How Firms Use Performance Pay to Mitigate “Promotion Risk”

Jan. 29, 2025

In today’s complex work environment shaped by AI, remote work, and shifting demographics, career advancement has become more uncertain. A recent study introduces the idea of “promotion risk”—the chance of employees being passed over for promotion even when they perform well. The research reveals how companies can use firm performance pay—bonuses that increase with both individual performance and firm-level outcome—as a form of insurance that mitigates the uncertainty of career advancement.

What is Firm Performance Pay?

Firm performance pay links part of an employee's incentive compensation to the overall success of the company. Once reserved for top executives, this practice is increasingly common for non-executive employees, especially in companies that rely heavily on human capital.

While traditional economic theory advocates steady pay to protect workers from firm-level risks, Swedish House of Finance researcher Alvin Chen argues that this perspective changes when employees face promotion risk. In such cases, compensating workers based on the company’s performance can act as a safety net, cushioning the financial impact of missed promotions.

Stronger Company Performance, Greater Promotion Risk

In many workplaces, promotions are scarce. A recent Google survey found that 77% of respondents noted limited promotion opportunities in their workplace. In such a setting, a paradox arises: a surplus of talented employees improves company performance but intensifies the competition for promotion.

Consistent with this observation, research shows that as co-workers perform better, individual promotion chances decline. Put differently, an abundance of talented employees may be good news for the company, it is bad news for employees hoping for a promotion.

The Optimal Contract

Chen’s research suggests that a firm can remedy the misalignment between its prospects and those of its employees by paying them more when it does better, making up for the decline in promotion prospects.

This insurance motive also helps explain why profit-sharing is typically reserved for high-performing employees. Low-performing workers are not candidates for promotion and therefore do not require the same level of promotion risk mitigation.

A Strategic Tool, Not a One-Size-Fits-All

While firm performance pay can offer a compelling solution to mitigate promotion uncertainty, it’s not universally applicable.

“My framework emphasizes how changes in the supply of talent affect promotion risk,” Chen notes. “But in some companies, changes in the demand of talent are more relevant.”

Companies with fewer organizational frictions—like start-ups or firms with flexible hierarchies—may expand promotion opportunities to accommodate an abundance of talent. For example, in recent years, many large law firms have introduced the position of non-equity partner to retain skilled associates who are not promoted to equit partner, effectively mitigating promotion risk without relying solely on compensation design.