Why Pay For Performance Works

In a post titled, "The Dangers of Performance Pay," Ezra Klein quotes The New Yorker’s James Surowiecki on the effects of stock-options as compensation for CEOs in order to argue that pay-for-performance is a bad thing — not just for CEOs, but for teachers as well. Klein then writes:

Depending on what metrics you’re using to evaluate performance (and thus dictate pay), you risk distorting a worker’s incentives to approach their job in a balanced, prudent, way. If a teacher’s whole compensation is based on test scores, for instance, you’ll not only have a lot of teaching to the test, you may simply see the test — or at least past versions of it — being taught. That may make for comfortingly high test scores, but it may also lead to less actual learning, less critical thinking, less adaptive educations, etc. If a CEO’s pay is based on stock options, amping up the price of the stock — even in the short-term — becomes more attractive.

It seems obvious that performance pay that’s all incentive and no (or very little) penalty is probably a bad idea. And it also seems pretty clear that merely "teaching the test" isn’t always the best way to drive up student education levels. But I don’t think either of these things are particularly good arguments against performance pay. Instead, they’re arguments against unbalanced incentives and poorly chosen metrics.

With CEOs, for example, the study that Surowiecki references suggests that stock options may not work so well, but stock ownership does. From a summary of the study:

CEOs who held large amounts of stock delivered results that were not as lopsidedly negative” as those recorded for option-loaded chiefs, they report. “Thus, CEO shareholdings seemed to promote a more prudent type of risk-taking than was generated by stock options.”

The professors add in conclusion: “Stock ownership causes CEOs to be equally concerned about gains and losses, whereas stock options encourage CEOs to think primarily about upside potential and little about downside. … The current trend toward motivating CEOs with restricted stock may be generally sensible.”

So the incentives of co-ownership — giving CEOs a stake in the performance of their company — seems to be productive. This is a type of performance pay, and one that works in the way that proponents of performance pay think it should: yoking the success of the CEO to the success of their company.

I doubt there’s much reason for alarm here. Seems likely that if studies (and profits) continue to show that firms with this type of compensation outperform others, practices will probably shift fairly quickly.

As for teachers, it seems obvious that standardized national metrics such as those in NCLB are going to be flawed. There’s just no way to develop a one-size-fits-all education platform for the entire country. But this doesn’t indicate that teachers shouldn’t be held accountable for their work. It just means that more nuanced metrics are necessary, and that every effort should be made to give local school districts more power to set make their own decisions about what’s working and what isn’t.