Many companies that took drastic actions, like freezing pay, to deal with the 2008-09 recession are subsequently wondering when the good old days will return. The truth is that most organizations would be well served if the answer is "never."
While that might sound harsh, the reasoning is that over the past 15 years what was intended to be "pay for performance" in many organizations deteriorated into a bland set of rewards based on an entitlement mindset. Even in a time of intense economic distress, many companies' pay decisions, particularly those about bonuses and incentives, demonstrate that this approach is alive and well.
The voices of entitlement often express these familiar sentiments:
• "All my people are top performers and deserve a large 'merit increase.'"
• "The company met its plan, so everyone should get a bonus at or above target."
• "I should get paid at least as much as others doing a similar job."
• "Our stock options are under water; the company should fix that."
Many leaders have begun to ask, "What are (or were) we getting for the millions we spend on raises, bonuses and other incentives?" For organizations that want to end compensation entitlement and move to true pay for performance, a business downturn is the best time to act—not just for the duration of the downturn, but also for the long term.
There is nothing wrong with generous rewards; the fault is in the approach and mindset through which these rewards are determined. For organizations seeking high performance, pay in all of its many forms must reflect the extent to which the individual and team contribute to the measurable, sustainable success of the employer.
Stranglehold on Pay
Many organizations claim to follow pay-for-performance practices. For most, however, their performance-oriented intentions have been squelched by the prevailing entitlement mindset. There are several reasons:
• A focus on retention.In robust economic times, retention is a real issue for most organizations. In an attempt to improve retention, some organizations adopt a compensation approach that is characterized by modest differentiation in base pay increases and bonuses and very little differentiation in long-term incentives. The result is that pay is kept competitive for almost every employee.
While such competitive pay helps retain average and low performers, it does little to retain high performers or improve company performance.
• Pay policies.Some policies and practices support entitlement. For example, it has become common for companies to announce their entire pay increase budget (i.e., 3.5 percent for base pay increases), which makes every employee think he or she will get at least the budgeted amount.
In reality, the average employee in this scenario should expect an increase of approximately 2 percent if the organization differentiates base pay for high performers and those who are being promoted.
• Easy administration.Pay for performance is relatively difficult to administer. It requires more measurement and more differentiation. For some populations, variable pay needs to be more frequent than annual, even though annual is easier to administer.
• Ineffective managers.Managers frequently are reluctant to give average and low performers the tough, candid performance messages they deserve. Such an approach is easier to justify when talent is hard to replace. Unambiguous performance communication is the foundation for differentiation and pay for performance.
• Familiarity.An entire generation of managers and employees has never experienced any other type of environment but entitlement. Even some of those who have lived through prior downturns have become soft on performance in recent years.
Entitlement Might Be Weak, but It's Not Over
Although many companies have tried to follow pay-for-performance practices and took steps in 2009 to use limited pay budgets in a more differentiated manner, they continue to harbor the wish that "this too will pass" and the old approach to pay will soon return. That could happen, because pay entitlement is hard to eliminate. While this way of thinking took hold during the talent shortages that emerged in 1998-2000 and 2006-2007, it was strong enough to survive the spikes in unemployment that began in 2003 and 2008.
If entitlement is not an appropriate approach when there is a talent shortage, it is certainly not suitable for the more normal state in which the economy is likely to settle: a generally strong supply of talent (for most types of jobs) with unemployment well above 4 percent. For this reason, organizations would be well served to stop the wishful thinking, declare entitlement dead and adopt a fundamentally different approach based on pay for performance.
What Pay for Performance Should Look Like
While there is no one correct approach to pay for performance, all employers should consider the following steps:
• Replace "merit pay" as the means for determining base pay increases. Merit pay is fundamentally flawed. Instead, organizations should manage base pay according to the value of the job, internally and in the market. Managers will have to justify increases with their peers and leadership rather than spending to a budget.
Why increase base pay for everyone when the labor market is flat? Why give pay increases that last forever, based on one year's performance? The result will be fewer base-pay increases that are based on a target amount and more lump-sum rewards and small, even zero, increases.
• Avoid over-relying on salary ranges and market comparisons. Organizations should end employees' sense that they deserve to be paid the exact market value of a job. A better strategy is to set salary ranges according to market and make pay adjustments according to performance and what the company can afford.
This might seem like a nuance, but it must be explained to employees that their pay "opportunity" is based on market and that some employees will be paid below market and some above.
• Use measurable performance to determine annual incentive payouts.Companies should reward according to individual, work-team and business-unit performance rather than "distant" corporate performance. This should hold even for senior leadership.
The organization's individual and group incentive plans should provide increased line of sight between individuals or groups and their bonuses. Bonus pools might be funded by overall company performance, but too many companies then distribute the entire pool, regardless of the impact of the individual or group on how the company performs.
• Design long-term incentive (LTI) plans so employees trade economic risk for rewards.Organizations should continue to deemphasize base pay for executives (i.e., by limiting or eliminating any restoration of 2009 salary freezes and reductions). In return, executives should participate in a long-term cash and equity program with an upside opportunity for significantly higher payouts.
This program should require participants to meet tough performance requirements to earn the larger award and should establish a long payout timeline (i.e., eliminate the mindset of 100 percent immediate payout through the use of an extended mandatory deferral period). Participants should forfeit large portions of their award if they leave before a specified time.
Finally, organizations should end the assumed right to long-term incentives based on organizational hierarchy. LTI plan eligibility should include only those individuals and roles (or teams of individuals) whose evidenced individual contribution results in the long-term, sustainable financial success of the enterprise. These tough criteria mean few will qualify to participate, earn an LTI award and/or receive full payout of any award earned.
Talent Attraction and Retention
During the general talent shortage that began in 1998, Sibson Consulting conducted a study with McKinsey & Co. that became known as the "War for Talent." Unfortunately, this title was widely misused to justify a "retain everyone" approach that was soft on performance. In reality, the study advocated just the opposite. Not just about retaining bodies, the study offered a plan for beating the competition by hiring and retaining better talent. At the time, Sibson consultants Jim Kochanski and Jude Rich wrote an article based on the study, entitled "Win the Talent War by Raising the Performance Bar." This is an even greater imperative now that the general economic conditions are not raising performance for all companies.
For example, during the height of the nursing shortage, one hospital in a major metropolitan area actually had a waiting list of nurse applicants. The reason? Unlike most of their competitors, they paid for performance. Nurses who were not pulling their weight were encouraged to leave. According to the hospital, "No one has to carry low performers on their unit." That is a winning formula in any economic environment, at any level of an organization.
Ending Entitlement Won't Be Easy
Many companies probably will lack the fortitude to end entitlement. They likely will slip back into their old patterns as soon as they are able, and the situation could get worse. During the inflationary 1980s, cost-of-living adjustments (COLAs) were the norm. That could happen again (although if inflation returns, employers should realize that they do not have to add COLA adjustments to base pay, where they become permanent).
Organizations that choose to pursue true pay for performance will need a unified coalition of leaders to enforce the rules constantly.
Some managers will try to game the system and get more pay for all their people. Having them justify their actions through calibration of pay recommendations in front of their peers and senior managers is a good way to create the right norms. Nevertheless, some managers will never be comfortable with pay for performance and probably should not be managers. Blaming poor managers, however, will not fix the problem. Rooting out entitlement and creating a performance culture that includes pay takes a unified and sustained effort by business leaders and their HR partners.
Myrna Hellerman is a senior vice president in the Chicago office of Sibson Consulting. She helps companies improve business results through the design and implementation of innovative, effective and sustainable reward strategies. Jim Kochanski is a senior vice president in the Raleigh office of Sibson Consulting. He works extensively with companies experiencing talent or performance gaps.
Reprinted by permission of The Segal Group, parent of The Segal Company and its Sibson Consulting division. © 2009 by The Segal Group. All rights reserved.