The relative effects of pay-for-performance plans on future performance

Abstract

In the compensation literature, previous studies have indicated that pay-for-performance has a strong influence on employee performance. However, there is little research that differentiates the effects of certain forms of pay-for-performance plans on future performance. By applying the precepts of expectancy theory to specific components of the pay-for-performance plans, this study examines the relative effects associated with three different compensation plans simultaneously on future performance. Using longitudinal data from a sample of 411 US employees from a service-related organization, I first estimated the determinants of three pay-for-performance rewards and captured differences in their reward structures. Second, I examined the impact of the three plans on future performance. In the analyses, using this two-stage procedure, the results provided mixed support for the hypotheses. As expected, I found that certain characteristics of different forms of financial rewards influenced future performance. A unit increase in permanent pay had a greater effect on future performance than a unit increase in temporal pay. In addition, I found that the compensation system with a greater link between performance and reward magnitude had a greater effect on future performance. However, the result did not support the prediction that all forms of pay-for-performance are associated with increased future job performance ratings. This study demonstrates that the effects of pay-for-performance plans on future performance can in part be explained by their levels of expectancy and valence, as evidence by the effects observed for merit pay and long-term incentives. However, contrary to the predictions of expectancy theory, bonuses were not associated with increased future performance. Because the design of pay-for-performance plans is a critical matter for organizations, future research is needed to refine theory describing how pay-for-performance plans operate simultaneously to affect employee performance.