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Originally published Sunday, June 21, 2009 at 12:00 AM

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Does pay for performance improve behavior?

An academic survey finds that CEOs who are offered performance-based pay tend to solicit advice from managers with different backgrounds and views — rather than the self-affirming "pseudo-advice" often sought from family and friends — which has helped improve their companies' financial performance.

Harvard Business Newsletters

There is a continuing debate about performance-based pay for top managers: We know it alters behavior, but does it improve it?

The trick is to strike the right balance. Intriguing academic research suggests that some elements of performance-based pay may enhance corporate results.

Michael McDonald at the University of Central Florida, Poonam Khanna at Arizona State University and Jim Westphal at the University of Michigan examined the connection between performance-based pay, CEO advice-seeking patterns and company performance.

CEOs often seek advice on strategic issues from executives at other firms. However, we also know from studies that, just like other people, these CEOs are inclined to solicit feedback from friends and people who are just like them. That's not genuine advice. By asking the opinion of friends, you are simply confirming to yourself that what you are doing is right.

Looking into the question of which CEOs engage in this pseudo-advice seeking and which truly turn to people who might actually disagree with them, McDonald and his colleagues surveyed 225 large U.S. industrial and service firms. They obtained information on how often executives sought the advice of other top managers on the outside and how well the CEOs knew those managers.

This information was correlated with the extent to which top managers received performance-contingent compensation and it found a clear result.

CEOs with a very small performance-related pay component sought very little true external advice. They relied on friends and family to tell them their actions were great, splendid and spot on.

In contrast, CEOs with a relatively large performance-contingent component often sought advice from other executives who were not their friends and who had different backgrounds.

Moreover, McDonald and colleagues showed that this advice seeking significantly helped the financial performance of the CEOs' companies by increasing the companies' market-to-book and return on assets.

Pay for performance stimulated executives to repress their natural inclination to avoid asking the opinions of those who might disagree with them. It is much safer to solicit advice from people who will say you're doing well, but it is much more useful — and lucrative — to put your performance to the test. If CEOs are rewarded for it, they'll be brave enough to take that test.

Freek Vermeulen is an associate professor of strategic and international management at the London Business School. Distributed by The New York Times Syndicate.

Copyright © 2009 The Seattle Times Company

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