An unintended consequence of incentive-based pay

Finance researcher discovers surprising trade-off in applying market-based solution to public-service sector

Private sector companies attract and retain successful executives with compensation packages that reward performance. But does this same compensation model work among federal employees tasked with regulating the banking, mortgage lending, financial markets and other industries?

Not necessarily, according to Auburn University faculty member Jason Chen, whose award-winning research study suggests the answer is more complicated.   

Rather than retaining the top regulators, pay-for-performance compensation actually encourages them to leave — and they often go to one of the companies that they were regulating, said Chen, an assistant professor of finance in the Harbert College of Business and author of the study.

“The purpose of these [compensation] reforms was to incentivize government financial regulators to work harder while retaining talent within the government agencies,” said Chen, referring to a series of reforms between 1981 and 2006 that changed how financial regulators were paid.

Before the reforms, career financial regulators received steady pay increases that were based on tenure rather than performance just like the rest of the civil service employees. Following the reform, compensation became more closely linked to performance. “What we find is that although it does incentivize more effort, it also led to more people leaving the government.”

In the study, Chen and his co-authors from the University of Rochester and HEC Montreal combined government payroll records with LinkedIn employment data for more than 30,000 financial regulators. They used these data to track employees’ positions, employing agencies, tenure, compensation, and career transitions before and after the introduction of performance-based pay.

Chen attributes the higher exit rate following the introduction of incentive-based pay to several factors.  

First, measuring the performance of government regulators is inherently more difficult than measuring performance in the private sector.

“In the corporate world, it’s relatively easy to measure CEO performance. If the stock price goes up, the CEO did a good job,” said Chen, noting that the company rewards the executive with bonuses or other financial perks. “But it’s it much harder to measure how well a government regulator is performing.”

As a result, government employees become dissatisfied with performance pay because they view the evaluation criteria as arbitrary and opaque.

“Performance-based pay also creates more volatility in their compensation. Employees don’t know whether they’ll receive a raise or how large it will be, which leads to dissatisfaction,” said Chen.

Second, the researchers found that while performance pay motivated the regulators to work harder, it also made them more attractive to private-sector employers.

“Let’s say a government [financial] regulator completes more projects and adds that to their resume,” Chen said. “If their resume looks better, they’re more likely to get poached by the banks they regulate.”

Why it matters

According to Chen, government regulators perform an important role in the overall economy. 

“For example, in the banking sector, [regulators] make sure that banks are operating in a safe and sound manner,” he explained. “More broadly, regulators write and enforce regulation that prevent financial crises and other forms of market misconduct, so understanding how performance pay affects those regulators has a broader implication on our economy as a whole.”

Their study can help policymakers better understand the trade-offs that occur when designing compensation plans for federal workers.

“Sure, performance-based pay may incentivize hard work, but at the same time, you risk losing experienced talent,” Chen said.

International recognition

Chen and fellow finance researchers Joseph Kalmenovitz at the University of Rochester and Jakub Hajda at HEC Montreal received the 2026 European Corporate Governance Institute (ECGI) Finance Prize for their working paper, “Escaping pay-for-performance.” ECGI recognizes only one paper in the finance field annually.

It's a tremendous honor to have our work recognized by a committee of leading scholars in finance," Chen said. "We're incredibly grateful for the recognition.”

Chen also acknowledged the support of Auburn University's Harbert College of Business and the Department of Finance.

"This research would not have been possible without the college's and department's support in funding the proprietary datasets that made the study possible," he said.

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Learn more about the Department of Finance in the Harbert College of Business