The default shader model for XNA 4.0 is 2.0. There are a number of limitations to this, the most significant is that you’re limited to 64 instructions slots.
Since pixel shader 3.0 is available in XNA 4.0 (and will run on the Xbox 360), you may decide to simply alter your pass technique as follows:
//PixelShader = compile ps_2_0 PixelShaderFunction();
PixelShader = compile ps_3_0 PixelShaderFunction();
The problem is that the default Vertex Shader is already compiled to the 2.0 shader model, and you can’t mix your shader models. What you need to do instead is add a default vertex shader and compile it in 3.0. You can find the following example on the XNA forums:
void SpriteVertexShader(inout float4 vColor : COLOR0, inout float2 texCoord : TEXCOORD0, inout float4 position : POSITION0)
position = mul(position, MatrixTransform);
Putting it all together, you’ll get something that looks like this: