% in the same survey), it is unclear what
effect capping salary really has on the overall pay gap, although it may be good
for public relations. Equally unclear, as noted previously, is whether employ-
ees actually care; other than one survey of working adults given a hypothetical
scenario about a fictional firm (Andersson & Bateman, 1997), there is little
published research documenting employee resentment about (and more
importantly, behavioral consequences, in terms of either incentive or sorting
effects, due to) executive pay. In saying this, though, we acknowledge that pro-
viding such evidence in forms most likely to be acceptable to top-tier journals
(e.g., employee attitudes combined with objective performance indicators or
behavioral assessments of performance by their supervisors) is difficult to
come by (e.g., not many firms want researchers poking around regarding
issues of perceived pay inequity).
In contrast, there has been more research on pay differentials by job level—
and their consequences—among top managers. Such differentials, which
generally arise as a result of PFP, have been hypothesized to have conse-
quences for outcomes such as financial performance and turnover. A first step
has been to understand what factors explain the size of the differentials. The
magnitude of the gap between the pay of the CEO and other executives in the
firm is seemingly better explained by tournament theory—which conceptual-
izes such pay differentials or gaps as providing strong incentives for effort and
advancement—than by other, non-economic theories (Henderson &

Fredrickson, 2001; Main, O’Reilly, & Wade, 1993). Consistent with this logic,
pay dispersion is also higher when firms have greater investment opportuni-
ties (which theoretically engenders a stronger need for the best managers to
rise to the top as suggested by tournament theory), and also when firms are
more highly diversified (Bloom & Michel, 2002). Conversely, when CEOs are
powerful and are themselves “overpaid” (relative to what would be expected
given firm size, human capital, etc.), research finds that lower-level managers
will also tend to be “overpaid” (Wade et al., 2006). Overpayment, of course,
is detrimental to financial firm performance, all else equal. However, from
an efficiency wage theory perspective, high-paying firms may reap certain
benefits such as greater ability to attract, retain, and motivate higher-quality

executive talent.
A second step has been to study the effects of pay dispersion. Evidence
indicates that dispersion is associated with lower executive tenure and higher
turnover among top managers (Bloom & Michel, 2002). The degree to which
top managers are highly paid relative to lower-level managers also predicts
the turnover of lower-level managers (Wade et al., 2006). Recent research
suggests that across firms, pay dispersion among top managers is positively
related to firm performance, consistent with tournament theory, and that
this relationship is stronger in firms with strong governance (Lee, Lev, &
Yeo, 2008). Other research finds that the effects of dispersion on perfor-
mance are moderated by organizational context. For example, the pay gap
between the CEO and other members of the highly paid executive group is
negatively associated with performance in multinational firms, especially in
firms with a stronger international presence (Carpenter & Sanders, 2004).
Similarly, pay disparities among top managers are negatively associated
with performance in high technology firms but not in low technology firms
(Siegel & Hambrick, 2005).
To conclude, pay differentials between executives and non-executives
(e.g., front-line employees) and between executives at different levels is often
seen as having performance consequences. One view is that larger differen-
tials induce perceptions of unfairness, which could harm performance. This
view is most often raised in discussions of differentials between executives
and front-line employees and some firms apparently accept this logic, given
that they have placed restrictions on at least the base salary component of
executive compensation. However, there is little empirical research on
employee reactions to differentials or the effect of policies restricting differen-
tials. An alternative view, consistent with tournament theory, is that pay
differentials serve a motivational purpose by encouraging the performance
necessary to progress up the ranks to higher paying jobs (where such progres-
sion is possible). Some empirical evidence seems to support this hypothesis,
although it appears to depend on contextual factors.
Summary
Agency theory emphasizes the use of PFP contracting schemes as a means of
controlling agency costs. Empirically, this suggests that we should observe
both that PFP exists, and that firms with PFP (or that execute it more
effectively) will perform better (unless the vast majority of firms are already at
optimal PFP levels). On the first point, the management literature is skeptical,
while the economics/finance literature generally takes the relationship
between executive compensation (mainly the stock-based portion, which
accounts for the largest part) and shareholder wealth as a given. Our reading
of the evidence concurs with the latter view. On the second point, evidence
has been slow to accumulate. Skepticism regarding the existence of PFP has
contributed to a search in the management literature for other explanations

for executive pay, such as sociopolitical factors. The challenge for researchers
is to more successfully determine the relative importance of PFP, sociopoliti-
cal, and other factors in explaining executive pay. Such evidence has great
potential for influencing PFP design in organizations, regulatory actions and,
perhaps, the motivation and performance of other executives and employees
in organizations.
Conclusion and Suggested Research Directions

In the opening of this chapter, we identified several issues of interest regarding
PFP: conceptual mechanisms; empirical evidence on effectiveness of different
programs such as merit pay or group incentives; the risks and challenges that
are often encountered in using such programs; and the case of PFP among
executives. We also saw in the opening of our chapter that there are strong
(and conflicting) opinions regarding what the empirical evidence says about
the existence and effectiveness of PFP. Some of our most important conclu-
sions are as follows.
First, as we stated earlier, “one best way” advice (e.g., do or do not use
individual PFP plans) or “sound-bite” conclusions (e.g., pay does or does
not motivate) are rarely valid, but rather depend on the circumstances.
Pfeffer and Sutton (2006, p. 133), in emphasizing the importance of evi-
dence-based management, state that “the use of financial incentives is a
subject filled with ideology and belief—and where many of those beliefs
have little or no evidence to support them” and that “consultants, gurus,
and executives charge ahead with assumptions and practices that reflect a
reckless disregard for the evidence”. As we saw earlier, Pfeffer (1998, pp.
214–215) has argued that “Literally hundreds of studies and scores of sys-
tematic reviews of incentive studies consistently document the ineffective-
ness of external rewards”. Although we agree on the importance of
evidence-based management, we disagree that such a simple and clear-cut
interpretation of the effectiveness of PFP is correct, based on the evidence
we have reviewed.
Second, while there are several longstanding theories of compensation and

motivation, most of these concentrate on the effect that PFP has, holding the
employee population constant, something we describe as the incentive effect.
This overly narrow focus has resulted in management research largely over-
looking one of the most important mechanisms by which PFP can have an
impact. Increasingly, however, scholars have recognized that PFP may change
the employee population and its attributes. This sorting effect can be as (or
more) important than the incentive effect in some circumstances. We believe
that future research should strive to do a better job of incorporating and esti-
mating the magnitude of sorting effects, as well as incentive effects. An espe-
cially interesting area for future research is the interplay between incentive
and sorting effects in group and organization-based plans where both cooper-
ation and strong individual contributions are needed.
Third, the empirical evidence demonstrates that the use and intensity of
PFP programs is typically associated with better individual, group, and orga-
nization performance. However, as with many areas of management
research, whether the causality of this relationship has been established to the
degree necessary to confidently advise organizations is something that can be
questioned. Certainly, what is beyond question is that PFP can and does fail,
both in the case of executives and nonexecutives. Thus, there is a risk/return
trade-off. PFP can be a major positive influence on effectiveness, but can also
harm it. Better evidence on survival, success, and failure of PFP plans would
be helpful. Another area of recommended attention is merit pay. Although
widely used, we continue to have remarkably little good evidence on its
effects and encourage researchers to “circle back” to more thoroughly exam-
ine this important issue. One aspect of merit pay for which we found some-
what more evidence concerns the question of how much PFP in the form of
merit pay actually exists. Although the strength of merit pay likely varies
from organization to organization, our review finds that merit pay is often
defined too narrowly (e.g., excluding other consequences of merit ratings
such as promotion, inter-organization mobility, and associated pay growth),
thus probably leading to an overly pessimistic view of its strength and
potential impact.
Fourth, any discussion of whether PFP “works” must, to be practically
useful, provide some sort of cost–benefit or ROI analysis (Sturman, Trevor,
Boudreau, & Gerhart, 2003). For almost any job, there will likely come a
point where increasing incentive intensity (PFP) will change behavior.
Whether it is worthwhile to do so depends on what the value of the change
in behavior is and what it costs to achieve it. Cost includes not only the
higher cost of compensation, but also potential unintended consequences
such as the use of undesirable means to achieve the ends and lessened atten-
tion to objectives not emphasized in the PFP plan.21 Such a “devil is in the
details” approach is, of course, not as straightforward as saying that PFP
either works or does not work, but it is more realistic and thus necessary for
effective decision making.
Fifth, we devoted significant attention to the special case of executive PFP.
Executives are unique in terms of the impact they can have on organization
performance and the public nature of their earnings. Because of what some
believe to be no meaningful relationship between firm financial performance
and pay among executives, the validity and relevance of agency theory has
been increasingly challenged and supplemented with alternative theories. Our
review, however, suggests that the field of management has gone too far in its
skepticism, largely dismissing the existence of PFP in executive pay and focus-
ing almost exclusively on the role of “mischief” (Dalton et al., 2007). Although
there certainly is mischief in executive pay, it is not the whole story. We

encourage researchers to more carefully consider how to define and estimate
the magnitude of PFP among executives in their research and whether current
conventional wisdom in the management literature is consistent with the full
range of evidence available in related fields. To us, it seems that the manage-
ment literature on executive compensation—as well as PFP among non-
executives—has done a thorough job of documenting all of the things that can
go wrong. While that line of research is important, it is most useful to the
degree that it also incorporates the role of performance, thus providing insight
into the relative importance of performance and non-performance factors
under varying conditions.
We have seen that the use and effectiveness of PFP, both for executives and
nonexecutives, is viewed with skepticism in parts of the management litera-
ture (Dalton et al., 2007; Hitt, 2005; Pfeffer, 1998; Pfeffer & Sutton, 2006).
Some degree of skepticism is always healthy, as long as it is based on facts. In
this vein, we saw that Pfeffer and Sutton (2006) warned against the influence
of “ideology and belief” and called for evidence-based management instead.
However, ideology and belief can perhaps help explain some of the skepticism
regarding PFP. A series of articles bemoans the influence of economic ideas in
management (Ferraro, Pfeffer, & Sutton, 2005; Ghoshal, 2005; Pfeffer, 2005).
Pfeffer (2005) says that “economics is indeed taking over management and
organization science” and that some aspects of this influence “can be harmful”
(p. 96). Further, a question is raised as to the evidence base for this influence.
Ferraro et al. (2005), in talking about the influence of economics, state that
“theories can ‘win’ in the marketplace for ideas, independent of their empiri-
cal validity, to the extent that their assumptions and language become taken
for granted and normatively valued, therefore creating conditions that make
them come ‘true’” (p. 8). One of their two examples to make this argument,
that (economic) theories can “win” despite a lack of solid evidence is “the
increasing reliance on contingent, extrinsic incentives” (p. 18). In contrast,
our view is that any increased reliance on contingent, extrinsic incentives is
not necessarily “independent of their empirical validity”. Rather, our reading
is that there is rather strong empirical evidence showing that PFP can improve
performance.
One concern we have is that management scholars may be too focused on
differentiating what they do from what is done in other business school disci-
plines, especially those grounded in economics. Differentiation is good, as
long as it is based on solid logic and carefully generated empirical evidence.
However, differentiation does not require showing that the other discipline
has got it all wrong. In the case of compensation, management research has
been of great value in showing how economic principles of incentives and PFP
can be informed by other social science perspectives (Gerhart & Rynes, 2003).
Nevertheless, doing so does not require (nor does the evidence in our view
support) almost blanket dismissals of the effectiveness of PFP or the impor-

tance of the role it plays in determining the pay—and performance—of
employees and, especially, executives.
One of the areas that management research has identified as important and
under-researched, and one that it should be uniquely qualified to study, is
whether executive pay has indirect effects on firm performance by influencing
employee behaviors. Do employees pay attention to the amount of money
paid to executives in their organizations? Do they care? Do they act differently
as a result? Do their reactions depend on how the company has performed?
There is much opinion on these questions, but little evidence that we could
find. This is certainly an area where management scholars are well-positioned
to provide some valuable insights.
Finally, we encourage researchers to pay more attention to the reporting
and interpreting of effect sizes in compensation research. We continue to see
examples where only the statistical significance of results is discussed with no
interpretation or discussion of regression coefficients or variance explained.
In an area like compensation, where key variables (compensation, financial
performance) are measured in inherently meaningful ratio-level scales, such
interpretations should take center stage. Knowing, for example, that perfor-
mance and/or sociopolitical factors have a relationship with executive pay that
is likely to be non-zero (i.e., statistically significant) is not very interesting by
itself. As argued earlier, the magnitude of such relationships needs to be the
focus, both for evaluating theories and for drawing practical implications.
Endnotes
1. Further, in some areas of compensation, such as executive compensation, the way
it is managed can also have wider repercussions, with employees, shareholders,
the public, and regulators all taking an interest (and sometimes action) in
response.
2. Nonmonetary rewards are also relevant to employee motivation, but we limit our
discussion here to financial/monetary rewards which, by themselves, constitute a
very large literature.
3. The d statistic is defined as the difference between the dependent variable mean
for Group A versus Group B, divided by the pooled standard deviation of Groups
A and B. Thus, it gives the difference between Group A and B in terms of standard
deviation units.
4. For a discussion of empirical work on the importance of monetary rewards rela-
tive to other rewards, see Gerhart and Rynes (2003) and Rynes, Gerhart, and
Minette (2004). For a discussion of evidence on the relationship between mone-
tary rewards and intrinsic motivation (in work settings), see Gerhart and Rynes
(2003) and Rynes, Gerhart, and Parks (2005).
5. There appears to be some shift toward the use of merit bonuses, where, unlike
merit pay, performance awards do not become a (permanent) part of base salary,
thus limiting growth of fixed costs.
6. Single-loop suggestions are those that do not question fundamental procedures

or assumptions; double-loop are the opposite.
7. There were two likely reasons for this change. First, Microsoft is no longer a
growth company, making stock price appreciation, and thus growth in employee
wealth via increased stock option value, a less powerful PFP program. Second,
changes in accounting standards (from intrinsic value to fair value) have made
stock options more costly for companies to use.
8. Although some authors (Katzenbach & Smith, 2003) make a distinction between
groups and teams, in this review we use the terms interchangeably to mean “inter-
dependent collections of individuals who share responsibility for specific
outcomes” (Sundstrom, DeMeuse, & Futrell, 1990).
9. Executives, unlike most rank-and-file employees, are also prohibited from short-
selling stock in their own companies, and must publically disclose their sales,
transfers, and investment hedging transactions involving company stock.
10. To interpret these PFP sensitivities, consider that in 2007, the median Fortune
500 company had a market value of $10 billion and the 50th company on the list
had a market value of $57 billion. Using the Jensen and Murphy (1990) estimate
of $3.25, a 10% increase in market value would imply $3.25 million and $18.53
million higher executive compensation, respectively. Using the Aggarwal and
Samwick (1999a) estimate of $14.53, a 10% increase in market value would imply
$14.53 million and $82.8 million higher compensation, respectively.
11. Indeed, it seems that one consequence of the agency theory idea that executives
should be encouraged to act in the best interests of owners has been a concerted
effort by organizations over time to have executives hold significant amounts of
stock and stock options.
12. In addition, stock options ordinarily have vesting requirements, meaning that
they cannot be exercised immediately. Executive stock options are also not trad-
able, meaning that option pricing models likely overstate their value.
13. Consider the example of Richard Fairbank, the CEO of Capital One, as reported
in the annual Wall Street Journal/Mercer CEO Compensation Survey (April 13,
2006). According to the Survey, in 2005, shareholders of Capital One earned a 1-
year total return of 2.7%. Over 5 years, shareholders earned an (annualized) total
return of 5.8%. Under the column, Total Direct Compensation Realized, the
Survey reported that Fairbank received $249.3 million from Capital One in 2005.
This apparent lack of alignment between shareholder return and CEO compen-
sation was reported widely in the popular press. Less widely reported, however,
was the fact that most of the $249.3 million received by Fairbank resulted from his
stock ownership, specifically his exercise of stock options granted to him in 1995
(and that would have expired in 2005 if they had not been exercised), and that
shareholder wealth increased by $23 billion between 1995 and 2005 for a cumu-
lative shareholder return of 802%.
14. One type of severance payment that has received much attention is the golden
parachute, which refers to the provision typically found in CEO employment
contracts that provides an often sizable severance payment to the CEO upon
change in control (e.g., when there is a takeover of the company). Critics question
the logic of paying a large sum of money to a CEO who facilitates a sale of the
company and then leaves, especially where other stakeholders such as employees
are adversely affected (e.g., by the lay-offs that often happen in such cases). The
stated rationale for a golden parachute is that it prevents a CEO from being so
entrenched as to be unwilling to facilitate a sale of the company, even if it is a good
deal for shareholders, for fear of losing his/her position.
15. An alternative view, expressed by Milton Friedman, is that “the social responsi-
bility of business is to increase profits” (Friedman, 1970). In Friedman’s view, a
single-minded focus on business goals can be seen as a moral imperative because
managers have a fiduciary duty under the principal-agent relationship to maxi-
mize the wealth of shareholders.
16. Age or time to retirement can also be a contingency factor. For executives who
receive pensions, as retirement approaches, a larger proportion of overall wealth
is in the form of debt (their accrued pension benefit) rather than equity, which is
in turn related to more conservative behavior (Sudaram & Yermack, 2007).
17. One challenge in studying the firm performance consequences of mergers and
acquisitions is the potential for unobserved heterogeneity if firms that engage in
this activity differ in their performance prospects from firms that do not. For
example, mergers and acquisitions that take place in declining industries may be
followed by poorer firm performance. However, one does not know what perfor-
mance would have been in the absence of the merger or acquisition.
18. Typically, when options are issued, the strike price (i.e., the price at which stock
can be purchased in the future) is set equal to the current stock price. For exam-
ple, if the options are issued on June 15 and the stock price is $20/share, the strike
price would also be $20/share. Then, if the stock price increases in the future (and
prior to the expiration of the option) to, for example, $30/share, the holder can
exercise the option and make a profit of $30–$20=$10/share. In contrast, backdat-
ing occurs if the option is actually issued on June 15, but the date of issue is
reported as an earlier date when the stock price was lower, giving the option more
value. For example, if the stock price had been at $10/share on February 10 of that
year and February 10 (instead of June 15) is the date that is reported, then the
option holder has already realized a profit of $10/share on June 15 when the
options are (actually) granted.
19. The Sarbanes-Oxley Act also has a clawback provision, but its coverage is limited.
20. Whole Foods’ pay multiple has increased from 10 in 1999 to 14 in 2000–2005 to
19 today (www.wholefoodsmarket.com/investor/proxy08.pdf, retrieved March
22, 2008), suggesting that the definition of internal equity changes periodically,
or, more likely, as was the case with Ben and Jerry’s, the realities of the external
labor market override the desire for internal equity (Laabs, 1995).
21. Also, at a meta-level, it would be very helpful not only to know the average
expected ROI on PFP plans of different types, but also the variance of such ROI,
which serves as a measure of the risk of using such plans (Gerhart et al., 1996).
Another challenge is to estimate the mean and variance of return in the face of
selection bias (i.e., where only plans with some minimum level of success survive
long enough to be observed).
References
Aggrawal, R.K., & Samwick, A.A. (1999a). The other side of the trade-off: The
impact of risk on executive compensation. Journal of Political Economy, 107,
65–105.
Aggarwal, R.K., & Samwick, A.A. (1999b). Executive compensation, strategic competi-
tion, and relative performance evaluation: Theory and evidence. The Journal of
Finance, 54, 1999–2043.
Aggarwal, R.K., & Samwick, A.A. (2003). Performance incentives within firms: The
effect of managerial responsibility. The Journal of Finance, 57, 1613–1649.
Aggarwal, R.K., & Samwick, A.A. (2006). Empire builders and shirkers: Investment,
firm performance, and managerial incentives. Journal of Corporate Finance, 12,
489–515.
Albanese, R., & Van Fleet, D.D. (1985). Rational behavior in groups: The free-riding
tendency. Academy of Management Review, 10, 244–255.
Alexakis, C., & Graskamp, E. (2007). The 2007 top 250: Long-term incentive grant prac-
tices for executives. Frederick W. Cook & Co. Inc. Retrieved June 1, 2008 from:
www.fwcook.com/alert_letters/2007_Top_250.pdf
Amabile, T.M., Hill, K.G., Hennessey, B.A., & Tighe, E.M. (1994). The Work Prefer-
ence Inventory: Assessing intrinsic and extrinsic motivational orientations.
Journal of Personality and Social Psychology, 66, 950–967.
Anderson, R.C., & Bizjak, J.M. (2003). An empirical examination of the role of the
CEO and the compensation committee in structuring executive pay. Journal of
Banking and Finance, 27, 1323–1348.
Andersson, L.M., & Bateman, T.S. (1997). Cynicism in the workplace: Some causes and
effects. Journal of Organizational Behavior, 13, 449–469.
Antle, R., & Smith, A. (1986). An empirical investigation of the relative performance
evaluation of corporate executives. Journal of Accounting Research, 24, 1–39.
Arthur, J.B., & Aiman-Smith, L. (2001). Gain sharing and organizational learning: An
analysis of employee suggestions over time. Academy of Management Journal,
44, 737–754.
Arthur, J.B., & Jelf, G.S. (1999). The effects of gain sharing on grievance rates and
absenteeism over time. Journal of Labor Research, 20, 133–145.
Arvey, R.D., & Murphy, K.R. (1998). Performance evaluation in work settings. Annual
Review of Psychology, 49, 141–168.
Ball, R., & Brown, P. (1968). An empirical evaluation of accounting income numbers.
Journal of Accounting Research, 6, 159–178.
Balsam, S., & Yin, Q.J. (2005). Explaining firm willingness to forfeit tax deductions
under Internal Revenue Code Section 162(m): The million-dollar cap. Journal of
Accounting and Public Policy, 24, 300–324.
Bandiera, O., Barankay, I., & Rasul, I. (2007). Incentives for managers and inequality
among workers: Evidence from a firm-level experiment. Quarterly Journal
of Economics, 122, 729–773.
Banker, R.D., Lee, S.-Y., Potter, G., & Srinivasan, D. (1996). Contextual analysis of
performance impacts of outcome-based incentive compensation. Academy of
Management Journal, 39, 920–948.
Barney, J. (1991). Firm resources and sustained competitive advantage. Journal
of Management, 17, 99–120.
Bartol, K.M., & Locke, E.A. (2000). Incentives and motivation. In S.L. Rynes & B.
Gerhart (Eds.), Compensation in organizations: Current research and practice
(pp. 104–147). San Francisco, CA: Jossey-Bass.
Bebchuk, L.A., & Fried, J.M. (2004). Pay without performance. Cambridge, MA:
Harvard Universtiy Press.
Bebchuk, L.A., Fried, J.M., & Walker, D.I. (2002). Managerial power and rent extrac-
tion in the design of executive compensation. The University of Chicago Law
Review, Summer, 761–846.
Bebchuk, L.A., & Grinstein, Y. (2005). The growth of executive pay. Oxford Review of
Economic Policy, 21(2), 283–303.
Beer, M., & Cannon, M.D. (2004). Promise and peril in implementing pay-for-perfor-
mance. Human Resource Management, 43, 3–20.
Beersma, B., Hollenbeck, J.R., Humphrey, S.E., Moon, H., Conlon, D.E., & Ilgen, D.R.
(2003). Cooperation, competition, and team performance: Toward a contin-
gency approach. Academy of Management Journal, 46, 572–590.
Belliveau, M.A. O’Reilly, C.A., & Wade, J.B. (1996). Social capital at the top: Effects of
social similarity and status on CEO compensation. Academy of Management
Journal, 39, 1568–1593.
Berle, A.A., & Means, G.C. (1932). The modern corporation and private property. New
York: Macmillan Publishing.
Berman, S.L., Wicks, A.C., Kotha, S., & Jones, T. (1999). Does stakeholder orientation
matter? The relationship between stakeholder management models and firm
financial performance. Academy of Management Journal, 42, 488–506.
Bettis, J.C., Bizjak, J.M., & Lemmon, M.L. (2001). Managerial ownership, incentive
contracting, and the use of zero-cost collars and equity swaps by corporate insid-
ers, Journal of Financial and Quantitative Analysis, 36, 345–371.
Blasi, J., Conte, M., & Kruse, D. (1996). Employee stock ownership and corporate per-
formance among public companies. Industrial and Labor Relations Review, 50, 60.
Blasi, J., Kruse, D., Sesil, J., & Kroumova, M. (2003). An assessment of employee
ownership in the United States with implications for the EU. International
Journal of Human Resource Management, 14, 893–919.
Blinder, A.S. (Ed.). (1990). Paying for productivity. Washington, DC: Brookings
Institution.
Bliss, R.T., & Rosen, R.J. (2001). CEO compensation and bank mergers. Journal of
Financial Economics, 61, 107–138.
Bloom, & Michel, J.G. (2002). The relationships among organizational context, pay
dispersion, and managerial turnover. Academy of Management Journal, 45,
33–42.
Bloom, M., & Milkovich, G.T. (1998). Relationships among risk, incentive pay,
and organizational performance. Academy of Management Journal, 41,
283–297.
Bohl, Don L. (1997). Saturn Corp.—A different kind of pay. Compensation and Benefits
Review, 29, November/December 51–56.
Bretz, R.D. Jr., Ash, R.A., & Dreher, G.F. (1989). Do people make the pace? An exami-
nation of the attraction–selection–attrition hypothesis. Personnel Psychology, 42,
561–581.
Brickley, J.A., Bhagat, S., & Lease, R. (1985). The impact of long-range managerial com-
pensation plans on shareholder wealth. Journal of Accounting and Economics, 7,
115–129.
Brogden, H.E. (1949). When testing pays off. Personnel Psychology, 2, 171–185.
Bureau of Labor Statistics. (2001). Productivity and costs. Retrieved from: http://
www.bls.gov/lpc/peoplebox.htm.
Burns, N., & Kedia, S. (2006). The impact of performance-based compensation on mis-
reporting. Journal of Financial Economics, 79, 35–67.
Cable, D.M., & Judge, T.A. (1994). Pay preferences and job search decisions: A person-
organization fit perspective. Personnel Psychology, 47, 317–348.
Cadsby, C.B., Song, F., & Tapon, F. (2007). Sorting and incentive effects of pay-for-
performance: An experimental investigation. Academy of Management Journal,
50, 387–405.
Carpenter, M.A., & Sanders, W.G. (2004). The effects of top management team pay
and firm internationalization on MNC performance. Journal of Management, 30,
509–528.
Carter, M.E., & Lynch, L.J. (2001). An examination of executive stock option repricing.
Journal of Financial Economics, 61, 207–225.
Case, J. (1998). The open-book experience. Reading, MA: Addison-Wesley.
Chance, D.M., Kumar, R., & Todd, R.B. (2000). The “repricing” of executive stock
options. Journal of Financial Economics, 57, 129–154.
Chillemi, O., & Gui, B. (1997). Team human capital and worker mobility. Journal of
Labor Economics, 15, 567–585.
Cohen, K. (2006). The pulse of the profession: 2006–07 salary budget survey. Work-
span, September, 23–26.
Colella, A., Paetzold, R.L., Zardkoohi, A., & Wesson, M.J. (2007). Exposing pay
secrecy. Academy of Management Review, 32, 55–71.
Conlon, E.J., & Parks, K.M. (1990). Effects of monitoring and tradition on compensa-
tion arrangements: An experiment with principal-agent dyads. Academy of
Conyon, M.J. (2006). Executive compensation and incentives. Academy of Management
Perspectives, 20, February, 25–44.
Conyon, M.J., & He, L. (2004). Compensation committees and CEO compensation
incentives in US entrepreneurial firms. Journal of Management Accounting
Research, 16, 35–56.
Conyon, M.J., & Peck, S.I. (1998). Board control, remuneration committees, and top
management compensation. Academy of Management Journal, 41, 146–158.
Cooper, C.L., Dyck, B., & Frolich, N. (1992). Improving the effectiveness of gain shar-
ing: The role of fairness and participation. Administrative Science Quarterly, 37,
471–490.
Core, J.E., Guay, W.R., & Larcker, D.F. (2003). Executive equity compensation and
incentives: A survey. Economic Policy Review: Federal Reserve Bank of New York,
9, 27–50.
Core, J.E., Guay, W.R., & Larcker, D.F. (2008). The power of the pen and executive
compensation. Journal of Financial Economics, 88, 1–25.
Core, J.E., Guay, W.R., & Thomas, R.S. (2005). Is US CEO compensation
inefficient pay without performance? Michigan Law Review, 103(6),
1142–1185.
Core, J.E., Holthausen, R.W., & Larcker, D.F. (1999). Corporate governance, chief
executive officer compensation, and firm performance. Journal of Financial
Economics, 51, 371–406.

Cowherd, D.M., & Levine, D.I. (1992). Product quality and pay equity between lower-
level employees and top management: An investigation of distributive justice
theory. Administrative Science Quarterly, 37, 302–320.
Daily, C.M., Johnson, J.L., Ellstrand, A.E., & Dalton, D.R. (1998). Compensation
committee composition as a determinant of CEO compensation. Academy of
Dalton, D.R., Daily, C.M., Certo, S.T., & Roengpitya, R. (2003). Meta-analyses of finan-
cial performance and equity: Fusion or confusion? Academy of Management
Journal, 46(1), 13–26.
Dalton, D.R., Hitt, M.A., Certo, S.T., & Dalton, C.M. (2007). The fundamental agency
problem and its mitigation: Independence, equity, and the market for corporate
control. The Academy of Management Annals, 1, 1–64.
David, P., Kochhar, R., & Levitas, E. (1998). The effects of institutional investors on
the level and mix of CEO compensation. Academy of Management Journal, 41,
200–207.
Dechow, P. (1994). Accounting earnings and cash flows as measures of firm perfor-
mance. The role of accounting accruals. Journal of Accounting and Economics,
18, 3–42.
DeMatteo, J.S., Eby, L.T., & Sundstrom, E. (1998). Team-based rewards: Current
empirical evidence and directions for future research. Research in Organizational
Behavior, 20, 141–183.
Deming, W.E. (1986). Out of the crisis. Cambridge, MA: Center for Advanced
Engineering Study, MIT.
Devers, C.E., Cannella, A.A., Reilly, G.P., & Yoder, M.E. (2007). Executive compensa-
tion: A multidisciplinary review of recent developments. Journal of Management,
33, 1016–1072.
Doucouliagos, C. (1995). Worker participation and productivity in labor-managed and
participatory capitalist firms: A meta-analysis. Industrial and Labor Relations
Review, 49, 58–77.
Easton, P.D., Harris, T.S., & Ohlson, J.A. (1992). Aggregate accounting earnings can
explain most of security returns: The case of long return intervals. Journal of
Accounting and Economics, 15, 119–142.
Eisenhardt, K.M. (1985a). Organizational and economic approaches. Management
Science, 31, 134–149.
Eisenhardt, K.M. (1985b). Agency-and institutional-theory explanations: The case of

retail sales compensation. Academy of Management Journal, 31, 488–511.
Eisenhardt, K.M. (1989). Agency theory: An assessment and review. Academy of
Management Review, 14, 57–74.
Ellig, B.R. (2002). The Complete guide to executive compensation. New York:
McGraw-Hill.
European Parliament. (1999). Labour costs and wage policy within EMU (Directorate-
General for Research, Economic Affairs Series, ECON 111 EN). Brussels, Belgium.
Fama, E.F., & Jensen, M.C. (1983a). Separation of ownership and control. Journal of
Law & Economics, 26, 391–323.
Fama, E.F., & Jensen, M.C. (1983b). Agency problems and residual claims. Journal of
Law & Economics, 26, 327–349.
Ferraro, F., Pfeffer, J., & Sutton, R.I. (2005). Economics language and assumptions: How
theories can become self-fulfilling. Academy of Management Review, 30, 8–24.

Finkelstein, S., & Hambrick, D.C. (1989). Chief executive compensation: A study of the
intersection of markets and political processes. Strategic Management Journal,
10, 121–134.
Freeman, R.E. (1999). Divergent stakeholder theory. Academy of Management Review,
24, 233–236.
Friedman, M. (1970, September 13). The social responsibility of business is to increase
its profits. New York Times Magazine.
Fulmer, I.S. (In press). The elephant in the room: Labor market influences on CEO
compensation. Personnel Psychology.
Fulmer, I.S., Gerhart, B., Scott, K.S. (2003). Are the 100 best better? An empirical inves-
tigation of the relationship between being a “great place to work” and firm per-
formance. Personnel Psychology, 56, 965–993.
Gabor, A. (1992). The man who discovered quality: How W. Edwards Deming brought
quality to America. New York: Penguin.
Garen, J.E. (1994). Executive compensation and principal-agent theory. The Journal of
Political Economy, 102, 1175–1199.
Garvey, G.T., & Milbourn, T.T. (2006). Asymmetric benchmarking in compensation:
Executives are rewarded for good luck but not penalized for bad. Journal of
Financial Economics, 82, 197–225.
Geletkanycz, M.A., Boyd, B.K., & Finkelstein, S. (2001). The strategic value of CEO
external directorate networks: Implications for CEO compensation. Strategic
Gerhart, B. (1990). Gender differences in current and starting salaries: The role of per-
formance, college major, and job title. Industrial and Labor Relations Review, 43,
418–433.
Gerhart, B. (2000). Compensation strategy and organizational performance. In S.L.
Rynes & B. Gerhart (Eds.), Compensation in organizations. San Francicso, CA:
Jossey-Bass.
Gerhart, B. (2001). Balancing results and behaviors in pay for performance plans. In C.
Fay (Ed.), The executive handbook of compensation (pp. 214–237). New York:
Free Press.
Gerhart, B. (2007). Horizontal and vertical fit in human resource systems. C. Ostroff &
T. Judge (Eds.), Perspectives on organizational fit (SIOP Organizational Frontiers
Series). New York: Lawrence Erlbaum.
Gerhart, B., & Milkovich, G.T. (1989). Salaries, salary growth, and promotions of men
and women in a large, private firm. In R. Michael, H. Hartmann, & B. O’Farrell
(Eds.), Pay equity: Empirical inquiries (pp. 23–43). Washington, DC: National
Academy Press.
Gerhart, B., & Milkovich, G.T. (1990). Organizational differences in managerial com-
pensation and financial performance. Academy of Management Journal, 33:
663–691.
Gerhart, B., & Milkovich, G.T. (1992). Employee compensation: Research and practice.
In M.D. Dunnette & L.M. Hough (Eds.), Handbook of industrial & organiza-
tional psychology (2nd ed., pp. 481–569). Palo Alto, CA: Consulting Psycholo-
gists Press, Inc.
Gerhart, B., & Rynes, S.L. (2003). Compensation: Theory, evidence, and strategic impli-
cations. Thousand Oaks, CA: Sage.
Gerhart, B., Trevor, C., & Graham, M. (1996). New directions in employee compen-
sation research. Research in Personnel and Human Resources Management,
143–203.
Ghoshal, S. (2005). Bad management theories are destroying good management prac-
tices. Academy of Learning & Education, 4, 75–91.
Gibbons, R. (1998). Incentives in organizations. Journal of Economic Perspectives, 12,
115–132.
Gibbons, B., & Murphy, K.J. (1990). Relative performance evaluation for chief execu-
tive officers. Industrial and Labor Relations Review, 43, 30–51.
Gomez-Mejia, L.R., & Balkin, D.B. (1992). Compensation, organizational strategy, and
firm performance. Cincinnati, OH: Southwestern Publishing.
Gomez-Mejia, L., Tosi, H.L., & Hinkin, T. (1987). Managerial control, performance,
and executive compesation. Academy of Management Journal, 30, 51–70.
Gray, S.R., & Cannella, A.A. (1997). The role of risk in executive compensation.
Journal of Management, 23, 517–540.
Greene, C.N., & Podsakoff, P.M. (1978). Effects of the removal of a pay incentive: A
field experiment. Academy of Management Proceedings (pp. 206–210), 34th
Annual Meeting.
Guzzo, R.A., Jette, R.D., & Katzell, R.A. (1985). The effects of psychologically based
intervention programs on worker productivity: A meta-analysis. Personnel
Psychology, 38, 275–291.
Hadlock, C.J., & Lumer, G.B. (1997). Compensation, turnover, and top management
incentives: Historical evidence. The Journal of Business, 70, 153–187.
Haire, M., Ghiselli, E.E., Gordon, M.E. (1967). A psychological study of pay. Journal of
Applied Psychology, 51, 1–24.
Hall, B.J. (2000). What you need to know about stock options. Harvard Business
Review, 78(2), 121–129.
Hall, B.J., & Liebman, J.B. (1998). Are CEOs paid like bureaucrats? The Quarterly
Journal of Economics, 113, 653–691.
Hall, B.J., & Murphy, K.J. (2002). Stock options for undiversified executives. Journal of
Accounting and Economics, 33, 3–42.
Hanlon, M., Rajgopal, S., & Shevlin, T. (2003). Are executive stock options associated
with future earnings. Journal of Accounting and Economics, 36, 3–43.
Harford, J., & Li, K. (2007). Decoupling CEO wealth and firm performance: The case of
acquiring CEOs. Journal of Finance, 62, 917–949.
Harris, J., & Bromiley, P. (2007). Incentives to cheat: The influence of executive com-
pensation and firm performance on financial misrepresentation. Organization
Science, 18, 350–367.
Harrison, D.A., Virick, M., & William, S. (1996). Working without a net: Time, perfor-
mance, and turnover under maximally contingent rewards. Journal of Applied
Hartzell, J.C., & Starks, L.T. (2003). Institutional investors and executive compensa-
tion. The Journal of Finance, 68, 2351–2374.
Hatcher, L., & Ross, T.L. (1991). From individual incentives to an organization-wide
gain sharing plan: Effects on teamwork and product quality. Journal of
Organizational Behavior, 12, 169–183.
Haubrich, J.G. (1994). Risk aversion, performance pay, and the principal-agent prob-
lem. Journal of Political Economy, 102, 258–349.
HayGroup. (2002). Managing performance: Achieving outstanding performance

through a “culture of dialogue”. Working paper.
Henderson, A.D., & Fredrickson, J.W. (1996). Information-processing demand as a
determinant of CEO compensation. Academy of Management Journal, 39,
575–606.
Heneman, H.G.III & Judge, T.A. (2000). Compensation attitudes. In S.L. Rynes & B.
Gerhart (Eds.), Compensation in organizations (pp. 61–103). San Francisco, CA:
Jossey-Bass.
Heneman, R.L. (1986). The relationship between supervisory ratings and results-ori-
ented measures of performance: A meta-analysis. Personnel Psychology, 39,
811–826.
Heneman, R.L. (1990). Merit pay research. Research in Personnel and Human Resource
Management, 8, 203–263.
Heneman, R.L. (1992). Merit pay: Linking pay increases to performance ratings.
Reading, MA: Addison-Wesley.
Heneman, R.L., & Werner, J. (2000). Merit pay: Linking pay to performance in a chang-
ing world (2nd ed.). Charlotte, NC: Information Age Publishing.
Heron, R.A., & Lie, E. (2007). Does backdating explain the stock price pattern around
executive stock option grants? Journal of Financial Economics, 83, 271–295.
Hill, C.W.L., & Phan, P. (1991). CEO tenure as a determinant of CEO pay. Academy of
Hitt, M.A. (2005). Management theory and research: Potential contribution to public
policy and public organizations. Academy of Management Journal, 48, 963–966.
Hollenbeck, J.R., DeRue, D.S., & Guzzo, R. (2004). Bridging the gap between I/O
research and HR practice: Improving team composition, team training, and
team task design. Human Resource Management, 43, 353–366.
Holmstrom, B. (1979). Moral hazard and observability. Bell Journal of Economics, 10,
74–91.
Holmstrom, B. (1982). Moral hazard in teams. Bell Journal of Economics, 13, 324–340.
Jenkins, D.G. Jr., Mitra, A., Gupta, N., & Shaw, J.D. (1998). Are financial incentives
related to performance? A meta-analytic review of empirical research. Journal of
Applied Psychology, 83, 777–787.
Jensen, M.C., & Meckling, W.H. (1976). Theory of the firm: Managerial behavior,
agency costs, and ownership structure. Journal of Financial Economics, 3,
305–350.
Jensen, M.C., & Murphy, K.J. (1990). Performance pay and top management incen-
tives. Journal of Political Economy, 98, 260–299.
Johnson, M.D., Hollenbeck, J.R., Humphrey, S.E., Ilgen, D.R., Jundt, D., & Meyer, C. J.
(2006). Cutthroat cooperation: Asymmetrical adaptation to changes in team
reward structures. Academy of Management Journal, 49, 103–119.
Jones, T.M. (1995). Instrumental stakeholder theory: A synthesis of ethics and eco-
nomics. Academy of Management Review, 20, 404–437.
Judge, T.A., & Ilies, R. (2002). Relationship of personality to performance motivation:
A meta-analytic review. Journal of Applied Psychology, 87, 797–807.
Judiesch, M.K. (1994). The effects of incentive compensation systems on productivity,
individual differences in output variability and selection utility (Doctoral disser-
tation, University of Iowa).
Kaplan, S.N. (2008). Are CEOs overpaid? Academy of Management Perspectives, 22(2),
5–20.
Katz, N. (2001). Getting the most out of your team. Harvard Business Review,
79(8), 22.
Katzenbach, J.R., & Smith, D. (2003). The wisdom of teams: Creating the high-
performance organization. New York: Collins Business Essentials.
Kaufman, R.T. (1992). The effects of Improshare on productivity. Industrial and Labor
Relations Review, 45, 311–322.
Kerr, J., & Bettis, R.A. (1987). Board of directors, top management compensation, and
shareholder returns. Academy of Management Journal, 30, 645–665.
Kim, J., & Graskamp, E. (2006). Why stock options still make sense. Financial
Executive, 22, 45–47.
Kim, S. (1998). Does profit sharing increase firms’ profits? Journal of Labor Research,
19, 351–370.
Klein, K.J. (1987). Employee stock ownership and employee attitudes: A test of three
models. Journal of Applied Psychology, 72, 319–332.
Kopelman, R.E., & Reinharth, L. (1982). Research results: The effect of merit-pay prac-
tices on white collar performance. Compensation Review, 14(4), 30–40.
Konrad, A.M., & Pfeffer, J. (1990). Do you get what you deserve? Factors affecting the
relationship between productivity and pay. Administrative Science Quarterly, 35,
258–285.
Kruse, D.L. (1993). Profit sharing: Does it make a difference? Kalamazoo, MI: Upjohn
Institute for Employment Research.
Laabs, J.L. (1995). CEO search prompts Ben & Jerry’s to raise salary cap. Personnel
Journal, 74, 12.
Lambert, R.A., Larcker, D.F., & Verecchia, R.E. (1991). Portfolio considerations in val-
uing executive compensation. Journal of Accounting Research, 29, 129–149.
Lawler, E.E. III. (1971). Pay and organizational effectiveness: A psychological view. New
York: McGraw-Hill.
Lawler, E.E.III. (1990). Strategic pay: Aligning organizational strategies and pay sys-
tems. San Francisco, CA: Jossey-Bass.
Lazear, E.P. (1986). Salaries and piece rates. Journal of Business, 59, 405–431.
Lazear, E. (2000). Performance pay and productivity. American Economic Review, 90,
1346–1361.
Lazear, E.P., & Rosen, S. (1981). Rank-order tournaments as optimum labor contracts.
Journal of Political Economy, 89, 841–864.
LeBlanc, P.V., & Mulvey, P.W. (1998). How American workers see the rewards of
work. Compensation & Benefits Review, 30(1), 24–28.
Ledford, G.E. (2004). Commentary on “Promise and peril in implementing pay-for-
performance”. Human Resource Management, 43, 39–40
Lee, K.W., Lev, B., & Yeo, G.H.H. (2008). Executive pay dispersion, corporate gover-
nance, and firm performance. Review of Quantitative Financial Accounting, 30,
315–338.
Lee, L., Shakespeare, C., & Walsh, J.P. (2008). The limits of empire: Asset churning and
CEO compensation. Unpublished Manuscript, Stephen M. Ross School of
Business, University of Michigan.
Lehn, K.M., & Zhao, M. (2006). CEO turnover after acquisitions. Journal of Finance,
61, 1759–1811.
Lie, E. (2005). On the timing of CEO stock option awards. Management Science, 51,
802–812.
Locke, E.A., Feren, D.B., McCaleb, V.M. Shaw, K.N., & Denny, A.T. (1980). The rela-
tive effectiveness of four methods of motivating employee performance. In K.D.
Duncan, M.M. Gruenberg, and D. Wallis (Eds.), Changes in working life (pp.
363–388). New York: Wiley.
Longenecker, C.O., Sims, H.P., & Gioia, D.A. (1987). Behind the mask: The politics of
employee appraisal. Academy of Management Executive, 1, 183–193.
Loring, J.M., & Taylor, C.K. (2006). Shareholder activism: Directorial responses to
investors’ attempts to change the corporate governance landscape. Wake Forest
Law Review, 41, 321–340.
Main, B.G.M., O’Reilly, C.A., & Wade, J. (1993). Top executive pay: Tournament or
teamwork? Journal of Labor Economics, 11, 606–628.
Masson, R.T. (1971). Executive motivations, earnings, and consequent equity perfor-
mance. Journal of Political Economy, 79, 1278–1292.
McAdams, J.L. (1995). Design, implementation, and results: Employee involvement
and performance reward plans. Compensation and Benefits Review, 27, March–
April, 45–55.
Meulbroek, L.K. (2001). The efficiency of equity-linked compensation: Understanding
the full cost of awarding executive stock options. Financial Management, 30, 5–45.
Milgrom, P., & Roberts, J. (1992). Economics, organization, and management.
Englewood Cliffs, NJ: Prentice Hall.
Milkovich, G.T. (1988). A strategic perspective on compensation management.
Research in Personnel and Human Resources Management, 6, 263–288.
Milkovich, G.T., & Newman, J.M. (2008). Compensation. New York: McGraw-Hill/Irwin.
Milkovich, G.T., & Wigdor, A.K. (1991). Pay for performance. Washington, DC:
National Academy Press.
Miller, J.S., Wiseman, R.M., & & Gomez-Mejia, L.R. (2002). The fit between CEO com-
pensation design and firm risk. Academy of Management Journal, 45, 745–756.
Mitchell, D.J.B., Lewin, D., & Lawler, E.E.III. (1990). Alternative pay systems, firm
performance, and productivity. In A.S. Blinder (Ed.), Paying for productivity.
Washington, DC: Brookings Institution.
Morck, R., Schliefer, A., & Vishny, R.W. (1988). Management ownership and market
valuation: An empirical analysis. Journal of Financial Economics, 20, 293–315.
Murphy, K.J. (1985). Corporate performance and managerial remuneration: An
empirical analysis. Journal of Accounting and Economics, 7, 11–42.
Murphy, K.J. (1999). Executive compensation. In O. Ashenfelter & D. Card (Eds.)

Handbook of Labor Economics (pp. 2485–2567). Amsterdam: Elsevier.
Murphy, K.R., & Cleveland, J.N. (1995). Understanding performance appraisal: Social,
organizational and goal-based perspectives. Thousand Oaks, CA: Sage.
Nichols, D.C., & Wahlen, J.M. (2004). How do earnings numbers relate to stock
returns? A review of classic accounting research with updated evidence.
Accounting Horizons, 18, 263–286.
Nyberg, A.J. (2008). Performance, compensation, and turnover (Doctoral dissertation,
School of Business, University of Wisconsin-Madison).
Nyberg, A.J., Fulmer I.S., Gerhart, B., & Carpenter, M.A. (2008). The future of agency
theory in executive compensation research: Separating fact from fiction. Working
paper.
O’Reilly, C., Main, B.S., & Crystal, G. (1988). CEO compensation as tournaments and
social comparisons: A tale of two theories. Administrative Science Quarterly, 33,

257–274.
Orlitzky, M., Schmidt, F.L., & Rynes, S.L. (2003). Corporate social and financial perfor-
mance: A meta-analysis. Organization Studies, 24, 403–441.
Ouchi, W.G. (1979). A conceptual framework for the design of organizational control
mechanisms. Management Science, 25, 833–848.
Oyer, P. (2004). Why do firms use incentives that have no incentive effects? Journal of
Finance, 59, 1619–1649.
Oyer, P., & Schaefer, S. (2005). Why do some firms give stock options to all employees?
An empirical examination of alternative theories. Journal of Financial Economics,
76, 99–133.
Paley, A.R. (2008, December 15). Executive pay limits may prove toothless. Washington
Post. Retrieved December 29, 2008, from: http://www.washingtonpost.com/wp-
dyn/content/article/2008/12/14/AR2008121402670.html.
Pearce, J.L., Stevenson, W.B., & Perry, J.L. (1985). Managerial compensation based on
organizational performance: A time series analysis of the effects of merit pay.
Academy of Management Journal, 28, 261–278.
Perry, T., & Zenner, M. (2001). Pay for performance? Government regulation and
the structure of compensation contracts. Journal of Financial Economics, 62,
453–488.
Petty, M.M., Singleton, B., & Connell, D.W. (1992). An experimental evaluation of an
organizational incentive plan in the electric utility industry. Journal of Applied
Pfeffer, J. (1998). The human equation: Building profits by putting people first. Boston,
MA: Harvard Business School Press.
Pfeffer, J. (2005). Why do bad management theories persist? A comment on Ghoshal.
Academy of Management Learning & Education, 4, 96–100.
Pfeffer, J., & Sutton, R.I. (2006). Hard facts, dangerous half-truths, and total nonsense:
Profiting from evidence-based management. Boston, MA: Harvard Business
School Publishing.
Pollock, T.G., Fischer, H.M., & Wade, J.B. (2002). The role of politics in repricing exec-
utive stock options. Academy of Management Journal, 45, 1172–1182.
Rajgopal, S., Shevlin, T., & Zamora, V. (2006). CEOs’ outside employment opportuni-
ties and the lack of relative performance evaluation in compensation contracts.
Journal of Finance, 61, 1813–1844.
Rose, N.L., & Wolfram, C. (2002). Regulating executive pay: Using the tax DOEE to
influence chief executive officer compensation. Journal of Labor Economics, 20,
S138–S175.
Rosen, S. (1986). Prizes and incentives in elimination tournaments. The American
Economic Review, 76, 701–715.
Roy, D. (1952). Quota restriction and gold bricking in a machine shop. American
Journal of Sociology, 57, 427–42.
Rynes, S.L., & Gerhart, B, & Minette, K.A. (2004). The importance of pay in employee
motivation: Discrepancies between what people say and what they do. Human
Resource Management, 43, 381—394.
Rynes, S.L., Gerhart, B., & Parks, L. (2005). Personnel psychology: Performance evalu-
ation and pay for performance Annual Review of Psychology, 56, 571–600.
Said, A.A., HassabElnaby, H.R., & Wier, B. (2003). An empirical investigation of the
performance consequences of nonfinancial measures. Journal of Management

Accounting Research, 15, 193–223.
Salamin, A., & Hom, P.W. (2005). In search of the elusive U-shaped performance-
turnover relationship: Are high performing Swiss bankers more liable to quit?
Journal of Applied Psychology, 90, 1204–16.
Sanders, W.G. (2001). Behavioral responses of CEOs to stock ownership and stock
option pay. Academy of Management Journal, 44, 477–492.
Sanders, W.G., & Hambrick, D.C. (2007). Swinging for the fences: The effects of
CEO stock options on company risk taking and performance. Academy of
Management Journal, 50, 1055–1078
Schneider, B. (1987). The people make the place. Personnel Psychology, 40, 437–453.
Schuster, M.H. (1984). Union-management cooperation: Structure, process, and impact.
Kalamazoo, MI: Upjohn Institute for Employment Research.
Schwab, D.P. (1973). Impact of alternative pay systems on pay valence and instrumen-
tality perceptions. Journal of Applied Psychology, 58, 308–312.
Scullen, S.E., Bergey, P.K., & Aiman-Smith, L. (2005). Forced distribution rating
systems and the improvement of workforce potential: A baseline simulation.
Personnel Psychology, 58, 1–32.
Shaw, J.D., & Gupta, N. (2007). Pay system characteristics and quit patterns of good,
average, and poor performers. Personnel Psychology, 60, 903–928.
Shaw, J.D., Gupta, N., & Delery, J.E. (2002). Pay dispersion and work force
performance: Moderating effects of incentives and interdependence. Strategic
Shepperd, J.A. (1993). Productivity loss in performance groups: A motivation analysis.
Psychological Bulletin, 113, 67–81.
Shleifer, A., & Vishny, R.W. (1989). Management entrenchment: The case of manager-
specific investments. Journal of Financial Economics, 25, 123–139.
Siegel, P.A., & Hambrick, D.C. (2005). Pay disparities within top management
groups: Evidence of harmful effects on performance of high-technology firms.
Organization Science, 16, 259–277.
Siemsen, E., Balasubramanian, S., & Roth, A.V. (2007). Incentives that induce task-
related effort, helping, and knowledge sharing in workgroups. Management
Science, 10, 1533–1550.
Siggelkow, N. (2002). Misperceiving interactions among complements and substitutes:
Organizational consequences. Management Science, 48, 900–916.
Stajkovic, A.D., & Luthans, F. (1997). A meta-analysis of the effects of organizational

behavior modification on task performance, 1975–1995. Academy of Management
Journal, 40, 1122–1149.
Stewart, G.L. (1996). Reward structure as a moderator of the relationship between
extraversion and sales performance. Journal of Applied Psychology, 81, 619–627.
Sturman, M.C., Trevor, C.O., Boudreau, J.W., & Gerhart, B. (2003). Is it worth it to win
the talent war? Evaluating the utility of performance-based pay. Personnel
Sudaram, R.K., & Yermack, D.L. (2007). Pay me later: Inside debt and its role in mana-
gerial compensation. Journal of Finance, 62, 1551–1588.
Sundstrom, E., DeMeuse, K.P., & Futrell, D. (1990). Work teams: Applications and
effectivenss. American Psychologist, 45, 120–133.
Thomas, R.S., & Martin, K.J. (1999). The effect of shareholder proposals on executive
compensation. University of Cincinnati Law Review, 67, 1021–1081.

Tosi, H.L., & Gomez-Mejia, L.R. (1989). The decoupling of CEO pay and performance:
An agency theory perspective. Administrative Science Quarterly, 34, 169–189.
Tosi, H.L., Misangyi, V.F., Fanelli, A., Waldman, D.A., & Yammarino, F.J. (2004). CEO
charisma, compensation, and firm performance. The Leadership Quarterly, 15,
405–420).
Tosi, H.L., Werner, S., Katz, J.P., & Gomez-Mejia, L.R. (2000). How much does perfor-
mance matter? A meta-analysis of CEO pay studies. Journal of Management, 26:
301–339.
Trank, C.Q., Rynes, S.L., & Bretz, R.D., Jr. (2002). Attracting applicants in the war for
talent: Differences in work preferences among high achievers. Journal of Business
and Psychology, 16, 331–345.
Trevor, C.O., Gerhart, B., & Boudreau, J.W. (1997). Voluntary turnover and job per-
formance: Curvilinearity and the moderating influences of salary growth and
promotions. Journal of Applied Psychology, 82, 44–61.
Turban, D.B., & Keon, T.L. (1993). Organizational attractiveness: An interactionist
perspective. Journal of Applied Psychology, 78, 184–193.
Viswesvaran, C., Ones, D.S., & Schmidt, F.L. (1996). Comparative analysis of the reli-
ability of job performance ratings. Journal of Applied Psychology, 81, 557–574.
Wade, J.B., O’Reilly, C.A., & Pollock, T.G. (2006). Overpaid CEOS and underpaid man-
agers: Fairness and executive compensation. Organization Science, 17, 527–544.
Wageman, R. (1995). Interdependence and group effectiveness. Administrative Science
Quarterly, 40, 145–180.
Wagner, J.A.III, Rubin, P., & Callahan, T.J. (1988). Incentive payment and nonmana-
gerial productivity: An interrupted time series analysis of magnitude and trend.
Organizational Behavior and Human Decision Processes, 42, 47–74.
Wagner, S.H., Parker, C.P., & Christiansen, N.D. (2002). Employees that think and act
like owners: Effects of ownership beliefs and behaviors on organizational effec-
tiveness. Personnel Psychology, 56, 847–871.
Walsh, J.P. (2008). CEO compensation and the responsibilities of the business scholar
to society. Academy of Management Perspectives, 22(2), 26–33.
Wall Street Journal (2008). WSJ 200: Survey of CEO compensation, April 14. Retrieved
June 18, 2009, from: http://www/wsj.com.
Warfield, T.D., & Wild, J.J. (1992). Accounting recognition and the relevance of earn-
ings as an explanatory variable for returns. Accounting Review, 67, 821–842.
Weinberger, T.E. (1998). A method for determining the equitable allocation of team-
based pay: Rewarding members of a cross-functional account team. Compensation
and Benefits Management, 14(4), 18–26.
Weiss, A. (1987). Incentives and worker behavior: Some evidence. In H.R. Nalbantian
(Ed.), Incentives, cooperation and risk taking (pp. 137–150). Lanham, MD: Row-
man & Littlefield.
Weitzman, M.L., & Kruse, D.L. (1990). Profit sharing and productivity. In A.S. Blinder
(Ed.), Paying for productivity (pp. 95–140). Washington, DC: Brookings Institution.
Welbourne, T.M., & Gomez-Mejia, L. (1995). Gain sharing: A critical review and a
future research agenda. Journal of Management, 21, 559–609.
Westphal, J.D., & Zajac, E.J. (1995). Who shall govern? CEO/board power, demo-
graphic similarity, and new director selection. Administrative Science Quarterly,
40, 60–83
Whyte, W.F. (1955). Money and motivation: An analysis of incentives in industry. New
York: Harper Brothers.
Williamson, O.E., Wachter, M.L., & Harris, J.E. (1975). Understanding the employ-
ment relation: The analysis of idiosyncratic exchange. Bell Journal of Economics,
6, 250–280.
Wood, D.J. (1991). Corporate social performance revisited. Academy of Management
Review, 16, 691–718.
Wright, P.M., George, J.M., Farnsworth, R., & McMahan, G.C. (1993). Productivity
and extra-role behavior: The effects of goals and incentives on spontaneous help-
ing. Journal of Applied Psychology, 78, 374–381.
Zenger, T.R., & Marshall, C.R. (2000). The determinants of incentive intensity in
group-based rewards. Academy of Management Journal, 43, 149–163.

Gerhart PFP

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Gerhart PFP

Uploaded by

Copyright:

Available Formats

This article was downloaded by: [University of Bath]

On: 07 October 2014, At: 10:56

The Academy of Management

6 Pay and Performance:

To link to this article: http://dx.doi.org/10.1080/19416520903047269

PLEASE SCROLL DOWN FOR ARTICLE

INGRID SMITHEY FULMER

*Corresponding author. Email: bgerhart@bus.wisc.edu

ISSN 1941-6520 print/ISSN 1941-6067 online

effects, but sometimes these are in unintended and unanticipated directions,

research areas. We encourage the management literature, which has increas-

Literally hundreds of studies and scores of systematic reviews of incen-

On average, the single largest operating cost for an organization is employee

of compensation—PFP. Although there are multiple dimensions of compen-

can choose to be different in an effort to achieve high performance, but in

Schneider’s (1987) attraction–selection–attrition (ASA) model in the applied

Defining and Measuring Performance

Behavior-based (subjective) versus results-based (objective) measures.

for organizations to justify differentiating employees based on such error-

activities must be at least equal to or greater than rates of return to activities

Individual and group (or collective) performance measures. Criticisms have

been leveled at organizations for focusing too much on individual perfor-

Summary. A major issue in designing PFP plans is how to define and

placed on results- versus behavior-based measures and on individual versus

Risk/Return and Fit/Misfit

Empirical Evidence on Individual and Group PFP Plans

Individual-Based PFP Plans

produced) or sales commissions, where pay is based on revenue produced. As

on cooperation among employees. However, to the degree that such systems

Rewards at the Supra-individual Level: Group- and Organization-level PFP Plans

Gain-sharing. Gain-sharing is a results-based program that generally

Wigdor (1991, p. 86) to suggest that it might:

Similarly, Banker, Lee, Potter, and Srinivasan (1996) compared results

formance measures, providing an estimated savings of somewhere between

number of employees covered by Improshare from around 200 to 400 was

effectiveness of group/organization-based PFP plans becomes weaker. (See

Profit-sharing. Profit-sharing plans pay out based on meeting a profit-

positive effect of profit-sharing on profits disappeared. Third, the effects of

Stock plans. According to the National Council on Employee Ownership

Moreover, partial employee ownership has grown from an estimated 1% of

associated with lower intentions). Adding the management philosophy and

Compensation for small groups and teams. In small group or team-based

identified five district managers “who expressed strong interest in participat-

managers developed monthly plans for delivering rewards to groups and/or

help weaker members, while simultaneously increasing weak performers’

time, however, the effectiveness of small-group compensation systems appears

with high task interdependence (measured via the existence of self-managed

In a subsequent study, Johnson et al. (2006) extended the findings of

Because of the limitations of any single pay program, organizations often

highly-productive workers, but fewer of them. Of course, not all companies

experimented with appear to have been mostly team-based programs (Led-

perceived lack of fit with the pre-existing culture, resulting in dissatisfaction

Executives and PFP

executives choose, which likely has implications for performance as judged by

Effects of Executive PFP: Empirical Evidence

equity-related incentives) reported in these reviews include extent of diversifi-

the fields of management and economics/finance have reached different

Research in economics, finance, and management… originally

directors. However, a recent meta-analysis concluded that no system-

Thus, different literatures have reached different answers to the question of

equity, or return on assets. In addition, these studies typically used short-term

Issues in Executive Compensation Research

new information (e.g., earnings above or below expectations) not already

against a company. Typically, the expense of a lawsuit is not booked until it is