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Has pay for

performance

had its day?

Jonathan D. Day, Paul Y. Mang, Ansgar Richter,

and John Roberts
The way to get your employees to focus on both the present and the future
is to adjust your culture and to weaken your financial incentives.

ay for performance has these days achieved the status of a management mantra. A generation of executives, motivated by performancemeasurement systems linking their actions to results and, ultimately, to
compensation, has embraced the creed and practice of making assets
sweat. To continue flourishing, however, companies need to innovate as
well as to exploit their existing assets. Yet most find it very hard to motivate

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their people to develop new business

ideas and, simultaneously, to
manage current performance.
The natural reflex might be that
people should receive higher pay for innovating effectively. But our research1 suggests otherwise. Surprisingly, the secret
of persuading people to focus simultaneously on developing new businesses
and managing current operations may be to rely less on pay for performance.
In fact, companies that achieve both objectives de-emphasize performance
pay or use it in a more nuanced, less intense manner. Crucially, they combine
it with an unusually inclusive culture. In these companies, employees feel
that their interests and those of the business are much the same, so they naturally try to do what is best for its current and long-term welfare, just as
they do for themselves in their personal lives. Pay for performance may still
have an important job to do in such a culture, but as a supplemental boost
rather than a primary driving force.
1

This article is based on McKinsey research, starting in January 2000, on the determinants of corporate adaptiveness. We looked at companies (such as Charles Schwab, GE, Hewlett-Packard, Nokia,
and 3M) that have a record of success in both developing new businesses and sustaining the performance of existing ones.

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Encouraging growth and performance

With few exceptions, corporate incentive schemes encourage managers to
concentrate either on executing current tasks or on developing and implementing new business ideas to fuel future growth, but not both. Most such
schemes are designed to motivate current performance: retail organizations,
for example, tie rewards to current sales, manufacturing companies to production costs and volumes. In such companies, the need to meet performance targets leaves people with little time to innovate. As one harried
manager in a global industrial company put it, We are very welcome to do
innovative stuffafter 11:30 PM.
Incentive mechanisms emphasizing current performance tend to be more
common because measuring the familiar tasks that boost itthe exploitation that leverages existing competenciesis so much easier than measuring
the exploration and experimentation that may lead to future growth.2 So, for
example, a company that wants to motivate its sales representatives to sell
more goods or services will track how many contracts its agents close, adjust
the scores for differences beyond their control (such as the number of customers in each area), and reward them accordingly. Effort and score are usually clearly linked, so the company can expect agents to work hard if high
scores are well rewarded.
But the achievements of these agents would be a lot harder to measure if the
company wanted them to bring back ideas for new product offerings based
on the changing needs of its customers. A simple tally wouldnt do, since it
might be years before an ideas real value could be assessed. The company
would also have to adjust for more elusive factors, such as the willingness
of customers to provide information about their preferences. All this is so
difficult to quantify that to use formal incentives effectively a company
would have to monitor, in minute detail, the way each sales agent actually
behaved with customers.
And performance in highly exploratory tasksbiochemical research, for
instance, or scenario planningcant really be measured at all. Who knows,
in advance, which experiments will yield fruitful results or which scenarios
will yield valuable insights? Proxy measurements can give a rough idea in
some contexts. Management consultants, for example, who often work in
teams, use peer observation to assess one anothers ability to come up with
new ideas. But few companies have a performance-management system that
2

James G. Marchs terminology contrasts exploration and exploitation as two fundamentally different types of activity. See James G. March, Exploration and exploitation in organizational learning,
Organization Science, Volume 2, Number 1, 1991, pp. 7187.

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assesses how well employees deal with growth-oriented tasks as accurately

as it assesses their current performance.
Some companies try to get around the problem of measuring exploratory
activities by promising a big, one-off bonus to anyone who comes up with
an idea that is later commercialized. But these arrangements can prove difficult to operate. In 1964 Peter Roberts
developed an innovative socket
wrench as an employee of Sears,
The problem of rating performance
Roebuck. For the rights to the
in explorator y tasks makes it hard
patent, Sears paid him $10,000, a
to design effective financial-reward
handsome sum to the 18-year-old
systems to motivate innovation
inventor. Five years later he sued
Sears, claiming that it had deliberately underestimated the tools sales potential, which had proved to be in the
millions of dollars. Roberts received an award of more than $8 million and,
after Sears appealed the judgment, settled for an undisclosed sum.
The problem of measuring performance in exploratory tasks makes it hard
to design effective financial-reward systems that motivate innovation. It is
doubly difficult to design incentive schemes that induce people to pay proper
attention to current performance as well as exploration.

Who should multitask?

Of course, not everyone, or even every manager, must allocate time between
both. Quite the contrary, the benefits of having some people concentrate
exclusively on one or the other can be enormous. To this end, some companies actually put exploratory and current activities in different business
unitsan approach known as cocooning.3 But even in these companies,
some people need to allocate scarce resources between current and future
activities.
Cocooning tends to shift the burden of balancing growth and performance
upward: top managerssometimes CEOsmust select the new ideas that
are pursued, drive promising ideas to fruition, ensure that current assets are
sweated effectively, and get rid of businesses that have passed their sell-by
date. In the extreme version of cocooning, everyone other than the CEO
would have only one task: to find new ideas for the company or to expand
existing businesses.
3

See Clayton M. Christensen, The Innovators Dilemma: When New Technologies Cause Great Firms to
Fail, Boston: Harvard Business School Press, 1997; and Mehrdad Baghai, Stephen Coley, and David
White, The Alchemy of Growth: Practical Insights for Building the Enduring Enterprise, Cambridge, Massachusetts: Perseus Publishing, 1999.

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In practice, this approach is unworkable except in the smallest companies. In

larger ones, top managers are generally too far from the places where ideas
are generated to be effective judges and motivators. Weak ideas may get too
much attention because the boss happens to like them, while great ideas
can end up outside the business as frustrated employees leave. Moreover,
if the trade-offs between growth and performance are pushed upward, the
result can be bottlenecks at the top of the organization and frustrated senior
executives who are overloaded with
information but still need to make
timely decisions.
Weak ideas may get too much

attention merely because the boss

happens to like them, while great
ideas end up outside the business

The better practice is to have managers at many levels pursuing new

business ideas and better current
performance simultaneously. This
approach keeps innovation alive and ensures that new ideas are linked to the
companys customers and markets. But how can top management motivate
people at a number of levels to pursue the seemingly conflicting objectives
of encouraging future growth and, at the same time, improving current performance? How can these people most effectively be persuaded to divide
their time between the two?

The rule of balanced incentives

To encourage any activity, companies can use either high- or low-powered
incentives. High-powered incentives offer people big financial rewards for
good performance and penalties or much lower rewards for poor performance. Top athletes on professional sports teams, for example, have highpowered incentives. Their performance is easy to observe. Those who do
well receive vast sums of money; bad performers leave the game. By contrast,
with low-powered incentivessuch as financial bonuses linked to the fortunes of a group or an entire corporationindividual differences in performance have less impact on the rewards employees receive. Still more
low-powered are the kinds of rewards that confer recognition and status
rather than pay. In some jobs (those of judges and the clergy may be examples), it is perfectly normal to offer little or no financial incentive for performance, even when it is measured.
High-powered incentives call for a relatively clear and sure link between
actions and results, which is why companies tend to award strong incentives
for current performance and weaker incentives for exploration. But with two
disparate tasks to perform, people naturally turn to the task they think will
bring them the greatest reward relative to the risks. So if companies follow

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the natural pathgiving high-powered rewards where they can and less
intense ones where they musttheir people will probably respond by focusing on the well-rewarded tasks.4
Clearly, companies need to balance the incentives they attach to familiar
and exploratory tasks if they want people to do both in equal measure.
This imperative may mean going against the vogue of pay for performance;
indeed, it may require companies to reduce the power of the incentives they
use to encourage their employees to undertake the more easily measured,
familiar tasks. The incentive encouraging the least easily
measurable task then becomes the standard for all
activities. If a retailer, for instance, wants its
salespeople to spend more time exploring the
needs of its customers, the best course may be to
lower the incentives for selling until they are comparable to those for gathering information.
Many managers think that the logic of relaxing pay
for performance in this way is counterintuitive. Yet
with a few exceptions, a system of low-powered incentives balanced between exploitative and exploratory
tasks will probably work better than either balanced
but high-powered incentives or the mismatched incentives
that many organizations use today.
A balance of high-powered incentives is rarely appropriate, for two reasons.
One of them is the fear of risk: high-powered incentives for undertaking
exploratory tasks may create a higher degree of financial uncertainty than
many employees can bear. Since it is hard for any one person in the organization to control the factors that make exploratory activities successful
and recognized, employees might be penalized indeed even firedfor
events that they couldnt influence. Few line managers will be able or willing
to accept financial risk.
The disputes that erupt over sharing the upside of innovation are the second
problem. A company that installs a system of balanced high-powered incentives must often give much of the value it generates back to employees in
compensation not just for their contribution but also for the extra risk they
assume. Shareholders too will naturally want a piece of the cake, but there
may not be enough left to satisfy them. Partnerships in professional-service
4

See Steven Kerr, On the folly of rewarding A, while hoping for B, Academy of Management Executive,
Volume 9, Number 1, 1995, pp. 714; Bengt Holmstrm and Paul Milgrom, Multitask principal-agent
analyses: Incentive contracts, asset ownership, and job design, Journal of Law, Economics, and
Organization, Volume 7, special issue, 1991, pp. 2452.

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firms actually can afford to offer their people high-powered incentives for
undertaking both routine and exploratory tasks, partly because the senior
employees of these firms also happen to be the shareholders. But few other
companies are in a similar position in this respect.
It is therefore unlikely that a balance of high-powered incentives will suit
many companies that want to encourage their people to pursue routine and
exploratory activities simultaneously. A more promising approach would be
to orchestrate a system of weak though balanced incentives. But then the
incentive system doesnt give employees much reason to go the extra mile
and exert the extra effort that is so valuable to companies. The solution lies
in their culture.

Schwabs way
Founded just over 30 years ago, Charles Schwab,
the San Franciscobased financial-services firm,
is now a leader in the US private-brokerage
market. It has consistently managed to develop
new businesses and business models, without
having to sacrifice operational efficiency in the
process.
Schwabs major breakthrough came in the
mid-1990s, when it introduced World Wide
Webbased on-line brokerage services. The
underlying technology had not been developed at
Schwab, and substantial innovation in its business system was needed to give its customers
the ability to switch seamlessly between branch
and on-line channels. The employees of the
branches would, for example, have to support
customers on-line, over the phone, and face-toface. Obviously, however, the new on-line channel would threaten those very employees. What
would motivate them to support on-line trading?
Would they be willing to help on-line customers?
Wouldnt they sabotage the channel for fear of
being cannibalized?

Schwab had to ensure that opening the new

channel was the employees goal as much as
the companys. Three principles were critical to
winning such a commitment:
1. Developing a joint vision. First, the company
needed to unite all its employees behind its
vision of exemplary customer service. This had
been Schwabs aim from the startbut people
in the branches, and not just their managers,
had to see its implications in the context of the
new channel. Everyone in the company had to
believe that customers must be supported both
on- and off-line. To bring this basic principle
home to employees, management not only had
to understand how it would look from their perspective but also needed to convey the message in person. A large team of managers at
Schwabs headquarters went out to the
branches and discussed with their employeessometimes in late-evening sessions
the meaning of seamless service across
channels for customers, the staff, and the
company as a whole. Schwab found that abso-

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Beyond incentives: Fostering a high-commitment culture

The companies that most effectively motivate their employees to pursue
future growth and, at the same time, to concentrate on current performance
use weak, balanced incentive structures but take care to supplement them
with unusually inclusive and motivating corporate cultures. At a company
of this kind, employees see a close fit between its long-term interests and
their own. Consequently, they are better motivated not only to work diligently and creatively with relatively low levels of explicit incentive pay but
also to divide their time between exploratory and predictable tasks in a way
that serves the business well. In such companies, the culture and incentive
schemes serve to reinforce each other.

lutely nothing could replace no-questionsbarred conversations for building and maintaining a high-commitment corporate culture.
2. Living the values. Installing the technology
for on-line brokerage services would put
employees of Schwabs branch network at
risk. Schwab countered their understandable
anxiety by appealing to its established values
of fairness and empathy: it promised that it
would not eliminate jobs and would give its
people enough time to adjust to the new order.
Nonetheless, Schwab didnt relax its commitment to individual and collective accountability.
People could still be fired if they failed to perform up to standard.
3. Using balanced incentives. Finally, to make
certain that the branch employees wouldnt
just tolerate the new channel but would instead
do everything they could to make it work,
Schwab tried to ensure that all of them could
share in its fortunes, by shifting the companys
compensation system toward low-powered
incentives based on the performance of groups

and of the company as a whole. As an

employee said, Designing a system that
enhanced team spirit was hard because, traditionally, brokers have such an individualistic
culture and performance ethic. On the other
hand, team spirit and teamwork are really part
of our values. But how do you design a program
that encourages teamwork and also absolutely
rewards those who contributed the most?
In the end, Schwab adopted a system that
required an entire branch to hit its target before
any branch, group, or team bonuses were
awarded. Once the branch did so, the bonuses
of employees would vary according to their individual performance, up to a ceiling of 25 percent
of their base salaryenough to make a difference but far below what other companies in the
sector offered at that time.
The success of Schwabs move to on-line trading
actually helped secure the jobs of employees in
the branch network, which was enlarged because
the new on-line customers wanted services at
branches as well.

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By contrast, employees in many companies dont feel that their personal

interests are aligned with those of the organization. Thus they need explicit
incentives to work as hard as the company wants them to and dont automatically divide their time between predictable and exploratory activities.
Such companies go to great lengths to motivate employees and allocate their
efforts wisely.
In private life, people usually manage the trade-offs between executing their
daily routine tasks and preparing for the futureplanning their childrens schooling, for example, or moving to a new apartment.
By pursuing their own perceived interests, they make the
right choices because they themselves directly reap the
benefits and pay the costs of their actions.
But in most companies, the chain linking the performance of an individual to a consequence for him or her
is much more cumbersome. Managers must identify each
useful activity they want an employee to perform, tie an incentive to it, measure the employees performance, and grant or withhold
the reward. A company that relies strictly on such formal incentives to shape
employee preferences must construct these chains with exquisite care and
accept the risk that they will fail to measure performance accurately and will
thus motivate employees to do the wrong things.
However, a company that creates and nourishes a culture in which its
employees identify its interests with their own increases the odds that they
will strike the right balance in their allocation of effort, without any strong
explicit incentives, just as they do in their private lives. A few companies
have evolved such cultures over time.5 Generally, their dominant values are
service to customers, fairness, empathy with the concerns of employees, and
open access to information. The key element of such a culture is the way it
promotes the employees sense of belonging to, or identity with, the company. Although we dont thoroughly understand how companies can build
such a culture, our research has shown how it promotes simultaneous innovation and current performance when combined with balanced low-powered
incentives (see sidebar, Schwabs way, on the previous spread).

Managers seeking to encourage high performance on current tasks and, at

the same time, innovative thinking about future opportunities ought to look
5

To describe such a culture, human-resources scholars use the term high commitment, referring to
the mutual commitment of employee and company. See, for example, James N. Baron and David M.
Kreps, Strategic Human Resources: Frameworks for General Managers, New York: Wiley, 1999.

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beyond simple pay-for-performance formulas and instead try to create a

proper balance among the formal incentives that are used to promote both
of these goals. Those incentives can be even more effective if they are supported by a culture that aligns the interests of a company with those of its
employees.

Jonathan Day is a principal in McKinseys London office; Paul Mang is an associate principal in
the Chicago office; Ansgar Richter, an alumnus of the Frankfurt office, is currently an assistant professor at the European Business School, in Oestrich-Winkel, Germany; John Roberts is senior
associate dean and the John H. and Irene S. Scully professor of economics, strategic management, and international business at the Stanford University Graduate School of Business.
Copyright 2002 McKinsey & Company. All rights reserved.

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