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Confidence and Compensation: Do Employees Sort Themselves?

By Melissa J. Anderson

When someone is overconfident about their performance abilities, they may be more willing to volunteer for a riskier compensation scheme. That’s according to recent research by Harvard Business School’s Ian Larkin and Stephen Leider.

Published in the American Economic Journal, the study tested individuals on their likelihood to opt for a riskier “convex” incentive plan or a less risky “linear” one based on their confidence level and their performance. Individuals exhibiting traits of overconfidence were more likely to choose the convex scheme – even when they performed poorly on tests, and when they were verbally advised to choose a different scheme.

Larkin and Leider write:

“Understanding the role of behavioral biases in employee sorting may be particularly important to firms for two reasons: first, employment contracts that take advantage of employee biases could better attract and retain employees; and second, these contracts might allow firms to hire employees at a lower cost compared to contracts that do not address the behavioral biases of employees.”

Larkin and Leider believe this may help overconfident employees self-sort into jobs like sales, where confidence is necessary and a convex pay structure is common. Would this produce more engaged employees? The researchers think it could.

Confidence Levels and Compensation Selection

Larkin and Leider called the results of their study “striking.” They explain:

“The attractiveness of convex pay schemes to overconfident employees is clear: by overestimating their likely performance, these employees believe they will earn more than they would in a typical linear pay scheme where pay does not accelerate as performance increases.”

Even when overconfident employees don’t perform well enough to make the convex payment scheme worth it, they keep choosing it over and over again. They explain:

“Subjects who are highly overconfident, as measured by their ex-ante performance expectations on the task, are 45 percentage points more likely to incorrectly choose the convex scheme. These mistakes cost the subjects 15% of their payoff in these rounds, suggesting that a firm could save on the wage bill by offering non-linear incentives and ‘sorting in’ overconfident workers.”

Even though they should have chosen a linear scheme, overconfident individuals keep taking the risk and choosing a convex scheme, despite their limited performance. They just believe they can do better.

Similarly, individuals who selected the linear model of compensation tended to underperform over time versus individuals who were simply assigned a linear model. “We also find that, while the linear and convex schemes have no difference in their direct incentive effects for the task in the experiment, subjects who choose the linear scheme significantly underperform compared to subjects who choose the convex scheme.”

The payment scheme itself doesn’t have an impact on performance – individuals’ beliefs about their abilities can limit their ability to succeed.

Motivation

What does all this have to do with employee motivation? According to Larkin and Leider, individuals who showed overconfidence from the beginning were more likely to maintain their level of motivation. Those who were underconfident and selected a linear scheme throughout, tended to lose interest.

They explain, “…the subjects who choose the linear scheme in all six periods, and perform the worst relative to their initial ability, are also somewhat more likely to be underconfident. Therefore, overconfident subjects may be more likely to maintain motivation throughout the task.”

Because individuals’ pay scheme selections were not linked to their skill levels, the researchers suggest, companies can take advantage of this.

“Importantly, our findings suggest this sorting does not occur along the skill dimension, which is the standard argument in the literature on the benefits of sorting. Rather, as with the literature on social preferences and sorting, our results suggest using an incentive system which sorts by a behavioral trait – overconfidence in the case of our study – may be beneficial to firms.”

Rather than pushing employees into roles and compensation schemes they deem appropriate, firms can empower employees to self-sort into the roles and compensation schemes that are amenable to themselves. The result is higher performing, more motivated employees. And possibly cost-savings along the way.

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