Is Financial Compensation Linked to Employee Performance?

By Caitlin Collins
Updated September 16, 2022
8 minute read

For decades, employee compensation decisions and performance appraisals have been rolled up into one messy annual performance review process. Though compensation and performance have been linked for decades, the relationship between the two doesn’t necessarily mean that money is the greatest motivator for employees. Financial compensation related to employee performance isn’t the only way to motivate employee development.

HR leaders are reengineering many human resource management programs, including compensation and performance management. Today, HR leaders are taking a more nuanced employee pay approach. Instead of tying pay directly to performance, many companies opt to write out a compensation strategy detailing the company’s pay philosophy.

Here’s how to motivate employees without tangling up performance with compensation.

Why Separate Performance Reviews From Pay?

Before rethinking performance-based pay, it’s essential to understand how compensation influences employee performance. While it may motivate performance in some measure, merit-based pay also introduces greater risks to your human capital management program.

Here are some of the impacts of compensation on employee performance.

Monetary Rewards May Incentivize the Wrong Outcomes

Employees may prioritize the wrong aspects of performance when incentivized only by money. For example, they may cut corners on quality to meet a quota or even turn to unethical means, as in the infamous Wells Fargo scandal.

While these circumstances are extreme, monetary rewards can dilute the quality of work and can lead to employees making poor decisions instead of decisions aligned with your company’s values.

And if employees are simply focused on getting the work done, they may lose sight of the greater purpose of their work. That loss of focus can pull them out of the organizational culture and lead to disengagement over time.

Performance-Based Pay Magnifies Bias and Inequity

Performance-based compensation can get muddled easily, potentially magnifying existing unconscious biases. Performance management has traditionally been subject to biases, such as:

  • Recency bias: where recent trends or patterns of behavior overshadow past actions.
  • The “horn” or “halo” effect: where the worker’s performance is appraised solely based on a perceived negative or positive quality.
  • Excessive leniency or severity: from the manager in an effort to be kind or well-liked on one hand or motivational on the other.

When tied to compensation, potential biases in performance management are extremely risky. They can lead to further inequities in pay—an issue that many companies are currently working very hard to overcome.

In addition to these biases, it’s often left up to the manager’s discretion to decide whether an employee has met their goals and earned a monetary reward n a merit-based pay system. There’s a greater risk of managers favoring employees they’re closer to or who they see more often. As more companies adopt long-term hybrid work, this bias becomes even more challenging to control.

Merit-Based Pay Doesn’t Make Employees Work Harder

Monetary rewards are an extrinsic motivator—they rarely incentivize employees to work harder or become more engaged in their work. Performance-based pay doesn’t connect the employee with the greater organization or culture. They’re more transactional and less aspirational than intrinsic motivators.

That’s why you need employees to find their rewards in the work itself. Whether being an active participant in workplace culture or finding learning opportunities embedded within daily tasks, intrinsic motivators drive more significant performance potential than monetary rewards.

4 Factors That Motivate Employees (That Aren’t Pay)

You need to find intrinsic motivators to incentivize better performance from your workforce. Here are some factors for motivating employees to improve employee performance.

Meaning and Purpose

Employees are most incentivized by a sense of purpose in their role. When they can find meaning in their work — and not just the daily grind — they’re more likely to aspire to achieve greater things, and work harder to get there.

To drive a greater sense of purpose, show employees the entire lifecycle of your company’s product. For manufacturing employees, for example, that could be seeing the actual final product. It could be seeing positive NPS scores from happy customers for customer service roles. Seeing what they’re contributing to can help employees find their sense of fulfillment in work.

Goal alignment software supports meaning and purpose for employees, too. When employees can see the strategic value of their work and how it produces business results, they’re more likely to find purpose and job satisfaction, leading to better individual performance.

Opportunities for Growth

Employees need to see opportunities to develop and reach their full potential within your company. Employees become more driven, and the work becomes more meaningful when they’re working towards something, and they’ll work harder if they can clearly see the opportunities ahead of them.

Provide clear career paths and options for mobility within the company. The prospect of promotion can improve employee performance. High-performing employees are more inclined to invest in their future and work hard to bring their goals to life.

A Connected, Inclusive Culture

Culture is a crucial factor in motivating the behaviors you want to see. When employees feel connected with each other (and the business), they’ll understand how their work impacts their colleagues. That team spirit drives more significant investment in the work and can improve individual performance.

The sense of community and culture you provide inspires greater job satisfaction, motivating employees to work harder. But changing norms, like the shift to remote work, complicate your ability to build a connected culture. Tools like goal alignment software bring employees together to work towards a shared purpose, enabling performance for hybrid teams.

Frequent Feedback and Recognition

Employees need a line of communication with managers to receive feedback and recognition in the flow of work. Frequent feedback helps team members see how they’re performing, which can inspire high-performing employees to work even harder and take greater pride in their work.

Don’t underestimate the power of recognition: Performance-based pay is rarely as motivating as frequent feedback and recognition of work well done. Even if it’s just verbal, receiving recognition from managers can motivate employees to work harder and produce higher quality work.

Recognition from top leaders can be even more inspiring. Employees want to feel like they’re moving in the right direction. There are few more validating and rewarding things than hearing your future plans confirmed by top-level leaders.

Update Performance Management for the New Economy

To keep high-performing employees moving in the right direction, you need to invest in updated performance management. Here’s how to ditch performance-related pay in favor of performance enablement and employee empowerment.

Align Employee Goals With Business Goals

Help employees see the role their work plays in driving business results. Connecting employees to the business strategy provides greater intrinsic motivation. When they know what they’re working towards, employees can take more control over their work. That sense of autonomy drives greater engagement, job satisfaction — and better performance.

Aligned goals are easier to track and, if written correctly, provide clear performance metrics. The objectives and key results (OKR) model allows employees to set their own goals to drive the business forward. But determining the key results forces employees to be more thoughtful about performance metrics.

Setting their own performance metrics that produce tangible business results does much more to inspire more extraordinary performance than performance-based compensation.

Train Managers as Coaches

Managers play an essential role in connecting employees to the business. As coaches, managers can help employees gain a greater sense of self-awareness, helping them understand their learning opportunities and engage with their roles better.

Armed with a clear org chart and career paths, managers can help employees discover their options for mobility within the company. The ability to grow within your organization can help employees harness their potential to perform better.

Invest in Employee Development

Employee development is vital for building greater capabilities for your business, and it gives employees something to work towards that they may value more than performance-based pay. Development opportunities demonstrate that the company is invested in the employee’s growth and learning.

Performance-based compensation doesn’t give employees anything to aspire to beyond rewards. Performance enablement helps employees see what they’re capable of and helps them achieve it.

Redesign Your Compensation Strategy

Performance-based compensation isn’t the only pay strategy out there. You can design a compensation strategy that works for your business and company culture — that doesn’t rely on managers interpreting performance to mete out arbitrary monetary rewards.

Here’s how to redesign your business’s compensation strategy.

Engage in Compensation Planning

If you’re ditching performance-based pay, you need to clarify what payment is based upon. Design a compensation plan that is clear and transparent.

Develop your compensation strategy alongside the business strategy. Compensation falls under your talent strategy, which is indispensable for achieving business objectives. Compensation is also essential in attracting and engaging the talent you need to achieve your goals.

Be specific about salaries, benefits, incentives, and pay-band details in your compensation plan. Benchmark your salaries against those on the market. While compensation may not drive performance, offering competitive pay is essential for attracting and retaining employees.

Engineer New Incentives

Develop new incentive programs to motivate employee engagement and performance. Consider rewarding employees with greater responsibilities, leadership opportunities, or flexible working arrangements.

Some of these incentives, like taking on greater responsibility, may be tied to compensation. But compensation, in this case, isn’t the underlying factor motivating employee performance.

There are several platforms you can use to incentivize performance through non-monetary rewards. These could be experiences employees have always wanted—learning opportunities, vacation, or travel benefits. An engaging rewards program gives employees the freedom to choose their own rewards, better motivating each employee to achieve their goals.

Implement Total Rewards

Invest in rewards beyond simple compensation. Consider benefits, responsibilities, workloads, schedules, and other types of recognition for a job well done.

Flexibility can be part of your total rewards strategy, for example. Employees need to achieve an appropriate balance between work and personal life. When you take care of their mental health and give them time to live a complete life outside of work, employees become more loyal and work harder for you.

Consider Variable Pay

In some professions, such as sales or customer success, a percentage of income can be tied to performance — up to as much as 50% of total income, in some cases. While it’s still necessary for some roles to have commissions or variable incentives in place, best practices suggest confining variable pay only to positions where the outcomes are clearly and completely measurable, such as a dollar-value sales quota.

Issues with variable incentives tend to arise when a significant portion of compensation is tied to more qualitative outcomes, such as onboarding a new employee or meeting with a certain number of new prospects, for which measurement isn’t as clear-cut.

In addition to commissions, bonuses may also fall under variable pay. Bonuses should be tied to clear metrics using the same criteria as commissions. Not every role may qualify for bonuses since some outcomes are more challenging to measure than others. Consider which roles qualify for bonuses when setting your compensation strategy.

Communicate Your Strategy to Employees

Employees and management should feel comfortable having open conversations about compensation. Transparency from leadership — especially around hot-button topics like pay — is key to supporting better employee experience and job satisfaction.

If you’re no longer relying on performance-related pay to increase your employees’ salaries, explain what criteria you’re using instead. Help employees understand how rewards are distributed and how pay bands are calculated.

Work to build a culture of transparency around compensation. Employees should never feel like they can’t approach their manager to ask how their pay is being factored or that they can’t talk to colleagues about their income. The more open leadership is about pay, the more transparent the culture. That transparency has helped several employees bring to light pay inequities, assisting organizations to move a little closer to closing the pay gap.

Avoid the Chaos of Performance-Based Compensation

Performance-based compensation is often complex and chaotic, but motivating employee performance doesn’t have to be. Compensation and performance management are two vital elements of workforce strategy, but one shouldn’t drive the other.

Performance-based pay doesn’t improve employee performance metrics, but it can confuse managers and lead to pay inequities. When financial compensation is linked to employee performance, team members are less likely to become top performers.

Separating pay from performance allows you to refine a total compensation plan based on more objective factors. Intrinsic motivation does more to inspire quality employees to give their best. When the work itself and the company culture are rewarding, job satisfaction improves — and so does performance.

Here’s how to implement a performance enablement model, empowering your people to succeed in the most dynamic, challenging conditions.

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