Pay for Performance: Make It More than a Catchphrase

"Pay for performance is a concept embraced by many but executed poorly by most," said Jim Kochansky, a senior vice president at Sibson Consulting, speaking at the 2011 WorldatWork Total Rewards Conference in San Diego.

The 2008-09 recession and sluggish economic growth in its aftermath have caused employers to rethink their approaches to pay. One result: a renewed emphasis on rewarding top performers even if overall pay raise budgets are smaller. According to Myrna Hellerman, senior vice president at Sibson Consulting, much can be learned from best-practice companies where base pay increases must be earned, based on demonstrated individual achievement. Pay raises "are not an entitlement; the entitlement era is over," she declared.

Other characteristics of the new pay mindset include:

• If there is no base pay increase budget, some high achievers might still get increases.
• If there is a base pay increase budget, some will get nothing while significant amounts will be given to the highest achievers.

Companies are thinking more creatively about incentive compensation. Instead of annual plans, payouts might be earned but delayed until a company returns to profitability, Kochansky noted.

In addition, companies are carving out a portion of their merit budgets to be set aside for high performers. "If you have a 3 percent budget for increases, employees are going to expect to receive a 3 percent raise," he pointed out. But if the company instead carves out 0.5 percent of the budget for high performers and communicates that the general budget for pay increases is 2.5 percent, then the expectation among average workers will be for a 2.5 percent raise. "Carve-outs should be done early in the budget process" so money is set aside and kept distinct, Kochansky recommended.

Welcome Low Performer Turnover

Along similar lines, Ken Abosch, compensation practice leader at Aon Hewitt, noted that high performers are attracted to companies that are committed to pay for performance, whereas low performers will self-select out of these organizations. He cited some of the main challenges of implementing effective pay for performance as:

• Insufficient funding.
• Faulty goal setting, with no clear definition of performance.
• Unrealistic employee reward expectations.
• Poor modeling by executives.
• The mindset that "everyone here is a high performer or they wouldn't be here."

It's human nature not to want to tell employees that their pay will reflect that their performance is below par, Abosch noted.

Another hurdle: managers' concerns about the turnover costs of replacing employees who leave because they were disappointed in their raise. "Studies have shown that below-average performers contributed less than 10 percent of the value of average performers to an organization," Abosch stated, "and above-average performers contribute almost twice the value of average performers to an organization. You can afford to replace below-average performers," and to do so repeatedly if the end result is to bring onboard additional high performers.

Marilu Malague, a senior compensation consultant at Aon Hewitt, advised using targeting budget increases as investments to drive average performers toward higher performance.

While much of the focus of pay for performance now is on variable pay (i.e., short-term incentive bonus payments and long-term incentive equity awards), base salary remains the largest reward component, Abosch said, and "employees value salary increases the most." While recognizing that cost of base salary increases compounds year after year—which dissuades some employers from offering merit raises—the value of pay raises as a motivator that drives behavior can't be dismissed, Abosch advised.

When variable pay is used to reward top performers, "the line of sight between performance and reward must be made clear," Malague added, or bonuses will fail to motivate high performance, or, worse, will be seen as a reward based on favoritism.

Equitable Treatment, Not Equal Treatment

'When an employee's extra efforts are not reflected in rewards and recognition, it erodes performance and commitment to the organization, said Tom McMullen, reward practice leader at Hay Group, a pay consultancy. At the same time, managers often confront a general notion of fairness among workers that goes back to childhood, which he summed up as "If he gets that, then I should get that, too."

But treating everyone "equally," despite their varying contributions to the organization, is not always fair. So managers can find themselves in a bind. "Don't confuse equitable treatment with equal treatment. A one-size-fits-all approach won't work," said Mark Royal, reward practice leader at Hay Group.

"There is a strong possibility for sour grapes if there is a lack of confidence in the process of allocating rewards. As rewards professionals, we impact perceptions of fairness," McMullen added.

Lack of consistency is often a driver for perceptions that the process in unfair. For instance, reward fairness is often delegated—or abdicated—to line managers to address. As an example: "Over 90 percent of organizations have no policies on making employees a counter-offer to keep them from jumping ship. They leave it to line managers," McMullen reported, based on Hay Group research.

Important criteria for impacting reward fairness include establishing a fair design for the compensation and performance assessment processes, making these transparent and communicating effectively how the system works. "Have senior leaders and line managers communicate the message," McMullen advised. "Don't just rely on HR. Ask for help from marketing and public relations in creating branded communications about rewards that can be distilled down to core messages showing that the organization rewards employees relative to their contributions." Consider using social media and short video presentations to get the message across.

"Few rewards programs explicitly address how fairness and equity are defined and managed, Royal said. "Most reward strategies/philosophies are not sufficiently robust and need to be made more explicit."

"The best reward program, if poorly implemented, will yield less than strong results," concluded McMullen. "If the reward program is not clearly explained, employee confidence in fairness and execution is likely to remain low."

Stephen Miller, CEBS, is an online editor/manager for SHRM.