It’s supposed to link high levels of performance to the bottom line. But in reality, it can foster internal conflict and encourage mediocrity.
By: Brent Longnecker & Brittny Tillman
Were you ever in a college honors class and informed by the teacher that the grading system for the semester would be based on a “bell-shaped curve” distribution?
Have you ever thought it curious that you are told to hire the “best,” which you do, but during performance evaluation time, you are instructed to force-rank a certain percentage of your staff as superior, above average, average, and below average?
Have you ever considered what the shareholders would think if you had to explain that most people within the company in which they have invested are only average or below?
As human capital consultants, we see scores of different performance evaluation programs companies use. The standard operating procedure and the general theme we notice in merit pay plans – no matter how strategic the process – are often reduced to a “forced-ranking” method. While forced-ranking sometimes has its place, we believe more effective approaches are available to determine an individual’s annual salary.
It is easy to rationalize forced ranking when the economy is down, your industry is hurting, and/or your company has had a bad year. However, what do you do when your department (or your company), because of the efforts of its people, has experienced exceptional performance that is evident in the bottom line? Traditionally, the standard merit pay system has adequately rewarded employees, but it has one major flaw: Companies continue to force-rank their employees – even in the good times.
The underlying premise surrounding the concept of merit pay is that employees should be paid different rates for various levels of competence and performance. The underlying criteria of a merit pay system can be summarized as the employee’s performance about pre-established understandable job responsibilities and the employer’s financial ability to pay.
In the 1980s, it was much easier to differentiate performance when merit budgets averaged 8 percent to 10 percent. Today, the merit budget has averaged around 3 – 3.5% over the last two decades, not close to present inflation. This makes it much more difficult for companies to distinguish exceptional work using performance-based merit increases. When this occurs, it is difficult to truly link an individual’s compensation and benefits to their efforts to improve the company’s bottom line.
Merit Pay as It Is
Today, merit pay can encourage average or mediocre performance. Once performance evaluation time rolls around, over half of the workforce typically will be force-ranking as average (or very close). At the same time, the remaining employees will be ranked below and above this midpoint. Employers generally rank employees by the pre-assigned performance distribution percentages to stay on track with the merit budget since it has a mathematical equation attached to it. As you can imagine, this scenario results in intense internal conflict and can destroy any semblance of employee teamwork and cooperation. Consider the employee who improves their performance; presumably, someone else will, in turn, be “squeezed down” to maintain a balance “fit” within the guidelines.
Merit pay alone may force evaluators to make determinations on a person-versus-person basis rather than a person-to-established-standards basis. In our opinion, this also causes management to move away from focusing on pre-established, objective job standards and toward evaluations based on personal attributes. A Pandora’s Box subsequently opens to all sorts of problems, including corporate infighting, person-rater bias, management subjectivity, and even lawsuits (all demotivators), which can negatively impact the organization’s overall productivity. In the final analysis, “pay for performance” is often just a catchy cliché.
The Reality of Some Myths
Can myths become reality? Will we point out the problems and give no solution? It will always be a battle to balance a company’s ability to pay with its ability to adequately recognize, reward, and retain its workforce. Our experience indicates that myriad approaches would align more with the actual concept of performance-based pay. Here are some that have been designed and tested:
· Generally, it is simply a truer “performance-based” compensation methodology to set the compensation strategy to pay base salaries at a level that reflects the external market and an individual’s performance in the job. Base salaries are fixed costs, and most companies want to minimize fixed costs, which means that an organization should consider variable incentive plans to make true performance-based distinctions in an employee’s compensation and link it to the company’s performance. We are not suggesting that the mechanics involved are suitable for every company. However, the developmental intent and achievable results of a program like the one illustrated below are standards most organizations should at least consider and expand.
· Develop job standards, skills, or competency definitions that provide an employee and manager with a baseline to evaluate the individual’s competency levels at least annually.
· Establish individual and team goals that are linked to corporate strategy.
· Develop a performance evaluation instrument and train evaluators in its use and administration.
· Establish a variable salary increase or merit budget based on corporate performance. For example:
Corporate Merit Budget as a Percent of Total Payroll
Threshold 3.0 percent
Target 4.0 percent
Maximum 6.0 percent
Reward employees with a salary increase that reflects their contribution to the organization. Employees not fully competent in their jobs should be compensated below the salary range midpoint. Qualified individuals should be paid at the midpoint, and fully seasoned performers and those who exceed expectations should be compensated above the midpoint.
Variable Compensation
In addition, variable compensation can be the true “EQUALIZER” and differentiator for companies if combined with merit pay. Specifically:
· Company, department, and/or individual performance levels should be preset so employees may receive a target award for achieving a slight stretch performance. The award opportunity should significantly vamp up if target performance is exceeded.
· Determine the funding mechanism for the award. Funding can be all corporate if a company wants to promote a “team” culture; however, subsidiaries may need to fund at least a portion so that they are not “dinged” in years of good performance when corporate performance is terrible.
· Communicate performance levels and relative payout levels so employees understand how much they will receive depending upon the actual performance level achieved.
· Pay awards as often as is reasonable so that the program is a continuous reminder of the performance goals. Constant communication is even more critical if awards can be paid only annually.
Consider Other Methods, Too
Above are just a few thoughts. Several methods should be considered and tested to determine their applicability within your organization's culture. Time, cost, and effort must be expended, especially when designing the performance evaluation instrument, setting goals, and training evaluators on the proper program techniques. At first glance, it might appear excessive, but review your alternatives. Performance-based pay, as it was meant to be, is paramount to creating shareholder value and the corporation's success. It boils down to pay now versus paying later.”
Besides, whoever agreed with the teacher using the “bell-shaped curve,” anyway?
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