Biased self-assessments, feedback, and employees' compensation plan choices

Abstract

We conduct a laboratory experiment to examine how task difficulty and different types of performance feedback – none, individual, and relative – affect individuals' selection of either a fixed pay contract or a relative-performance-based pay contract that provides a bonus for above-average performance. We find that participants exhibit a strong better-than-average bias in assessing their relative skills on easy tasks and a moderate worse-than-average bias in assessing their relative skills on difficult tasks. In turn, these biases guide compensation plan choices, leading to participants being more likely to inappropriately select performance-based pay than fixed pay when a task is easy versus when a task is difficult. Our results regarding performance feedback suggest that the provision of individual performance feedback does not exacerbate participants' preferences for relative-performance-based pay when working on an easy task or exacerbate participants' preferences for fixed pay when working on a difficult task. However, we find some evidence that the provision of relative performance feedback has an asymmetric effect on the relation between task difficulty and compensation plan selection. Specifically, when working on an easy task, participants' compensation plan choices were similar between the no feedback and relative feedback conditions, but participants working on a difficult task were more likely to choose relative-performance-based pay in the relative feedback condition than in the no feedback condition. We further find that the relation between task difficulty and compensation plan selection is fully mediated by participants' assessments of their relative skill. Finally we find that performance-based pay does, on average, attract participants with higher skill levels and that risk preferences play an important role in compensation plan selection.