Time To Rethink Pay Structure Design?

In 2006 a research-intensive organization designs new pay structures for its employees. The Scientists & Engineers represent about 2/3 of the workforce, mostly data scientists and software engineers. The organization creates career ladders with four levels in each job family (Associate, S/E, Senior S/E and Principal S/E). A comprehensive review of prevailing practice and competitive pay levels produces four grades for each family and pay ranges with a midpoint to midpoint progression of 20% and ranges that are 50% wide. The framework is set for the administration of a merit pay system.

For the next five years prevailing pay rates in the relevant markets are flat, due to a significant economic downturn. Surveys show that pay- rates are going up at 2-3% per year and that structures are being increased by 1 – 2%. The organization was able to afford a budget of about 3% each year and believed it was tracking the market levels with that level of spending. And the pay ranges were increased by 1% each year. Since the organization was a government contractor it was obligated to pay no more than market average and diverging from that created a breach of contract. But an in-depth analysis of the surveys by one of the data scientists discovers that the methodology used by the surveying organizations is flawed and statistical anomalies have been created because of this. The surveys reporting on budgets failed to realize that when the economic picture darkened a number of organizations stopped reporting their data. After all, if you have frozen pay and/or reduced pay or staff levels why would you bother to report in the survey, so you could pay for data you would not be acting on? The surveys of pay levels suffered the same deficiency and they showed a continued increase in competitive pay levels when in fact that result was attributable to sample change and market levels had not actually moved.

Now the organization faces two problems. 

  1. One is that their spending level has outpaced the true market movement and since they were at market previously they were now ahead of the real market average.
  2. The second problem is that employee pay rates are still significantly below midpoint. Since their pay policy included a clause that stated that satisfactory performers should reach their range midpoint in about 5 years they clearly had not fulfilled that commitment. Employees began to complain that they must be paid well below competitive market rates because of this. So the reality was that the organization had run ahead of the market but was perceived to be below market. How could this happen if it had supposedly followed the market?

A 40 year analysis that I did recently shows that on average pay levels have moved about 1% per year faster than cost of living and about 1.5% per year more than average pay structure movement (see a prior posting). This means that an employee newly hired or just entering a job who starts at or near the minimum is going to take about 18 years to reach range midpoint. This is going to create discontent, since being fully competent in a job but being paid well below the market rate contradicts how pay levels should be distributed in pay structures.

Perhaps the realities of the last decade (and likely near future) makes the traditional pay structure design obsolete. There is greater pressure on organizations to motivate the most capable employees to contribute their best. Yet research has shown that when an outstanding performance rating results in a pay increase that is only 2-3% more than someone rated as satisfactory it is unlikely that they will view that difference as warranting the extra effort and as being equitable. And being below range midpoint for very long is likely to be viewed by exceptional performers as a failure on the part of the organization to appropriately reward their contribution.

The most common range width is 50%. So is a 50% range too wide for the current context? Should ranges be narrowed to 25% so those entering a job at the range minimum can be brought up to the midpoint in a more reasonable time? One approach is to have narrower ranges for jobs with shorter learning curves and with limited ability to contribute much more than satisfactory performance. And many organizations do that. But is 50% still workable even for professional and managerial jobs, or should they be truncated as well? The “broad-banding” fad that seems to break out every 7-10 years has pretty much withered again… 100-200% ranges are useless when it comes to administration, since they no longer serve as control parameters. When I bring the possibility of narrower ranges up I typically get resistance because there is a perception that a lot of headroom above competitive market levels is necessary to accommodate long service people. But how many jobs allow incumbents to contribute value at a level that warrants paying more than 20% over market? I get considerable resistance when executive jobs are being considered, but there has been a trend to use variable pay much more, to provide upside income opportunity that is warranted when results are stellar. Tech jobs have really created a challenge. When Bill Gates said his top programmer was at least ten times as productive as the second rank does that mean pay levels have to reflect this?

That would challenge organizations in two ways:

  1. justifying that relationship
  2. finding the money to fund it.

It is surprising that many tech firms have not turned to variable pay more extensively, since in theory extraordinary contributions could be compensated with one-time awards, avoiding rapid compounding of fixed cost payroll.

The existence of wide ranges when time-based step progression is used can produce excessive pay levels… and pay levels related to longevity rather than performance. This is still common practice in the public sector, although steps are disappearing at many entities. And since inflated base pay rates inflate generous pension benefits it results in indefensible benefits cost escalation. There is less pressure on costs in the not-for-profit arena and it is difficult to convince city councils, county boards and state legislatures to begin to exercise the necessary level of restraint, particularly near elections. If steps are to continue for some jobs it seems reasonable to limit pay ranges to no more than 20% in width.

Each organization should seriously question whether their current pay structures and pay administration programs are effective and appropriate in this era. Although it is difficult to predict the next 10-20 years most Economists would advise that organizations anticipate wide economic cycles with patterns that have not been seen in the past. In 2018 there is little evidence of increasing pressure on pay levels even while unemployment is at the lowest level for many years. Continuing to operate with pay structures and practices that seem to be out of synch with the environment seems a chancy strategy.

If I were running a start-up or emerging organization I would put tight constraints on base pay levels and I would look to well-designed incentive programs to motivate the desired results and to control the growth of fixed costs, such as base payroll. When downturns in fortunes materialize it is far easier to retain critical talent and avoid dysfunctional downsizing when you are not faced with cutting base pay to achieve immediate cost reductions. Every base pay adjustment is a career annuity – employees do not accept your request for a refund when revenues drop. They after all base their standard of living on base pay and look at reductions as a breach of contract – emotional even if not legal. Replacing a portion of base pay increases with variable pay awards is not a simple task however. An earlier post addressed a test of readiness for using variable pay. And there may be employee resistance. But an “all base pay” direct compensation package has all of the issues just discussed. And aligning rewards with organizational performance in addition to individual performance may create a shared destiny mindset, which should convince employees they are a part of a larger organization and the funds for rewards has to be generated somehow.