Rewarding Performance With A Limited Budget

Economists are divided about the direction the current economic environment will take over the next few years. The last five years have been prosperous for many organizations, domestic and global. But compensation levels have not increased rapidly, despite very low unemployment rates. During recent years the rate at which pay levels have increased has been very low compared to historic averages, although pay rates have recovered somewhat from the economic downtown that started in 2007-8. According to the Salary Budget Survey published by the World at Work the low point for salary budgets was 2.2% in 2009, when the full force of the downturn that began in 2007 was felt. Since then the budgets have slowly increased to 3%, where they are projected to stay for 2019.

With unemployment being as low as it is in the U.S. it has surprised many that pay levels have not increased at a more rapid rate. Possible explanations have been plentiful but whether it is uncertainty on the part of organizations or some other factor the historically low rate of 3% does not provide the resources required to reward performance adequately… at least in the way most organizations have allocated budgets. Over the last 45 years salary budgets have on average exceeded the inflation rate by 1%, which offered organizations the latitude to keep raises larger than the cost of living. But during the 2005-11 period the gap between inflation and budgets was less than 0.5% (the exception was in 2009 when inflation was zero or negative). Since 2016 there has been a gap of less than 1% between budgets and inflation.

Given the current realities the question facing most compensation planners is how to optimally allocate the 3% budget. Since inflation was 2.4% in 2018 and is not expected to change much in 2019 organizations will struggle to increase real wages for their workforce by much. A second challenge has been moving employees through established salary ranges at a rate the convinces employees they are being fairly compensated. Since structures are typically anchored by tying the range midpoints to competitive averages prevailing in the labor markets an employee who has been in a job for at least five years and performed well will be likely to believe that (s)he is entitled to be paid at or near the midpoint. Making that happen given the current realities is a big challenge.

Optimal Allocation of Budgets

Most organizations using merit pay systems, the most common form of pay for performance, create guidelines to help managers allocate the budgets they are given. An example of a model for guiding increases is shown below. The assumptions are:

  1. a 3% budget,
  2. pay rates are evenly distributed across the pay range, and
  3. performance ratings are distributed as indicated in the table.

There are two principles underlying this approach:

  1. People who perform at higher levels should receive larger increases,
  2. Since increases are expressed as a % of current pay those in the lower part of the range should receive a higher % of their relatively low pay than those in the upper part of the range whose pay is significantly higher. If both parties were to receive the same $ increase the effect would be similar. If an organization has a weak performance management system this approach will not work well, since measuring performance accurately is not possible. And if an organization does not believe in differentiating based on performance their system will not result in pay actions that motivate performance.

Many public sector entities still use automatic, time-based step increases, which ties pay adjustments to longevity rather than performance. These systems do not provide motivation to perform well and they do not work well when economic conditions vary. The U.S. President claimed to have frozen pay for federal employees in the GS system for two years during the economic crisis, but in fact only froze the pay structure. Employees still got 5% step increases irrespective of their performance, which cost taxpayers more than competitive market conditions would have dictated. And when pay rates escalate more during good economic times the step rate system fails to reflect the realities prevailing in the market. Over the last decade a large number of public sector entities have converted their step rate structure to open ranges that enabled them to align more closely with competitive practice.

Although the merit pay guideline model is widely used there remains the issue of how well the system motivates people to perform well. In the model shown here the increase for an outstanding performer is twice that of someone who meets standards, assuming their pay rates are in the same zone of the range. The relative size of the increases would seem to send the message that performance is valued and rewarded. But the absolute size of the increases is likely to be the focus of employee scrutiny. Is a 5% increase (which is only 2.5% greater than the increase for someone meeting expectations) adequate for someone who is in the top 10% and whose current pay rate is at or near market average levels? When that employee asks why the reward for “leaving it all on the field” was not greater one of the responses could be that the budget is small and that employees who meet standards should receive some reward, even though it is only half of theirs on a relative basis. If that outstanding performer has read a good book on compensation management they might respond by saying someone who is at or near market and who just meets standards may not need an increase.

Finding the optimal allocation approach is important if employees are to view the distribution of budgets as equitable, competitive and appropriate. But there is no one “best” answer for an organization. There are other ways to approach allocation. One is to introduce performance-based cash awards. If pay rates are reasonably in line with competitive levels further base pay increases increase fixed costs, since pay adjustments are career annuities in most cases. By allocating 1% of the 3% budget to performance-based cash awards the approach shown below can provide a greater reward for performance. It also reduces the rate at which payroll cost is compounded.

This approach increases the impact of performance ratings on awards and for that reason it should not be considered if the performance management system is not well designed and accepted as sound by the parties at interest. Hooking up higher current appliances to old wiring may not be wise and differentiating this dramatically based on performance ratings should be considered only when those ratings are trusted.

A final option when there is considerable uncertainty about the organization’s short-term economic outlook is to replace base pay increases with cash awards, at least in the short-run. This avoids increasing fixed costs and receiving the award in one lump sum may be more attractive to employees than working the whole year to get the full amount.

Organization culture will certainly impact decisions about how to allocate budgets. So will the nature of an organization’s revenue stream. If revenue is highly variable spending the budget for base pay adjustments increases fixed costs and that can cause a misalignment between revenue and costs… not a good long-term strategy. If revenues fall dramatically and management decides payroll cost must be frozen or even reduced another set of issues arises. Payroll reductions can be accomplished by reducing pay rates or reducing staff size. I was asked by the HR Director of a city how they should reduce payroll by 1.5% without terminating employees during a crisis period. The person was astute and realized that given the costs associated with terminations would probably outweigh the savings in the short run (see Responsible Restructuring by Wayne Cascio for an excellent treatment of these issues). We discussed ways of reducing pay rates, the last option on the table, and decided they could cut the rates of the highest paid people by 3%, those in the middle by 1.5% and not to cut the pay of those closest to subsistence level. But the complexities of executing that strategy were daunting and another option surfaced. Employees were contributing only 5% to the cost of health care benefits, when the competitive range was more like 20-25% of the cost, so increasing the contribution rate could produce the savings needed. This was an approach that had the double benefit of avoiding pay cuts and also adjusting the employee contribution share to a more reasonable level. Pay cuts can be viewed as a breach of an emotional, if not legal, contract and the prospect of cutting pay can spur ingenuity by compensation practitioners.

The good news would be that everyone is in the same boat, struggling with allocating small budgets optimally. But that is of course not the case. Some organizations are in a position to budget more for awards, whether they be in the form of base pay increases, cash awards or even equity. The playing field is not level. Each organization needs to compete for talent in a manner that fits their realities. Some may choose to differentiate across the workforce, rewarding people in critical occupations that are in short supply more generously. Although that can raise equity issues economic realities may mandate it. To reiterate my favorite principle: what works if what fits… a specific organization at a specific time.