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Is the Annual Pay Raise Obsolete?

Yearly salary increases are giving way to variable lump-sum payouts

A woman is sitting at a desk and looking at her phone.

When General Electric talks about its people practices, it makes headlines. The news that the company is considering doing away with annual salary increases was no exception. But changing a long-held practice that employees have come to view as an entitlement is not easy.

Smaller companies tend to be much more nimble in breaking away from scheduled annual raises. When Tekla Wlodarczyk Núñez started her cleaning business, Middleton, Wis.-based Mother Earth Cleaners, in 2014, she learned from past experiences and made sure salary increases would be tied to specific employee achievements so that workers would not feel entitled to pay increases based on length of service. 

Her company, which focuses on hiring individuals with hotel cleaning experience, employs people at an hourly rate comparable to what area hotels pay for cleaning staff. Then, after a six-week probationary period, the firm gives each employee a $1 per hour pay increase to encourage employees who have proven to be reliable to stay with the firm. Over time, as employees gain experience and expand their skills, including spoken English language for non-native speakers, the company gives pay raises on a case-by-case basis. 

"I think it is much more meaningful to an employee to get a raise out of the blue" rather than at a specific time of year, Núñez said. "This is a way to tell them that we value them and they are doing a great job. If the raise is expected and automatic, why work any harder, why take a class, why improve?"

Seeking Motivation

How to make annual salary increases more meaningful and motivating to employees has been an ongoing challenge for employers. For a decade or more, salary increase budgets have hovered around 3 percent annually. This is not a figure that is likely to get employees excited.

Even when employers allocate raises by performance, the top performers are unlikely to receive a salary increase of more than 5 percent or so.

Yet, for any organization, increasing pay levels by 3 percent per year is a major investment. "This can represent hundreds of millions of dollars, but what kind of return on investment do those companies get?" asked Laura Sejen, managing director of talent and rewards with Willis Towers Watson in New York City. 

"In many cases, employers end up annoying the 80 or 90 percent of their employees who get that 3 percent increase or even less so that the company can give top performers maybe a percentage point more," she noted.

Focusing on Variable Pay

Companies interested in doing something different might consider shifting some—or even all—of their salary increase budget to a short-term (annual) variable pay incentive program and limit base pay increases to market adjustments. 

"If certain employees have been in their jobs for a long time without much change in their performance from year to year, employers could just make periodic adjustments to make sure that base pay remains competitive in the market," said Sejen.

Using this approach, employers could develop a salary increase budget of, say, 1 or 2 percent to keep pay competitive under current market conditions. The other 1 or 2 percent could be shifted to performance-driven, variable-pay bonuses that could be used to enhance the organization's value proposition for employees.

"Eliminating merit increases does not mean backing away from competitive pay for solid, average contributors," Sejen said. "It means that pay adjustments for those performers will come in a different form and likely at a different frequency."

For employers in stable economic and labor markets with fairly low inflation, these salary adjustments might occur every 18 months or as needed rather than every year. Companies could review salaries more frequently—say, every six months—for lower-level employees who are progressing quickly and adding more skills, and for employees in jobs with a very competitive labor market.

"The goal is to give managers much more flexibility to reward the strongest and most important performers," said Sejen.

To back up these new approaches, Chris Bolte, CEO of Paysa, a career and salary technology firm based in Palo Alto, Calif., suggested that employers implement more frequent discussions with employees to provide feedback and assess performance. 

"The point is to engage employees with the work they are doing, the results they are achieving and how the employee can improve," he said. "People have their annual goals, and companies can use a quarterly review as a way to check in to see how things are progressing. If there is a market change [for the position], the employee might see an adjustment at that time."

[SHRM members-only toolkit: Designing and Managing Incentive Compensation Programs]

Keeping—but Refining—Merit Raises

Employers that are wary of jettisoning annual raises in favor of variable performance-driven payouts have another option—use current salary increase budgets more effectively. Consider these options:

  • Set different expectations for merit-based pay raises. Instead of talking about average merit increases, focus on different funding levels for different levels of performance. "Employers will still probably only spend 3 percent of payroll," said Ken Abosch, leader of the broad-based compensation practice at Aon Hewitt in Lincolnshire, Ill. The difference is that these firms can "communicate that the budget pool for average performers is 2 percent and that the budget pool for outstanding performers is 6 percent." This creates a more variable funding mechanism for salary increases and will help set employee expectations for those increases.

  • Improve goal setting. Do a better job of setting goals for employees, and make sure performance ratings accurately reflect each employee's performance and contribution. "None of this is going to work if 50 percent of the workforce is rated outstanding or above average," Abosch said. "Organizations have to learn to do a better job of differentiating performance." He suggested holding back a portion of the merit increase pool until managers make initial merit increase recommendations, and then pushing those reserve dollars to the highest-rated performers as a way to force differentiation.

  • Mix salary increase and lump sums. The highest performers could have merit payouts added as a salary increase, Abosch suggested, while average performers receive part of the payout as a lump sum and the rest as a salary increase, and poor performers would get a payout (if any) only as a one-time lump sum.

Joanne Sammer is a New Jersey-based business and financial writer.

Related SHRM Online Articles:

Bonus Binge: Variable Pay Outpaces Salary, SHRM Online Compensation, August 2016

How Variable Pay Can Align Performance with Rewards, SHRM Online Compensation, June 2016

Variable Pay: Ready to Make the Leap?, SHRM Online Compensation, June 2016

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