Introduction
Quick warning: This post is a little longer than most of my other topics. But in my opinion (hopefully yours soon), it’s time well spent since this is likely THE most divisive OKRs topic I’ll examine in this series on courting OKRs controversy, and perhaps the most important. I should also note at the outset that my goal is not to convince you that linking OKRs to incentive compensation is necessarily right for every organization. Rather, my aim is to help you make an informed decision in light of empirical research and actual facts rather than relying on blogs written by people who have little actual experience in the strategy execution trenches.
Should You Link OKRs to Incentive Compensation?
As with a number of OKRs considerations, this is not as easy a decision as ten minutes of research on the internet might suggest. So, to begin, what would those six-hundred seconds of research reveal? Overwhelmingly, you’d be advised not to link OKRs to any type of pay-for-performance plan or incentive compensation. The primary rationale offered for this stance is the possibility of ‘sandbagging,’ i.e., people or teams setting easily achievable targets on their OKRs in order to ensure an incentive is received. At first glance, that makes sense; most humans are self-serving, and who among us wouldn’t want to receive an easy reward with little effort invested? But, before we write the topic off completely, let’s turn back the clock a bit to see what history can teach us.
Looking Back: The Balanced Scorecard and Incentive Compensation
Twenty-five years ago, the Balanced Scorecard (BSC) was the OKRs of its day; the “hot” performance measurement and management system. It’s still popular today. I’m not going to go deep on contrasting the Balanced Scorecard with OKRs, but suffice it to say that they share about 90% of the same DNA. An objective in the BSC is an objective in OKRs. A key result in OKRs is a measure in the BSC world. The primary difference relates to the categorization of objectives. As the name implies, the BSC dictates objectives and measures in four ‘balanced’ perspectives of performance, whereas OKRs simply warrant a focus on what matters most right now. But again, the models are quite similar in that both focus on the execution of strategy.
Here’s the thing… with the Balanced Scorecard, not only did people forgo debate on the idea of linking it to incentive compensation, that linkage was taken as a given. Here are just a few statistics supporting that claim:
- A Hay Group study of 15 sophisticated users of the Balanced Scorecard found that 13 of them linked pay to the Scorecard.
- A Mercer survey of compensation practices in 214 companies found that 88% of responding companies consider the use of BSC measures linked to reward systems to be effective.
- Another survey of scorecard implementations found that 70 percent of the respondents already use the balanced scorecard or some variant for compensation purposes.
This wasn’t just a group of rogue practitioners making a bold decision. Robert Kaplan and David Norton, the co-creators of the Balanced Scorecard, said: “Ultimately, for the Scorecard to create cultural change, incentive compensation must be connected to the achievement of corporate objectives. The issue is not whether, but when and how the connection should be made.” Note the language there – the issue is not “whether” but “when.” A powerful recommendation.
Linking Performance to Incentive Compensation: Broader Insights
Maybe we should step even further back to determine whether linking performance to incentive compensation using any framework is a good idea. Entire books have been written on that subject, but here are a couple of anecdotes suggesting the link is entirely warranted:
- In a study of “what really works” within successful organizations, authors Nitin Nohria, William Joyce, and Bruce Robertson bluntly asserted, “It should be obvious that the best way to hold people to high standards is to directly reward achievement. Ninety percent of the winning companies in our study tightly linked pay to performance, while only fifteen percent of the losers did.”
- Similarly, it has been suggested that the effective implementation of a strategic plan is greatly enhanced when reward and recognition systems gear employee attention and focus towards the key dimensions of the new direction.
Addressing the Sandbagging Problem
But what about that pesky sandbagging problem, you say. Well, if you adhere to the true spirit of OKRs and institute a governance process in which managers have regular coaching conversations with their employees, the sandbagging argument is specious at best. OKRs should never be set without negotiation. For example, if I (Paul) report to Kim, I should develop my draft OKRs and then have a conversation with Kim about them, determining whether the level of stretch inherent in the OKRs is appropriate. This conversation fosters my understanding of the strategy (which will improve the quality of the OKRs) and drives engagement as I am getting direct feedback on what matters most – how I can contribute to the company’s strategy execution efforts. Thus, the final OKRs should represent appropriate stretch and be relevant for a potential incentive compensation link.
To put it differently and bluntly, if an employee or an entire team can convince their manager to accept an artificially lowball key result target, that is more an indictment of the manager’s competence than it is a reflection of any potential downsides of linking OKRs and incentive compensation.
Bonus Content for Those Really Interested in the Topic…
If you were to even consider poking the bear of linking incentive compensation with OKRs results, how might you go about it? What are some of the actual mechanics? I have a couple of – admittedly unproven – ideas I’d like to share with you on that topic.
More Frequent Rewards
One of my focus areas is making OKRs a positive habit for my clients. My exploration into habit formation led me to Wendy Wood’s book “Good Habits, Bad Habits,” where she delves into various domains, including casinos. Did you know that nearly seventy percent of gaming profits now come from slots and video poker? This isn’t surprising when you understand the psychology that keeps players eagerly pulling the lever for those elusive Triple 7s.
Wood notes that these machines are programmed to display near misses more often than chance, heightening the players’ feelings of “I almost won!” This sense of almost winning activates dopamine reward pathways, reinforcing the habit and keeping players engaged. She also suggests that for rewards to be effective, they must be closely tied to behavior and appear immediately after the action. Think of a slot machine: you pull the lever and, if lucky, are rewarded immediately.
The implication for OKRs is clear: linking them to incentive compensation can be highly effective if payouts are provided quarterly. This approach ties rewards directly to performance in both action and time. Most organizations pursue quarterly OKRs, offering a perfect opportunity to connect performance with rewards in a short period, unlike annual variable compensation systems where employees wait until year-end for bonuses. Quarterly rewards can build the “performance” habit much faster.
The Clawback Approach: A Solution
And now for something completely different: I’d like to introduce the “clawback” approach. In case you’re wondering, it has nothing to do with what happens should you accidentally stick your finger in the lobster tank at the supermarket (not that I’d know anything about that). No, the “clawback” approach to incentives leverages the psychological principle of loss aversion, which suggests that people are more motivated to avoid losses than to achieve equivalent gains. This concept, explored in numerous studies, notes that the fear of losing something we perceive as ours can be a more powerful motivator than the prospect of gaining something new. The clawback approach takes advantage of this principle by provisionally granting rewards to individuals, which they can lose if specific performance targets are not met.
In the context of OKRs and incentive compensation, the clawback approach could be particularly effective. Instead of the traditional method where employees receive bonuses only after achieving their performance goals (OKRs in our case), companies can allocate these bonuses at the start of the performance period. Employees are informed that bonuses are provisionally theirs, contingent on meeting their OKRs by the end of the quarter. This framing creates a sense of immediate ownership of the bonus, making the prospect of losing it a powerful motivator. Studies have shown that the clawback approach can lead to sustained productivity gains, as employees feel a stronger incentive to perform.
Maximizing the Impact of the Clawback Approach
By integrating the clawback method, organizations have the potential to more effectively align individual performance with strategic goals, fostering a culture of accountability and continuous improvement while maximizing the impact of their incentive programs. This approach not only addresses the potential issue of sandbagging but also harnesses a powerful behavioral economics principle to drive performance. Employees remain highly motivated throughout the performance period, as the fear of losing a provisionally granted bonus keeps them engaged and focused on their OKRs. The result is a more dynamic and effective incentive compensation system that benefits both the employees and the organization as a whole. And no lobsters will be disturbed or fingers lost in the process. A win-win!
Sources cited in this article:
- BSC and incentive compensation: Christopher D.Ittner, David F.Larcker, and Marshall W. Meyer “Performance, Compensation, and the Balanced Scorecard,” 1997
- Broader compensation insights:
- Nitin Nohria, William Joyce, and Bruce Robertson, “What Really Works,” Harvard Business Review, July 2003, p.46.
- Elspeth J. Murray and Peter Richardson, Fast Forward: Organizational Change in 100 Days (New York, NY, Oxford University Press, 2002) p. 112.
- Habit formation: Wendy Wood, “Good Habits, Bad Habits, (New York, NY, Farrar, Straus and Giroux, 2019)
- Clawback approach: John A. List, “The Voltage Effect,” (New York, NY, Crown Currency, 2022).