Problem with variable pay

Slowdown in profit growth and decline in stock prices might lead to growing employee dissatisfaction under variable pay plans in the quarters ahead

Cafe Economics | Niranjan Rajadhyaksha

It has been estimated that about one-third to half of all American workers have part of their earnings tied to the overall performance of the firms that employ them, through profit sharing, direct ownership or stock options.

This particular tide is rising in India as well. In a recent survey of 540 locally owned, foreign-owned and joint venture companies conducted by consulting firm Hewitt Associates, 95% of the respondents said they had variable pay plans in 2007. The use of stock options, too, is growing, with most large companies listed on the stock exchange giving their employees the option to buy shares at a later date and at a predetermined price.

Tying an individual’s performance to the overall performance of a company seems a good idea. The interests of shareholders and employees are aligned. You really care whether the company prospers or goes down the tube. Some economists have shown that both employee productivity and company growth are higher when employees have a stake in the growth of the firm that employs them. There is some form of incentive compatibility.

But there are several problems as well, though they will tend to remain under the surface when profits are growing rapidly and stock prices are soaring. But I suspect that the coming slowdown in profit growth (which will hurt variable payments to employees) and the decline in stock prices (which will send stock options below their strike price, or under water) will lead to growing employee dissatisfaction in the quarters ahead.

Are company human resource departments ready for this?

There has been a lot of research by economists in recent years about the system of paying workers — either directly through variable pay or indirectly through stock ownership — based on company performance rather than the market price of labour. There is even a name for these arrangements: shared capitalism.

The first big problem in shared capitalism is what is called the free rider problem. Say you are one of the hundreds of employees who will get paid a large chunk of their salary in the form of variable pay. Individually, you have little direct impact on the overall performance of the company: You are a cog in the wheel. There is, thus, an incentive to take it easy in office; you hope the other cogs will work hard enough to help the company meet its goal. You are what economists call a free rider.

This would be less of a problem when the economy is booming. Companies find it relatively easy to meet their sales and profit targets, and so everybody walks away with an impressive stash of money. Free riders are less likely to be abhorred. But the mood could change in a downturn. The ant may ask why the grasshopper is getting the same variable pay deal as it is. There could be tensions in cubicle land.

The other problem is more personal. You have already bet your human capital on one company. Shared capitalism ensures that you are also betting large parts of your financial capital on the same company. It’s a poor diversification of risks—too many eggs have been placed in this one basket.

In a new paper published this month by the National Bureau of Economic Research, an American research outfit, three economists have examined issues of risk and the lack of diversification in shared capitalism. “Since shared capitalism, especially in the form of employee stock ownership and stock options, is an investment, we need to examine it from the critical perspective of risk,” write Joseph R. Blasi of Rutgers University, Douglas L. Kruse of Rutgets University and Harry M. Markowitz of the Rady School of Management in California. (Markowitz is a pioneer of the modern theory of portfolio choice, for which he won the Nobel Prize in economics in 1990.)

They ask whether risk is really “the Achilles heel of employee ownership”. There is little doubt that employees with stock ownership or options have put too much risk in one basket. But Blasi, Kruse and Markowitz show that a lot also depends on each individual’s view of risk and the culture of the companies they work in.

For example, risk-averse employees are less likely to respond to the incentives provided by stock options. Employees who feel they are underpaid are more likely to look at the payments from ownership as wage substitutes rather than added incentives.

And a lot also depends on workplace culture. “In the absence of empowerment, shared capitalism may easily be seen as nothing more than increased income risk, whereas empowerment creates a greater sense that one can affect workplace performance and rewards under shared capitalism.”

In other words: The success or failure of variable pay and stock option schemes depends on the context, both personal and organizational. This is something that Indian companies, too, will have to understand if the current headwinds continue to blow them off their path.

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