We can make you work for less: the psychology of pay

Why delving deeper into the science of pay could end our fixation with the annual increase

Money has rarely proved a source of happiness in popular music. But even so, the experience of The KLF is an extreme example. In 1994, in one of the UK’s most notorious art-pop spectacles, the duo behind the chart-topping band (famous for hits including Last Train To Transcentral) burned £1 million in bank notes, without explanation, on a remote Scottish island. Whatever reaction they expected, they later admitted they weren’t ready for the sheer anger of the public: when they attempted to tour a film exploring their actions, screenings were called off amid chaos as furious mobs besieged them.

The act also led to a more prosaic problem. Two decades later, the band admitted they were short of money and could really do with a spare million quid. But however ironic, KLF’s actions demonstrate the inevitable psychic misery associated with money – whether having too much or not being able to access enough. In the workplace, these issues come to a head.

“Psychological research has consistently suggested that where money has motivational power it is nearly always negative,” writes Adrian Furnham, professor of psychology at University College London, in The New Psychology of Money. A major reason is that money (or ‘extrinsic reward’) crowds out our innate desire to do a good job (‘intrinsic reward’) and leads to behaviours that work against employers’ interests.

As a century of psychological research has proved beyond doubt that any lift we get from a pay rise is purely illusory, and the quest for materialism is almost always unfulfilling, why are we still in thrall to the sum on our monthly pay cheque? And why is HR still struggling with salary bands and pay grades when true happiness at work, for most people, is a far deeper affair?

Money carries what psychologists Paul Webley and Stephen Lea describe as an “emotional charge” that goes far beyond its purely economic function. It is a tool we can use to acquire things we desire, which means we covet it, but – more powerfully – neuroscientific experiments show that it also acts like a drug, stimulating areas of the brain associated with immediate gratification.

This emotional charge manifests even in very simple experiments that show people are drawn to the physical form of money: we feel a sense of loss when a familiar coin changes shape, even though its value remains the same. We also manage virtual money less effectively than cash, which suggests that we may value our salaries less now that they are paid directly into our banks than when pay packets were handed out at the end of the week.

What’s more, money is symbolic. “Salary is an index of status and prestige,” writes Furnham. “Pay is a form of social approval.” The obvious inference is that if organisations want to motivate their staff to deliver against organisational objectives, they should decouple pay from performance entirely and introduce incentives that play to employees’ intrinsic motivations, which are generally agreed to be autonomy (the ability to direct your own life and work), mastery (the opportunity to get better at something that matters) and purpose (the desire to do what we do in the service of something larger than ourselves).

But doing this would involve a major cultural shift from the rational economics that underpin traditional reward practice, towards behavioural economics, based on the knowledge that human beings are irrational, our behaviour characterised by all sorts of cognitive biases and decision-making shortcuts.

Unfortunately, one of the lessons from behavioural science is that people react more strongly to something being withdrawn, even if they don’t value it, than they do to something being given to them, even if the new thing is of higher value. In psychological terms, this is known as ‘loss aversion’, and is part of ‘prospect theory’, which assesses how people determine the value of losses and gains. In short, you can lose £5 one day and find £5 the next, but you won’t feel like you’ve broken even.

But while no organisation would be advised to withdraw performance-related pay altogether, there are insights to be gained from the growing body of research in the field of behavioural science – in particular, behavioural economics, cognitive neuroscience and psychology – that can give reward practitioners a better understanding of how to incentivise people at all levels.

Psychologists have popularised behavioural science by appealing to our self-interest. Dan Ariely, author of Predictably Irrational: The Hidden Forces that Shape our Decisions, says keeping the reward ‘contract’ within the realms of ‘social exchange’ rather than ‘market exchange’ would help employers and employees enjoy more mutually rewarding relationships.

“It’s the difference between ‘complete’ and ‘incomplete’ contracts, the latter being those where we can’t specify exactly what happens,” says Ariely. “In a work context, we are taking people’s ability to have deep and meaningful relationships and trying to translate them into financial exchanges. Every time a financial exchange pops up, we say to ourselves: ‘Really? That’s it?’ And we’re not interested any more.”

Behavioural economics literature bristles with examples highlighting the flaws in our traditional approach to all elements of reward, not just performance-related pay. But the behavioural scientists themselves admit their discipline is not a panacea for reward challenges. Richard Whittle, lead economist and associate director of the behavioural economics consultancy unit at Manchester Metropolitan University, and co-author of a CIPD report on the behavioural science of reward, Show me the money!, describes behavioural science as “a useful tool for getting new insights; another lens through which to look at reward approaches”.

What’s more, adds Charles Cotton, performance and reward adviser at the CIPD: “The research throws up many contradictory findings, so there are all sorts of decisions and trade-offs you have to make.” This is hardly surprising given that even in one individual the unconscious (or instinctive, or emotional) and conscious (or reflective, or logical) parts of the brain send different messages.

Tara Swart, CEO of The Unlimited Mind, and a senior lecturer in neuroscience for leadership at MIT, explains: “Dopamine is the neurotransmitter in the reward pathways in our brains. You can get as much dopamine from someone saying thank you, or well done, as you can from being given a pay rise – the chemical effect is the same. But social constructs override this. So intrinsic motivation is important, but we also want money for certainty and security. If you get no bonus but your boss treats you well, it can make up for it in terms of the dopamine release in the brain.”

In general, the instinctive and reflective parts of the brain work together, says Swart: “All our decisions are biased by emotion, and that balance is good.” The problem is, the social constructs that affect our reflective, or conscious, response to reward can become toxic – literally. “I work a lot in financial services where people are financially incentivised to extend themselves further and further to the point where they drop dead of heart attacks. It happens all the time,” she says.

Two of the most important psychological factors that have a bearing on base pay are a deeply ingrained need for fairness – we look for rigour and transparency in the way our employers determine pay and progression – and a natural tendency to overvalue our own skills in relation to others (a term known as ‘endowment bias’). The picture is complicated further by the fact that relative pay is more important to us than the absolute amount we receive. So while transparency plays to our need for fairness, it is also likely to demotivate us if we see others earning more.

The relative pay problem is largely to blame for spiralling executive rewards. According to Incomes Data Services, in 2000 the ‘average’ FTSE 100 CEO earned 47 times the amount received by the average full-time employee. By 2014, despite the prolonged recession, this differential had increased to 120 times.

“Whether you get a £1.5 million bonus or a £2 million bonus is not important, as long as your bonus is bigger than other people’s,” says Almuth McDowall, lecturer in organisational psychology at Birkbeck University of London, and co-author of a new CIPD report on what behavioural science teaches us about executive reward. “There is a sort of strange ‘normalising’ going on where people [at the top] don’t question the size of their pay packet.”

But money isn’t everything, even to City high flyers. “While some people are aiming to earn enough money to retire at 45, others feel they have more than enough cash and are motivated instead by competition and winning,” says Michael Brooke, chartered psychologist and UK head of talent and L&D at BNP Paribas Fortis. “There is no simple answer to the question of what motivates people.”

And with money being less of a motivating factor at executive level, organisations have to look to other intrinsic motivators such as “the satisfaction of turning a company around”, says Brooke. “But it does beg the question: why are we paying them so much? Sometimes the wrong people are put in these executive roles and businesses continue to reward them, despite displaying the wrong behaviours.”

Another factor at play in executive reward is long-term incentives. Traditional reward theory holds that if the interests of executives and companies are aligned, it will encourage sustainable organisational performance. But our ability to make accurate assessments of future worth is limited, and this has a big effect on our perception of the value of future reward – a concept known as ‘temporal discounting’.

Humans are programmed to want short-term gratification, indicating that smaller, more immediate and regular bonuses would be more effective – and cheaper for organisations to provide, given that temporal discounting means they need to increase the value of the long-term incentive to make it feel worthwhile for executives.

More regular bonuses would also help mitigate another problem: we adapt very quickly to pay rises. This is to do with what the psychologists call ‘attention theory’ – we concentrate on the most salient thing, which is what we can do with the money, and exaggerate its effect. When we receive it, our attention shifts to what we need to do to earn it, which is work even harder. And there’s a triple whammy, because by now most of us will have already ‘spent’, in our heads at least, the extra money we have gained. Most people spend any additional money on material goods, which research shows do little to increase our store of happiness and wellbeing because of ‘hedonic adaptation’.

Professor Nick Powdthavee, principal research fellow in the wellbeing research programme at the Centre for Economic Performance at the London School of Economics, suggests it is no accident that increasing pay around the world is accompanied by rising stress and mental ill-health. “We underestimate the negative things that go hand in hand with high pay, and, while surveys find people saying they would swap money for happiness or ‘good living’, behaviour doesn’t bear that out,” he says.

Performance-related pay fails on several counts, according to behavioural scientists. It undermines our need for autonomy (because of the monitoring required); it works against our desire for ‘fairness’ if we see others earning more; and if we get a smaller proportion of performance-related pay one year, we suffer from ‘loss aversion’.

Group bonuses can work better, says Alex Bryson, head of the employment group at the National Institute of Economic and Social Research: “Some argue that group dynamics mean it’s not rational to put in effort because you will all earn the same anyway. But behavioural science shows that this is unlikely, because you will gain a reputation among your colleagues as a loafer.”

Benefits, particularly flexible ones, can form an important and effective part of reward strategy, not least because the notion of choice supports employees’ need for autonomy. Yet even this area of reward is a psychological minefield. Behavioural science shows that having to make decisions may seem like a ‘cost’ to staff, so they avoid making the choice, and their inertia can mean they retain a benefit they no longer value – resulting in a perceived ‘loss’ greater than the original value of the benefit. There is clearly an argument for minimising the range of benefits offered, and simplifying the process of selecting them.

In all of this, communication is key. “Because saliency is so important when it comes to reward, people need to be reminded of what they are getting,” says Powdthavee. This is particularly the case with pensions, which research unsurprisingly shows are valued far less by younger people than those nearing retirement.

Regular communication about the value of pension contributions can help – provided it’s not overdone. “Nudging younger employees about the value of pension contributions can be useful for a while, but it can become annoying because it reminds them of the sacrifice to their current salary,” says Whittle.

While psychologists and academics are helping reward specialists unpick the complex factors at play surrounding pay, as research advances in this area it’s likely that getting the mix of intrinsic and extrinsic motivating factors right for individuals will prove trickier than ever. At least you can be sure that, unless your employees are spectacularly self-indulgent, they’ll probably be spending the money rather than burning it.

Read the CIPD report: 'Show me the money! The behavioural science of reward'.

The science of money

Two experiments that demonstrate our complex relationship with reward.

Dan Ariely asked groups of volunteers to repeatedly drag a circle on a computer screen into a box, recording how many times they did it in five minutes. He paid the first group $5 for their efforts, the second group 50 cents and the third group nothing – but told them they would be doing him a favour. The first group dragged on average 159 circles into the box, the second group dragged 101 circles and the third 168.

This, says Ariely, demonstrates that incentive pay can work in certain circumstances, to a certain extent: although the first group was paid 10 times as much as the second, they were only 50 per cent more productive. The fact that the most productive group was the one doing a favour illustrates the supremacy of social norms over market norms.

Management author and speaker Daniel Pink often challenges audiences to solve ‘the candle problem’, which involves giving people a candle and a box of nails and asking them to nail the candle to the wall. In an experiment, one group were told that they were going to be timed.

A second group were also told they were going to be timed and that $5 would be given to the 25 per cent of people who solved the problem fastest, and $20 to the one who solved it fastest of all. It took the incentivised group, on average, three and a half minutes longer than the other group to solve the problem. The same result has been replicated in 40 years’ worth of studies. “You’ve got an incentive designed to sharpen thinking and accelerate creativity, and it does just the opposite,” says Pink.

And the answer? It takes a while for people to overcome their ‘functional fixedness’ and approach the problem from the right point of view. Instead of trying to nail the candle to the wall, you should nail the box to the wall and stand the candle in it.