Variable pay or performance contingent pay or pay at risk are various names used to denote that component of pay which employees receive only on attaining certain performance targets. In this sense, it is different from base pay ( Generally a combination of basic + Dearness Allowance in India) which is the worth of job and paid to employee irrespective of performance.
I take Agency theory in explaining the rationale behind the variable pay.As per this theory, Principals(stockholders of the company) are risk- neutral i.e. they would have diversified their investments across different investment options, where as Agents( Executives of the company)are risk-averse because their fortunes (Salary,Employment Continuity etc) are tied to a single organization. Hence under normal conditions, Agents try to take conservative decisions which protects their income even at the cost of lost opportunities to the organization. This is not in sync with Principals aspirations who want to have optimize returns from each of the investments. Hence to get alignment between the interests of Principal & Agent, a component of Agent's ( Executive) pay compensation is tied to the firm performance and paid only on achievement of firm objectives .
But the question is under what circumstances does variable pay is effective?
Now lets look at the possible areas where variable pay would be effective. For explanation , lets take variable pay as applied for senior management ( the proportion of variable pay in total compensation would be higher as one moves higher in the hierarchy as their actions can directly influence the organization's outcomes compared to some one at entry level)
Scenario 1:Low Risk Environment
For explanation, lets look at variable pay in companies which are well established in the market place and there are processes in place. Unless the efforts of senior management produces significant results, there is not much use in putting more variable pay because the higher the percentage of variable pay in overall compensation, more compensation the employee demands as he takes a risk by putting a portion of his earnings at risk. Infact in some cases he might be tempted to take decisions which may not be in the best interest of stockholders
Scenario 2: High Risk environment
This is the environment where outcomes are not as predictable as in case of scenario 1. There might be forces which are beyond the control of the executive. Now by putting a large portion of pay under variable pay might work both ways. If the organization performs well because of the overall market scenario, stockholders end up rewarding the executive for outcomes which cannot be directly related to him and when organization doesn't perform well, end up penalizing the executive even when he had done every thing right under this control .This might lead to competent people leaving the organization for places where their actions determine the fate of their compensation
Scenario 3: Moderate Risk Environment
This is the environment which falls some where in between scenario 1 and 2 where there is some level of certainity but at the same time scope for improving the performance of organization based on executive's actions. So this offers for perfect scenario for solving agency problem ( Agent acting to protect his self interest and not working for optimum results of principal)where in by tying up a portion of salary to the results and by providing increased chances of earning higher incomes based on results, alignment can be obtained between the objectives of stockholders and executive
To Summarize, in environment where outcome can be obtained by following set guidelines ( low risk environment) or where outcomes are beyond the control of executive ( high risk environment) , pay for performance may not be the right option where as for moderate risk environment, it is ideal to pay variable pay and at an increasing rate based on performance
No comments:
Post a Comment