Firm Performance Pay as Insurance against Promotion Risk

Key Question Being Explored in This Insight:

How does the prevalence of pay based on risky firm outcomes for nonexecutive workers challenge conventional contract theory, while revealing new insights about competition for promotions and the link between firm hierarchy and pay structure?

View the page of: Alvin Chen

Institution: Stockholm School of Economics

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This video discusses the concept of "promotion risk," which refers to the possibility of being passed over for a promotion despite high performance, particularly in competitive workplace environments where promotions are limited. It highlights the idea that not only must employees perform well, but they must also outperform their coworkers to secure promotions. This video is illustrated through a Google Consumer survey indicating employees perceive promotions as the key way to increase pay, and data showing high-performing workers are less likely to be promoted when their peers also perform well.

The author argues that firm performance pay—where workers' compensation is tied to company performance—may serve as a form of insurance against promotion risk. This video challenges the conventional view that it merely imposes risk on employees. Instead, the framework proposed suggests that when firms provide performance-based pay, they compensate employees for the lower probability of promotion that comes when many coworkers are also excelling.

Through examples and theoretical discussions, the text outlines how promotion risk and firm performance pay are interconnected. It concludes that understanding this dynamic can help better inform compensation practices and bridge gaps between organizational economics and finance literature, emphasizing the need for more research in this area.

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Here are five key points from the video:

1. **Promotion Tournaments and Competition**: The video discusses how workplace promotions often resemble tournaments, where employees must not only perform well but also outshine their coworkers. This competition can create a perception of limited promotion opportunities, even among high performers.

2. **Promotion Risk Concept**: The author introduces the idea of "promotion risk," which refers to the possibility of being overlooked for promotion despite strong performance. This risk becomes significant in highly competitive environments where many employees are vying for a limited number of promotions.

3. **Firm Performance Pay as Insurance**: The paper reassesses the common view that firm performance pay (e.g., stock options, profit-sharing) is an indicator of inefficient risk-sharing. Instead, it argues this pay structure acts as a form of insurance against promotion risk, compensating workers when their chances of promotion decrease due to high competition.

4. **Negative Correlation between Individual and Firm Outcomes**: The video explains that when overall firm performance is strong, promotion prospects for individual high performers may actually decrease due to the increased pool of high achievers. This creates a negative correlation between an individual's promotion chances and the firm's success.

5. **Connection to Broader Economic Literature**: The author positions their findings within larger economic and finance literatures, suggesting that how firms design their hierarchical structure and compensation systems can have broader implications for performance, investment, and innovation strategies.

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Here are some key quotes extracted from the video you , which focus on the central themes regarding workplace promotion, performance, and compensation:

1. **Promotion and Competition:**
- "In order to secure a promotion, it's not enough just to perform at a high level in absolute terms. You also have to perform better than your coworkers."
- "The way to get ahead and to get paid more is to secure promotions. And more importantly, they point out that there are a limited number of promotions even if everybody does well."

2. **Promotion Risk:**
- "In that convideo... I introduce a concept that I call promotion risk. And what promotion risk is, it's the possibility you still end up getting passed over for promotion."
- "The fact that we see firm performance pay is indicative of inefficient risk sharing... rather the firm performance pay itself is a type of insurance."

3. **Firm Performance Pay:**
- "One study I quite like is by Cruz Etal... with something like 30 to 40% of workers in the United States get some kind of firm performance pay, including stock options, profit sharing."
- "If so many of our colleagues are generating... performance, it's likely that the firm is making a lot of money... bad news for us in terms of its performance."

4. **Risk and Reward Framework:**
- "In my framework, if you think about the underlying friction, suppose there were zero frictions and the firm can promote everybody that they find to be qualified, then nobody would be exposed to risk."
- "In some circumstances, we can think about firm performance pay a little differently."

5. **Organizational Economics and Compensation:**
- "What I'm kind of showing is that perspective has maybe unintended or knock on effects on how you have to then set up compensation."
- "My work highlights an under... broad literature in economics as well as finance."

These quotes emphasize the concepts of competition for promotions, the implications of promotion risk, the rationale behind firm performance pay, and the connection between organizational design and compensation strategies.

X-TIMESTAMP-MAP=LOCAL:00:00:00.000,MPEGTS:90000

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You look at the typical workplace

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promotion tournaments are actually very common, right?

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And it's just this idea that in order to secure a promotion,

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it's not enough just

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to perform at a high level in absolute terms.

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You also have to perform better than your coworkers.

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And I think instinctively most people kind of understand

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that they're competing against their

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coworkers for promotion.

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So for instance, there's a recent Google Consumer survey

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and something like 16,000 respondents to the survey.

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A majority of them pointed out that at their workplace

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the way to get ahead

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and to get paid more is to secure promotions.

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And more importantly, they point out

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that there are a limited number of promotions

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even if everybody does well, right?

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And this perception is actually quite consistent with sort

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of aggregated, data and aggregated analysis, right?

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For instance, jet Devaro looks at,

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micro data from several different metropolitan areas in the

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United States, and he finds that workers,

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even the high performing workers, are less likely

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to be promoted if the typical performance of their

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coworker is high, right?

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And so this idea that we have

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to compete against our coworkers in order

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to secure a promotion is actually

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quite prevalent in the workplace.

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And so in that context,

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and against that backdrop, I introduce a concept

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that I call promotion risk.

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And what promotion risk is, it's the possibility

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that despite performing at a very high level,

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you still end up getting passed over for promotion.

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And really what my paper tries to do is to study what

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that does for optimal contracting.

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The starting point of this project was actually the

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observation that non-executive workers,

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and by non-executive workers, I mean workers that are

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below upper management, right?

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So entry level professional, all the way up

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to maybe lower tier or lower management.

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These type of workers routinely get paid performance pay

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that's subject to

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or exposed to some level of, firm exposure, right?

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So you can think the firm's stock price in the case

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of stock options and stock pay

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or the firm's overall profitability when you think

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about profit sharing.

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And so from the perspective of standard theory,

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this observation is very ply, right?

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Because standard theory says, look, people are risk averse,

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and so you don't wanna pay them based on risky outcomes

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that they can individually control.

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And that's exactly what firm performance pay is doing.

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And in particular for firms that are very large

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and financially stable, to conventional wisdom,

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would look at the existing

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or the prevalence of a lot of firm performance pay

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as an indication

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that there's some inefficient risk sharing going on, right?

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Like in other words, these very large

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and financially stable firms aren't ensuring their workers

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like they're supposed to.

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One, study I quite like is by, by Cruz Etal,

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where they look at these surveys, from the MBER,

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and they're sort of the ones that document just how,

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how widespread the, the sort of the practice

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of firm performance pay is with something like 30 to 40%

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of workers in the United States get some kind

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of firm performance pay, including stock, stock options,

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profit sharing, and that's, and those sort of things.

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What I really try to do in this paper is to kind

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of reassess this conventional view, right?

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So this idea

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that firm performance pay imposes risk on workers sort

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of informs a lot

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of work in the non-executive pay literature.

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And the way they think about this is, look,

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since workers don't like risk

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and we're imposing risk on them, there has

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to be some benefit that's sufficiently large

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to justify that cost, right?

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Maybe it's tax savings,

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maybe it's favorable accounting treatments.

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Maybe this helps us retain workers

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or make them more engaged.

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And I'm not saying that those things aren't true.

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In fact, I find a lot of those arguments very convincing.

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Instead, what I wanna try to do is to present a framework

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that reassess this or cost and benefit trade off.

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And in particular that in certain circumstances

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where workers are exposed to promotion risk, the fact

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that we see firm performance pay is an indicative

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of inefficient risk sharing.

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Like rather the firm performance pay itself

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is a type of insurance.

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And that's what my framework is trying to show.

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The way you want to think about per,

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why firm performance pay provides insurance against,

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promotion risk is you want to think about

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how promotion risk operates, right?

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And to kind of fix ideas, imagine that you

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and I are associate attorneys

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that say at a large prestigious law firm,

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and we both understand that among our cohort,

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not everybody is gonna make partner, right?

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They're only gonna take the top performers out of our cohort

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and elevate them to the position of, partner.

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And that's suppose that you and I are just fantastic.

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We're rock stars and we're crushing it

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and we're generating 2,500 billable hours every year, right?

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And if you and I are the only ones

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that are meeting this very high standard, then our chances

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of making a equity partner is gonna be very hot.

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On the other hand, suppose again, we are doing very well,

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generating 2,500 billable hours every year,

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but so is the other a hundred attorneys at the firm, right?

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Even though we've generated the exact same level

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of performance, 2,500 billable hours, our possibility

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or the probability of getting promoted is now lower, right?

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Even through no fault of our own,

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because we've still generated this high

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level of performance.

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So the upshot here is if so many

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of our colleagues are generating so many number

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of billable hours, it's likely that the firm is making a lot

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of money, right?

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And so, in other words, bad news for us in terms

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of promotion prospects is good news for the firm in terms

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of its performance, right?

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And so here you have this negative correlation

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between promotion prospects at the individual level

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and the overall firm outcome, right?

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And that's how firm performance pay

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ensures us against promotion risk, right?

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So here, firm performance pay means performance pay.

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That increases with the firm outcome, right?

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So when the firm's making a lot of money, that's kind

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of when our promotion prospects tend to be low.

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So paying us more when the firm is doing better helps

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compensate us for the lower promotion prospect.

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And that in a nutshell is

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how firm performance pay ensures against promotion risk.

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In my framework, if you think about the

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underlying friction, right?

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I suppose there were zero frictions

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and the firm can promote everybody that they find

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to be qualified, then nobody would be exposed to risk.

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And in that world there would be no promotion risk

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to actually ensure.

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So kind of loosely speaking, there's sort of two types

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of promotions out there.

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The first type is the one that you get

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whenever you demonstrate a level of experience, a level

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of mastery, a level of competence, right?

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Like if we were junior accountants at a firm,

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once we've had a couple of years

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of experience under our belt

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and we show that we're competent at doing our work,

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we get promoted to say, senior accountant.

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And it doesn't matter how many other junior accountants at

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the firm demonstrated that same level of proficiency, right?

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But as we kind of climb up the organizational hierarchy,

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at some point we're gonna reach a bottleneck, right?

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And that's typically where we have a transition to sort

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of management type roles.

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And because of this bottleneck,

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not everybody who's qualified can be

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promoted into that next level.

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And then because of this,

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we're gonna have promotion risk when there's a surplus

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of talent and not everybody can get promoted.

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I think overall the kind of the, the main result

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of the paper is to show that in some circumstances we kind

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of have to think about the imposition of risk

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with firm performance pay a little differently.

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And I hope that my framework help people better understand a

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very common compensation practice, which is

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to offer firm performance pay

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to very high performing workers.

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And sort of more broadly, I think my work also helps connect

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to broad literature, to broad literature, in economics

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as well as finance, right?

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So recall it's important in my framework

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that workers actually face some level

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Of promotion risk.

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That is that there's some likelihood that they can get,

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that they might get passed over for promotion.

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And there's a large organizational economics literature

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that concerns itself with how best to design the hierarchy

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of an organization to solve all sorts of different problems.

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Like how best to, allow the flow of information

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through the organization, how best to signal its quality

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to outsiders, how best to manage its production process.

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And what I'm kind of showing is

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that the way you design the organization from

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that perspective has maybe unintended

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or knock on effects on how you have

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to then set up compensation.

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And in the finance literature, there's a sizable literature

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that actually, or a sizable number of works that look at

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how the way the firm compensates its workers

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actually affects its other policies.

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Like what its capital structure is, how much it invests to

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what extent it actually innovates.

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And so more broadly, I think my work highlights an under

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explored connection between this organizational economics

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literature as well as topics in finance.

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And sort of moving forward I hope to see more as well as

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to contribute more research that kind of bridges that gap.

Understanding Promotion Risk in Competitive Work Environments

00:00:00 - You look at the typical workplace promotion tournaments are actually very common, right? And it's just this idea that in order to secure a promotion, it's not enough just to perform at a high level in absolute terms. You also have to perform better than your coworkers. And I think instinctively most people kind of understand that they're competing against their coworkers for promotion. So for instance, there's a recent Google Consumer survey and something like 16,000 respondents to the survey.

00:00:36 - the way to get ahead and to get paid more is to secure promotions. And more importantly, they point out that there are a limited number of promotions even if everybody does well, right? And this perception is actually quite consistent with sort of aggregated, data and aggregated analysis, right? For instance, jet Devaro looks at, micro data from several different metropolitan areas in the

00:01:05 - even the high performing workers, are less likely to be promoted if the typical performance of their coworker is high, right? And so this idea that we have to compete against our coworkers in order to secure a promotion is actually quite prevalent in the workplace. And so in that context, and against that backdrop, I introduce a concept that I call promotion risk. And what promotion risk is, it's the possibility

Promotion Risk and Firm Performance Pay

00:01:37 - you still end up getting passed over for promotion. And really what my paper tries to do is to study what that does for optimal contracting. The starting point of this project was actually the observation that non-executive workers, and by non-executive workers, I mean workers that are below upper management, right? So entry level professional, all the way up to maybe lower tier or lower management.

00:02:08 - that's subject to or exposed to some level of, firm exposure, right? So you can think the firm's stock price in the case of stock options and stock pay or the firm's overall profitability when you think about profit sharing. And so from the perspective of standard theory, this observation is very ply, right? Because standard theory says, look, people are risk averse, and so you don't wanna pay them based on risky outcomes

00:02:38 - And that's exactly what firm performance pay is doing. And in particular for firms that are very large and financially stable, to conventional wisdom, would look at the existing or the prevalence of a lot of firm performance pay as an indication that there's some inefficient risk sharing going on, right? Like in other words, these very large and financially stable firms aren't ensuring their workers like they're supposed to. One, study I quite like is by, by Cruz Etal,

Reevaluating Firm Performance Pay as Insurance Against Promotion Risk

00:03:14 - and they're sort of the ones that document just how, how widespread the, the sort of the practice of firm performance pay is with something like 30 to 40% of workers in the United States get some kind of firm performance pay, including stock, stock options, profit sharing, and that's, and those sort of things. What I really try to do in this paper is to kind of reassess this conventional view, right? So this idea

00:03:45 - of informs a lot of work in the non-executive pay literature. And the way they think about this is, look, since workers don't like risk and we're imposing risk on them, there has to be some benefit that's sufficiently large to justify that cost, right? Maybe it's tax savings, maybe it's favorable accounting treatments. Maybe this helps us retain workers or make them more engaged. And I'm not saying that those things aren't true.

00:04:16 - Instead, what I wanna try to do is to present a framework that reassess this or cost and benefit trade off. And in particular that in certain circumstances where workers are exposed to promotion risk, the fact that we see firm performance pay is an indicative of inefficient risk sharing. Like rather the firm performance pay itself is a type of insurance. And that's what my framework is trying to show.

Promotion Risk and Firm Performance Pay Dynamics

00:04:45 - why firm performance pay provides insurance against, promotion risk is you want to think about how promotion risk operates, right? And to kind of fix ideas, imagine that you and I are associate attorneys that say at a large prestigious law firm, and we both understand that among our cohort, not everybody is gonna make partner, right? They're only gonna take the top performers out of our cohort and elevate them to the position of, partner.

00:05:18 - We're rock stars and we're crushing it and we're generating 2,500 billable hours every year, right? And if you and I are the only ones that are meeting this very high standard, then our chances of making a equity partner is gonna be very hot. On the other hand, suppose again, we are doing very well, generating 2,500 billable hours every year, but so is the other a hundred attorneys at the firm, right?

00:05:49 - of performance, 2,500 billable hours, our possibility or the probability of getting promoted is now lower, right? Even through no fault of our own, because we've still generated this high level of performance. So the upshot here is if so many of our colleagues are generating so many number of billable hours, it's likely that the firm is making a lot of money, right? And so, in other words, bad news for us in terms

Promotion Risk and Firm Performance Pay

00:06:20 - of its performance, right? And so here you have this negative correlation between promotion prospects at the individual level and the overall firm outcome, right? And that's how firm performance pay ensures us against promotion risk, right? So here, firm performance pay means performance pay. That increases with the firm outcome, right? So when the firm's making a lot of money, that's kind of when our promotion prospects tend to be low.

00:06:52 - compensate us for the lower promotion prospect. And that in a nutshell is how firm performance pay ensures against promotion risk. In my framework, if you think about the underlying friction, right? I suppose there were zero frictions and the firm can promote everybody that they find to be qualified, then nobody would be exposed to risk. And in that world there would be no promotion risk to actually ensure. So kind of loosely speaking, there's sort of two types

00:07:23 - The first type is the one that you get whenever you demonstrate a level of experience, a level of mastery, a level of competence, right? Like if we were junior accountants at a firm, once we've had a couple of years of experience under our belt and we show that we're competent at doing our work, we get promoted to say, senior accountant. And it doesn't matter how many other junior accountants at the firm demonstrated that same level of proficiency, right? But as we kind of climb up the organizational hierarchy,

Understanding Promotion Risk and Compensation Dynamics

00:07:55 - And that's typically where we have a transition to sort of management type roles. And because of this bottleneck, not everybody who's qualified can be promoted into that next level. And then because of this, we're gonna have promotion risk when there's a surplus of talent and not everybody can get promoted. I think overall the kind of the, the main result of the paper is to show that in some circumstances we kind

00:08:25 - with firm performance pay a little differently. And I hope that my framework help people better understand a very common compensation practice, which is to offer firm performance pay to very high performing workers. And sort of more broadly, I think my work also helps connect to broad literature, to broad literature, in economics as well as finance, right? So recall it's important in my framework that workers actually face some level

00:08:56 - That is that there's some likelihood that they can get, that they might get passed over for promotion. And there's a large organizational economics literature that concerns itself with how best to design the hierarchy of an organization to solve all sorts of different problems. Like how best to, allow the flow of information through the organization, how best to signal its quality to outsiders, how best to manage its production process. And what I'm kind of showing is

Impacts of Compensation on Organizational Policy

00:09:28 - that perspective has maybe unintended or knock on effects on how you have to then set up compensation. And in the finance literature, there's a sizable literature that actually, or a sizable number of works that look at how the way the firm compensates its workers actually affects its other policies. Like what its capital structure is, how much it invests to what extent it actually innovates. And so more broadly, I think my work highlights an under

00:10:09 - literature as well as topics in finance. And sort of moving forward I hope to see more as well as to contribute more research that kind of bridges that gap.

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