Firm Performance Pay as Insurance against Promotion Risk

Conventional wisdom suggests that workers should neither be rewarded nor punished for outcomes beyond their individual control. Yet, non-executive workers routinely receive performance-based pay linked to uncertain firm outcomes, such as the firm’s stock price or total revenue (e.g., Kruse, Blasi, and Park (2010)). Standard economic theory argues that such pay cannot provide meaningful incentives due to the free-rider problem—after all, it is unlikely that an individual non-executive worker believes their personal effort significantly alters the overall firm outcome. From this perspective, performance pay tied to uncertain firm outcomes seems counterintuitive, as it imposes risk on workers for little apparent benefit. In a recent article, I argue that when workers compete for promotions, such pay actually serves as a form of insurance.

Promotion Risk

Promotion competitions are common in the workplace. For instance, DeVaro (2006) analyzes microdata from four U.S. metropolitan areas and reports that workers, even high-performing ones, are less likely to be promoted when the typical performance of their co-workers is higher. Consistent with this evidence, 77.4% of 16,377 respondents to a Google Consumer Survey say that there are a “limited number of promotion slots [at their workplace], even if all workers perform well” (see Cowgill (2015)). As a result of limited promotion opportunities, workers face promotion risk—the possibility of being passed over for promotion despite performing at a high level.

The Insurance Role of Firm Performance Pay

My study emphasizes a particular tension in the employment relationship. When more workers perform well, the firm outcome tends to be higher. However, as more workers performing well, the bar for promotion is raised due to the limited number of promotion opportunities (for analyses of economic frictions that limit such opportunities, see Oi (1983) and Levin & Tadelis (2005)). In this context, a better firm outcome translates to worse promotion prospects for any given high-performing worker. As a result, firm performance pay—performance pay that increases with the firm outcome—helps offset the decrease in the high-performing worker’s promotion probability with increased pay. This insurance motive aligns with many common compensation practices such as vesting based on individual performance. Only high-performing workers receive pay that increases with the firm outcome (e.g., stock, stock options, profit-sharing). Low-performing workers are not candidates for promotion and do not require insurance against promotion risk.

The insurance role of firm performance pay may also explain some puzzling empirical findings. For instance, non-executive workers tend to overvalue stock option pay (a form of firm performance pay) compared to market prices (Oyer & Schaefer (2005), Hallock & Olson (2006)), while CEOs tend to undervalue it (Hall & Murphy (2002), Bettis, Bizjak, & Lemmon (2005)). Non-executive workers, who are exposed to promotion risk, receive an insurance benefit from stock option pay, increasing their subjective valuation. In contrast, CEOs, who are already at the top of the corporate hierarchy and do not face promotion risk, gain no such insurance benefit. As a result, they tend to view stock options through the lens of an underdiversified investor, leading to a subjective valuation below market price.

Applications

One natural setting to apply my framework is a large professional services firm. First, non-executive workers in this setting (i.e., associates) typically face a promotion-to-partner tournament. They compete over a period of time for the limited number of partner positions. Second, professional services firms rely heavily on their workers’ human capital to generate revenue. A stronger link between firm outcome (e.g., total revenue) and the aggregate performance of associates (e.g., total billable hours) makes firm performance pay more effective as insurance against promotion risk. Consistent with my framework’s predictions, large professional services firms routinely pay their associates bonuses that are contingent on individual performance (e.g., 2,000 billable hours) and the firm surpassing some profitability threshold.

My framework also applies to mid-level employees in large corporations in knowledge-intensive industries. Organizational frictions often result in a bottleneck in the middle of the corporate hierarchy (e.g., Baker, Gibbs, & Holmstrom (1994), Treble et al. (2001)), limiting promotion opportunities. In fact, many large corporations have explicit promotion tournament policies, such as the common practice of forced ranking. For instance, Yahoo! ranked its white-collar employees, placing 10% into the top category of “greatly exceeds”, 25% into “exceeds”, and so forth periodically; those not ranked highly missed out on promotions (Carlson (2015)). Compensation plans for mid-level employees at large corporations routinely include year-end bonuses based on two multipliers with minimum thresholds: one based on individual performance, the other based on a firm outcome.

Firm Hierarchy and Compensation

Organizational frictions that limit promotion opportunities drive the negative relationship between the firm’s performance and its workers’ promotion prospects. These frictions are central to the insurance role of firm performance pay. Consequently, my study highlights an underexplored connection between organizational economics and firm policies such as compensation.