Reward strategies drive the cost of one of the biggest controllable costs available to management. The vast majority of organizations want to pay competitively so they can attract and retain the talent they need. But how employees are rewarded can be varied, even if the how much is dictated by competitive pressure and budgetary constraints. And rewards can be structured so they do not increase fixed costs, which may become unsustainable in the future.
Most employees think of their wage/salary when asked how much they are paid. And in many cases that is the only component of direct compensation they receive. Variable (incentive) compensation is fairly common in the private sector, although much more prevalent for executives and sales personnel… it is extremely rare in the public and not-for-profit sector. But there are factors that must be considered when using variable compensation. One is that different approaches are the first choice for organizations and employees. Organizations, if given their preference, would make all compensation variable, based on organizational performance and its current ability to pay. Employees generally would vote for all base pay, since it is certain, although highly motivated and competent employees may opt for significant variability since they believe they will end up getting more.
By delivering all of the current rewards in the form of base pay increases can have a dark side. Over time fixed cost payroll climbs, often to unsustainable levels. Yet a significant portion of the public sector still uses automatic step increases, despite the fact that this is rewarding survival rather than contribution (although the percentage has dropped considerably in recent years). And public sector employees are more apt to stay with the same employer for their career, magnifying the impact of step increases on fixed costs. But even when organizations use merit pay every pay increase is a career annuity… there are no refunds to the organization if performance declines next year. Some industries in the U.S. have in the past so inflated fixed costs that they became non-competitive.
The economic downturn starting in 2007/8 drove home the reality that when available resources decline sharply direct compensation is inelastic. And cuts to wages/salaries are extreme acts of aggression in the eyes to employees. After all, the organization set the pay level and did not mention that if business got worse they could not count on the previous income level to maintain the standard of living they in good faith committed to. Freezing base pay suddenly after employees have gotten used to annual increases is also shock therapy. Due to these realities many organizations found that reducing headcount was the only feasible solution. Technology that can perform tasks done by people in the past became more attractive. More customers had to attempt to have robotic software empathize with their difficulties with the product they had been sold. And the pressure to offshore more activities intensified. All of these approaches left a large number of employees in the U.S. feeling left behind by events.
This author has argued that more reliance on variable pay can help to alleviate the anguish caused by declining revenues when people costs are fixed. But variable pay is even more challenging to manage effectively than base pay. So what can be done to manage base pay better, and to manage it in a way that precludes the use of incentive plans?
The use of merit guide charts is widespread. The philosophy behind these tools is that the largest (%) increase should go to high performers paid low in the range, while smaller or zero adjustments should go to people paid high in the range but whose performance does not warrant the pay rate. Exhibit 1 is an example of a guide chart that incorporates this principle.
The difficulty with this approach is that every increase still increases the fixed cost payroll going forward. And the differences between doing OK and doing outstanding work are too small when budgets are tight, diminishing the motivation to excel.
Another approach is to segment the budget into base pay increases and performance cash awards. Any portion of the budget allocated to cash awards does not increase fixed cost payroll and over time the compounding of fixed cost payroll is lessened. Exhibit 2 illustrates a “combination base pay increase/cash award” approach.
Using this approach the compounding impact of base pay increases is reduced by one-third. But more importantly the use of outstanding performance awards increases the motivation to perform well. Cash awards also have more impact because they show up all at once, rather than in 12 or 26 increments like base pay adjustments do. Base pay increases send the message that you have to work here all year next year to get the full amount, a reality conveniently not mentioned by organizations. So even in the last few years when 2-3% budgets have been the norm outstanding performers would be rewarded well if this strategy were used. And they are being rewarded contingently… the cash award can disappear the next year if performance drops off.
In order to make this approach fully effective there needs to be a sound performance management system in place and managers must be held to a high standard relative to the allocation of ratings and adjustments. This is bad news for many organizations, since performance management is often the weakest link in reward systems. Dropping ratings altogether, trusting managers to use good judgment, is not possible if this strategy is to be employed.
But one must seriously question whether that is sound management anyway.