How a Pay-for-Performance Compensation Strategy Pays Off

By Sharon Koss Jan 3, 2008
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Next to an organization’s strategic planning efforts, dovetailing the compensation philosophy to support the organization’s goals is paramount to success. For example, if quality, experience and a sophisticated skill set are an organization’s strategic advantages, then it will not be successful hiring employees significantly below the market rate for that position.

It is important to review the organization’s strategic plan at least annually, and to discuss basic strategic pay decisions with senior management to ensure the success of the pay-for-performance compensation strategy and prevent serious consequences, such as employee turnover and lawsuits.

​Goals for the Pay-for-Performance System
A compensation system should influence employees to make personal decisions that are congruent with the organization’s needs. Generally, this goal can be broken down into three parts:

    Motivate people to join the organization.
    Motivate employees to perform at the top of their skill set.
    Motivate employees to stay.

Important considerations that should be a part of this ongoing discussion include the following:

Where does the organization want to be in terms of market competitiveness?

In this competitive job market, it is important to be aware of the organization’s competing firms. An organization can lead, meet or lag the market.

    • Lag the market. An organization may choose to offer a compensation package that is valued less than packages offered for a similar job in the labor market. An employer with a “lag the market” philosophy is likely to be at the back of the line when it comes to hiring and retaining employees, especially those with special skills. These problems are the direct result of below-market pay. With the Internet providing pay information with a click of a mouse, employees are less willing to stay and support an organization when they know they are underpaid. Good employees may leave, while less-skilled employees may stay with the organization.

    Turnover is very expensive. It is estimated to be at least six months’ pay for a non-exempt (hourly) employee and one years’ pay for an exempt (salaried) employee. No organization wants to be a training ground to groom employees for its competitors.

    • Meet the market. This is the most common compensation strategy. This level of competitiveness occurs when an organization’s compensation strategy is equal to the labor market for the same position. This is the pay philosophy that makes the most sense for most organizations. By having a base pay strategy that meets the market, an employer can easily add or subtract variable pay and/or fringe benefits. By selecting this level, employers can balance cost pressures and the need to attract and retain employees.

    • Lead the market. The “lead the market” pay strategy can be defined as a total compensation package that is above the labor market for a similar position. This strategy may occur because an organization believes that by paying more, it will receive more experienced employees for the same position (although it has not been proven that a higher salary guarantees higher-quality employees)

    Organizations may choose to lead the market in good financial times, but it can leave them in a tight spot in a downturn.

Pay Policies: Advantages and Disadvantages

Compensation Policy

Advantages

Disadvantages

Lag: Pay lags the market

1. Lower costs.

2. Money can be used for benefits.

1. Hard to attract employees.

2. Trained employees leave for your competitors.

Match: Pay matches the market

1. Pay and costs match the competition.

2. During good financial times, can share bonuses and short-term incentives.

1. May not be able to attract star performers when labor market is tight.

2. May not be able to keep emerging stars.

Lead: Pay leads the market

1. Able to attract and keep stars.

2. Promotes perception of organization as employer of choice.

1. Must be financially able to afford.

2. During financial hard times, may not be able to change financial commitment quickly.

Source: Solving the Compensation Puzzle, by Sharon Koss, SHRM Publications, 2008

Mixed Market Position

This market position is becoming more common as employers are realizing that a one-size-fits-all strategy does not suit their workforce. The following are examples of a mixed market pay policy:

An organization that is several miles outside a major city may be able to pay lower for their lower-level hourly employees to match a lower cost of living, but may have to pay at market or above market to attract employees to a smaller, more remote city.

An organization has a mix of difficult-to-fill clinical positions and easier-to-fill administrative positions. To compete in a market with an extreme shortage, it may make business sense to pay the clinical positions at least at market or above market and pay the administrative positions closer to below market.

What are the strengths and weaknesses of the organization’s current compensation system?

An important component of market competitiveness is to find answers to the following questions:

Is the organization able to attract the appropriate skill sets and types of employees when needed?

Where is the organization hiring its best employees?

How long do most employees stay at the organization?

Where do employees go when they leave the organization?

What are the organization’s promotion policies?

Are employees frequently asked to take on new tasks without being rewarded for their efforts?

Do employees value the company’s benefits, incentives, work environment? What of these items should be changed or updated?

What is the employee morale? This information can be gathered from managers, exit interviews, employee surveys and other communication tools. Employee survey feedback, in particular, provides valuable information for moving forward.

What mix of base pay, incentive pay, work environment and benefit levels make the most sense for the organization when considering the competition, types of jobs, niche and labor market available?

How is pay distributed?

How does the organization’s current compensation plan link pay with performance on base pay?

Is there a pay matrix that rewards high-performing employees with a larger annual merit increase?

How well does the organization’s performance appraisal process work?

Are the organization’s promotional pay policies consistent?

Does the organization review where employees fall on the pay range according to experience, performance and longevity?

How is the organization’s pay system administered?

What are the strengths and weaknesses of the current system? How is your system structured and what do you want to change about the following:

Number of grades.

Separate scales for different types of jobs such as non-exempt, exempt and executive.

Size of jump between grade mid-points.

Placing a newly created job in the pay range.

Determining how and when a job gets reviewed due to changes in responsibilities.

What are some constraints?

It is too easy for an employer to take a shortcut and not acknowledge that all organizations have to work within some important constraints when managing their pay-for-performance system. There are five major constraints: the organization’s ability to pay; legal constraints; union and non-union issues; the internal labor market and the external labor market.

    1. Ability to pay. Fancy compensation programs are impressive, but the bottom line is that an organization must be able to afford its pay system. This is true in good and in bad financial times. It is critical that design decisions align with the organization’s financial ability to pay. By partnering with an organization’s chief financial offer, it will be easier to develop a plan that makes sense financially.

    2. Legal constraints. In general, base pay plans are regulated by the Fair Labor Standards Act (FLSA), which regulates wages, hours and recordkeeping.

    3. Union/non-union issues. For unionized organizations, pay issues are a mandatory bargaining issue that must be negotiated. Organizations must obtain buy in from union leadership early in the negotiation process to be successful in changing the way they pay their employees.

    4. Internal labor market. This is where internal equity comes into play. Pay plans must motivate employees to want to stay with the organization and, hopefully, take on management roles or higher-level technical roles in the future. To illustrate, an organization can structure a pay plan that will motivate high-level technical employees to move out of overtime-eligible positions into first-line management positions that do not pay overtime.

    5. External labor market. In today’s global market, organizations cannot operate their pay plan in a vacuum. Basic economics of supply and demand affect employee compensation. To illustrate, the amount of education required to become a pharmacist recently changed. To compound the problem, Medicare added a pharmacy plan for senior citizens. This resulted in a shortage in pharmacists and an increase in pay levels for the job.

Collecting information regarding the above compensation questions and issues will give HR professionals a good start in developing a compensation philosophy that can then be shared internally with their employees and externally with the general public, customers and potential applicant pool.

HR professionals should enlist senior management to help champion the compensation philosophy as a working document that can set the stage for the design of a new compensation system.

12 Steps for Designing a Pay-for-Performance System

Step 1: Determine the organization’s pay philosophy. After senior management has determined the organization’s pay philosophy, the next step is to summarize it and review it with middle management.

Step 2: Determine the gaps. Where are the gaps between the compensation philosophy and what the organization is currently doing?

Step 3: Update job descriptions. Since jobs change so rapidly, it is important to update your job descriptions before working on any other part of the compensation system.

Step 4: Decide what sources will be used for external market information. Use at least three salary survey sources for each job. By participating in a survey (usually requiring one short window of about six weeks per year), organizations can save almost 50 percent on the survey purchase price.

Step 5: Plan on how the market survey will be completed. Does the HR department have enough time and expertise to accomplish this task without outside help? Matching jobs to accurate salaries is more difficult than it appears. If this is a brand-new salary plan, it may be a wise decision to work with an outside consultant who has experience in the process.

Step 6: Review market data and slot into salary grades. Each set of market data points must be reviewed to ensure there is a pattern with no statistical outliers. When there is a good average for each job, the next step is slotting the jobs into salary grades based on this salary survey market average.

Step 7: Review preliminary salary survey results with senior management. Senior management should be involved early in the salary matching process to obtain management buy-in at an early stage; identify and resolve problems before the project continues; and assess internal equity.

Step 8: Match employee titles to the market study titles. For many organizations, it is not clear what employees match up to which job descriptions, and which match up to new titles in the new salary grades. Understanding who does what, who belongs in which department, and which supervisors oversee jobs can be confusing even in a smaller organization.

Step 9: Review financial impact of setting new salary ranges. There will be pay situations where the employee’s current salary is either above the new salary range (red circled) or below the new range (green circled). First, look at all employee pay that falls below the minimum. What is the financial impact of moving these employees up to the minimum? If cash flow and/or money are tight, get the chief financial officer involved in this process early because he or she will be crucial in deciding affordability and timing for all market adjustments.

Step 10: Review and update the performance appraisal process. Does the performance system work well with the new pay-for-performance system? If the performance appraisal process is more than two years old and it has been at least that long for any management training, set aside time to drive this important piece of the project.

Step 11: Design a pay-for-performance merit matrix. Match the performance levels to be achieved against a merit schedule that rewards raises based on an employee’s performance. In order not to overspend, do a dry run using last year’s employee performance scores with the new corresponding merit pay number. If the final numbers from this exercise are too high, then trim the merit pay matrix or raise the merit budget allowance.

Step 12: Review, audit and communicate. Before starting next year’s compensation, market study and communication process, gather specific information on what worked and what did not.

Sharon K. Koss, SPHR, the author of Solving the Compensation Puzzle, has owned her own HR consulting/compensation firm since 1986. Altogether, she has more than 30 years of HR experience, during which time she completed more than 500 salary plans. Koss speaks regularly on the topics of compensation and general HR and has been on the SHRM Faculty for more than 12 years, and served as chair of the Human Resource Certification Institute.

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