Denying poor performers merit increases can pay off.
The term “merit increase” should mean that an employee is getting a pay increase based on merit. All too often, however, employees get salary increases regardless of whether their performance over the previous year was meritorious. In fact, many employees who don’t meet the minimum requirements of their job collect “merit” increases year after year.
Even if those increases are marginal, experts say, giving them to all employees regardless of their results sends the wrong message—both to poor performers who are being rewarded for less-than-stellar achievement and to top performers who get a smaller piece of the salary-budget pie.
Culturally, however, managers may not be ready to stomach the seemingly harsh practice of giving poor performers no merit increase at all. They may find it is easier to spread rewards around to all employees to avoid the conflict that withholding pay increases from some workers could unleash. Or, HR may view withholding merit increases as unfair to employees who may be held back from reaching their full potential by circumstances beyond their control. It’s clear that employers’ compensation systems aren’t making the grade. Only 10 percent of organizations describe their merit pay programs as “very effective,” according to an employee attitude survey conducted in 2002 of 335 companies by Hay Insight (the research and survey arm of Philadelphia-based HR consulting firm The Hay Group), WorldatWork and Loyola University of Chicago.
By contrast, adopting—and enforcing—the get-tough approach to merit pay has clear advantages: It doesn’t waste increasingly precious salary-budget dollars, it sends the right message that improvement is imperative, and it doesn’t fund underperformers at the expense of high-performing employees. (For a legal reason to implement this system, see “The Legal Danger of Rewarding Poor Performers”.)
Making ‘Tough Love’ Work
The problem for many organizations is that the budget for pay increases is small—on average 3.5 percent, according to research by Hewitt Associates. That leaves little room to differentiate pay between top performers and mid-level performers—much less bottom performers.
And that’s not an effective way to spur performance. “You cannot get entrepreneurial results from a communistic approach—that socialistic feeling that everybody gets something,” says Chuck Coonradt, founder and CEO of The Game of Work, a management consulting company in Park City, Utah. “In my opinion, it’s a practice we ought to scrap.”
Coonradt believes a lot of what he calls “merit fear” comes from lack of courage on the part of managers to deny rewards to the undeserving.
But, when companies spread pay raises around to all employees, something unintentional happens, says Larry Reissman, New England practice leader for The Hay Group. “Long-tenured low performers penetrate the top portions of salary ranges, while high performers change jobs so often that they never get to those ranges at all,” he says.
This wouldn’t happen at one investment firm Reissman worked with that gives new meaning to the term “tough love.” There, merit dollars are given to eligible employees who consistently—year after year—exhibit exceptional performance. In general, top performers are funded at the expense of lower performers and nonperformers.
In fact, even average performers at the company generally get less than the average salary increase budget number—which can pose a communication challenge for managers, he says.
Communicating Your Policy
The trick to making a compensation system like this work is to combine clearly defined goals, good communication, and a fair and frequent performance review system.
“It’s futile to try to establish a pay-for-performance culture without openly discussing goals, how to accomplish them and what it means to an employee’s pocketbook,” says Paul Shafer, business leader in the broad-based pay practice for Hewitt Associates in Lincolnshire, Ill.
Employees also need to know what the consequences are for not meeting performance expectations, including a clear statement in the employee handbook and at performance reviews that they’re not automatically entitled to an annual merit increase.
Regardless of whether times are flush, that statement alone can send a powerful signal from management that the company is serious about everyone’s performance. The top performers get more. Those holding back the organization get less—or nothing.
That’s exactly the message employees hear at SecureWorks Inc., where the company’s CEO gets involved in every employee’s compensation review, says Kerry Solomon, vice president of HR at the 103-employee Internet security services provider in Atlanta.
After an employee self-evaluation, manager assessment and input from Solomon, a proposed evaluation and pay recommendation is presented to the CEO. “The CEO reviews and blesses” the recommendation on whether the employee should or should not receive a pay increase.
And when the company implemented a new pay-for-performance plan in 2002, it was communicated in writing, in person—and over and over again throughout the year. “Our CEO and department heads repeat the message continually,” Solomon says.
“It’s human nature not to hear or understand something new. People hear what they want to hear. You must clearly, consistently and frequently repeat your message. Saying it once is simply not enough,” she says.
Constant play helps employees get the message that the company compensates on the basis of results, not simply effort. “Your base salary is about meeting your base job requirements,” Solomon says. “Employees know that if they’re not meeting or exceeding or learning or growing, they’re not going to get a regular increase.”
That includes cost-of-living adjustments. At SecureWorks, cost-of-living increases are considered at the same time as annual reviews. If an employee is performing and excelling, he’s granted a base increase. But if a merit raise isn’t called for, the company also doesn’t automatically grant a cost-of-living increase.
Employees have at least two other chances to earn other compensation throughout the year—either a stock option grant or restricted stock and a bonus. If performance improves, one or both of these rewards are available to the employee, which usually more than accounts for any loss of a cost-of-living raise. But if the employee’s performance still lags requirements, Solomon says, “it’s safe to assume they’ve self-selected out” of the company “and will no longer be a member of our team by the next annual performance review.”
The payoff? Since the new pay plan was implemented, voluntary employee turnover has stayed at less than 5 percent. “After year one of the program, there was a lot of jubilation,” Solomon says. “Those who weren’t happy virtually self-selected out.”
At SecureWorks, goals are set at the beginning of each year. Company goals are set by the management team and are printed and framed on the walls of the company’s offices, break rooms and rest rooms. “Repeat it, distribute it, post it and re-emphasize it in person,” Solomon stresses.
Department goals, which support the corporate goals, are set by managers and their teams. Individual goals, which support company and department goals, are set by each employee together with their manager. All goals must be achievable, measurable and aligned with the corporate strategy.
Individual goals have to be based on a realistic view of the future and connected to what the company needs to achieve.
Getting Managers On Board
The hardest part of a system that withholds merit increases from poor performers is giving the bad news to the employee who isn’t getting a raise that year. Managers fear delivering the news, and HR fears the backlash.
Experts say the best way to fend off a bad reaction is to make sure no one is surprised by the news. If your organization does a good job of continually communicating throughout the year that poor performers don’t receive a merit increase, and managers do a good job of communicating how their employees are doing on their performance throughout the year, there should be no surprises. Offering feedback throughout the year also should give employees a chance to improve their performance.
To help managers give good feedback, provide them with tools and talking points about topics such as what “superior” and “unacceptable” performance looks like, how merit raises should link to employee achievement and growth on the job, and how to deal with the tough questions likely to come from less-than-stellar performers. Take managers through role-playing exercises, for example, that guide them on having the difficult conversations.
Reissman cites the example of a financial services company whose culture was very accepting of speeding through performance reviews and not wanting to deliver bad news to anybody. When a new CEO joined the company, however, he brought in a new pay plan with highly differentiated rewards. Under the new system, there is no limit to what star performers can earn in merit increases—and some go as high as 20 percent. Poor performers get nothing, Reissman says. Managers who have to make the tough decisions during performance conversations get coaching to boost their skills.
The company credits its tougher merit system with helping it to achieve a doubling of its stock price two years after going public. The tougher system weeded out poor performers voluntarily—a “good” kind of turnover. Plus, high performers reached even higher because they were more accurately rewarded with dollars they deserved. All of this led to better overall company profitability and performance.
To add some checks and balances to your organization’s performance review system, Shafer says, HR must establish organizationwide consistency in divvying up the merit money. He suggests the creative use of peer pressure by sharing information with all managers on how each one of them distributed their pay increase budgets.
“You can see who stayed within the [compensation strategy] guidelines and who didn’t,” he says. “It can work very well to get people to conform to your rules.”
If withholding pay seems like harsh punishment for an employee with promise, consider delaying the merit increase. “Sometimes, giving the employee three to six months to turn it around can help achieve performance worthy of reward,” Reissman says.
Another strategy is to offer lump-sum payments instead of a base-salary increase. For example, instead of giving a 3 percent salary jump, give a 3 percent payout in one lump sum. “It looks like a bonus, comes out of the merit budget pool, but doesn’t have the effect of raising salary” or hourly wages, Reissman notes. Distributing rewards this way helps stretch merit budgets while over time slowing down salary growth—an attractive goal for many compensation managers. “The biggest challenge is getting managers to not overuse it,” Reissman says.
Above all, keep it simple.
“If you differentiate pay, you need to do a good job of assessing performance,” he says. “That means everyone should know who’s doing the job, who’s outstanding and who’s not doing the job. Don’t micromanage shades of gray; get managers to really think about who it is in the company who deserves more—and who doesn’t.”
Brad Hill, principal of Tandehill Human Capital, a consulting firm in Warrenville, Ill., says HR and managers need to remember that base pay or merit increases “are forever and an annual event” that raises salary from that point on. “So over time,” he says, “you want to absolutely make sure those increases meant something.”
Susan J. Wells, a business journalist in the Washington, D.C., area and a contributing editor of HR Magazine , has 20 years of experience covering business news and workforce issues.