Evaluating Form and Functionality of Pay‐for‐Performance Plans: The Relative Incentive and Sorting Effects of Merit Pay, Bonuses, and Long‐Term Incentives

• DOI: http://doi.org/10.1002/hrm.21740
• Date: 01 July 2016
• Published date: 01 July 2016
• Author: Michael C. Sturman,Sanghee Park

Human Resource Management, July–August 2016, Vol. 55, No. 4. Pp. 697–719

© 2015 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).

DOI:10.1002/hrm.21740

Correspondence to: Sanghee Park, Assistant Professor, School of Management and Labor Relations, Rutgers,

TheState University of New Jersey, Piscataway, NJ, 08854, Phone: (848) 445-1051, Fax: (732) 445-2830,

E-mail: spark@smlr.rutgers.edu

EVALUATING FORM AND

FUNCTIONALITY OF

PAY-FOR-PERFORMANCE PLANS:

THE RELATIVE INCENTIVE

ANDSORTING EFFECTS OF MERIT

PAY, BONUSES, AND LONG-TERM

INCENTIVES

SANGHEE PARK AND MICHAEL C. STURMAN

Using two-year longitudinal data from a large sample of US employees from a

service-related organization, the present study investigates the relative effects of

three forms of pay-for-performance (PFP) plans on employees’ job performance

(incentive effects) and voluntary turnover (sorting effects). The study differenti-

ates between three forms of pay: merit pay, individual-based bonuses, and long-

term incentives. By defi nition, these PFP plans have different structural elements

that distinguish them from each other (i.e., pay plan form) and different charac-

teristics (functionality), such as the degree to which pay and performance are

linked and the size of the rewards, which can vary both within and across plan

types. Our results provide evidence that merit raises have larger incentive and

sorting effects than bonuses and long-term incentives in multi-PFP plan environ-

ments where the three PFP plans are operating simultaneously. Only merit pay

has both incentive and sorting effects among the three PFP plans. The implica-

tions for the PFP-related theory, as well as for the design and implementation of

PFP plans, are discussed. ©2015Wiley Periodicals,Inc.

Keywords: pay-for-performance plans, incentive effect, sorting effect,

compensation

698 HUMAN RESOURCE MANAGEMENT, JULY–AUGUST 2016

Human Resource Management DOI: 10.1002/hrm

Even with a

substantial body of

research discussing

the effects of

particular PFP

interventions, PFP

research has typically

failed to consider the

complex, multiplan

environments

in which many

organizations invest

and many employees

face.

examinations of individual PFP plans. Most stud-

ies examine a single form of PFP at a time, par-

ticularly in laboratory studies (e.g., Bandiera,

Barankay, & Rasul, 2007; Cadsby et al., 2007;

Eisenberger, Rhoades, & Cameron, 1999; Kwong

& Wong, 2014), but also in organizational settings

(e.g., Banker, Lee, Potter, & Srinivasan, 1996, 2001;

Dunford, Boudreau, & Boswell, 2005; Eisenberger

et al., 1999; Pearce et al., 1985; Schaubroeck, Shaw,

Duffy, & Mitra, 2008). Other work provides only

broad overviews of PFP plans’ effects, such as in

strategic HR management research that typically

asks general questions about the extent to which

employees are covered by PFP (e.g., Bhattacharya,

Gibson, & Doty, 2005; Delery & Doty, 1996;

Gerhart & Milkovich, 1992; Toh, Morgeson, &

Campion, 2008; Wright, Gardner, Moynihan, &

Allen, 2005). This previous work has certainly

been valuable for providing information on the

nature of PFP effects; however, the generalizability

of theory and findings from single-plan focal stud-

ies to multiplan environments is questionable.

Many companies use multiple types of PFP

simultaneously (Cohen, 2011; Gerhart & Fang,

2014; Gerhart et al., 2009; Rynes et al., 2005). A

2010 WorldatWork Survey showed that 92 percent

of companies use merit raises, 80 percent provide

some form of individual-based variable pay pro-

gram (not including sales commissions or merit

raises), and 57 percent use some sort of perfor-

mance-sharing plan. The same survey conducted

in 2012 (WorldatWork, 2012) showed this to be an

increasing trend, with 95 percent offering merit

pay, 84 percent with some form of individual-

based variable pay program, and 58 percent using

some form of performance sharing. While these

surveys do not explicitly report the number of dif-

ferent incentive plans covering the same employ-

ees, mathematically, we can extrapolate that at

least three-quarters of companies use at least two

forms of PFP, and over one quarter are simultane-

ously using three different PFP plans. Despite this

prevalent complexity, though, there is minimal

research considering the relative effectiveness of

different PFP plans.

Studying PFP explicitly within the more com-

plex environment of multiple PFP plans is critical

to gain a better understanding of the relative effec-

tiveness of different PFP forms. This study makes

several contributions to our understanding of the

effectiveness of PFP. First, this study considers

multiple PFP plans simultaneously in multi-PFP

plan environments. As previously noted, most

prior PFP research has considered a single PFP

plan at a time, with it either being explicitly on a

single plan, or unstated or unexplored if other PFP

plans were operating simultaneously. It is unclear

Theory and empirical evidence indicate

that, in general, pay-for-performance (PFP)

plans have positive effects on employee

job performance (e.g., Gerhart & Fang,

2014; Gerhart & Rynes, 2003; Jenkins,

Mitra, Gupta, & Shaw, 1998; Lawler, 1971; Zenger,

1992). A common component of compensation

systems, PFP plans are referred to as “pay that

varies with some measure of individual or orga-

nizational performance” (Milkovich, Newman,

& Gerhart, 2013, p. 335). Theory attributes the

influences of PFP plans to two broad sets of effects:

incentive effects and sorting effects (Cadsby, Song,

& Tapon, 2007; Gerhart & Fang, 2014; Gerhart &

Milkovich, 1992; Gerhart & Rynes, 2003; Gerhart,

Rynes, & Fulmer, 2009; Rynes, Gerhart, & Parks,

2005). Incentive effects represent

the influence of PFP plans through

employee motivation, based on the

premise that PFP plans can increase

employee motivation and, hence,

employee performance. Sorting

effects alter the composition of the

workforce, in that PFP plans can

affect the quality of workers who

apply for jobs (Lazear, 1986; Rynes

et al., 2005) and the performance

level of those leaving the organiza-

tion (Salamin & Hom, 2005; Shaw

& Gupta, 2007; Trevor, Gerhart, &

Boudreau, 1997). While there are

still some examples of ineffective

PFP plans (e.g., Beer & Cannon,

2004; Kahn & Sherer, 1990; Lawler,

2000; Pearce, Stevenson, & Perry,

1985; Pfeffer, 1998), the prepon-

derance of evidence shows that

PFP plans have positive effects (cf.,

Gerhart & Fang, 2014; Gerhart et

al., 2009). Yet, even with a substan-

tial body of research discussing the

effects of particular PFP interven-

tions, PFP research has typically failed to consider

the complex, multiplan environments in which

many organizations invest and many employees

face (Gerhart et al., 2009; Rynes et al., 2005). This

lack of consideration of more multifaceted envi-

ronments presents a theoretical gap for under-

standing and testing how relevant PFP theories

apply in more complex environments, and a

practical gap for organizations needing to predict

the sort of effects they should expect from their

multiplan environments.

While the literature on PFP plans is quite

extensive (for reviews, see Gerhart & Fang, 2014;

Gerhart et al., 2009; Guthrie, 2007; Rynes et al.,

2005), prior PFP research is largely based on specific