Pay-for-Performance: Look Before You Leap!
By James T. Stodd, SPHR
As employers struggle to increase employee engagement and productivity, there seems to be a surge of interest in compensation and reward systems that will generate higher morale, enthusiasm, engagement and performance among- the troops. One of the topics getting a lot of attention today is “pay-for-performance” (P4P). In fact, I’ve seen at least five articles on the topic circulated in major HR and management newsletters just this week alone! But despite the current frenzy, we need to step back and recognize that P4P is not at all a new concept! Rather, these programs have been around for years and have demonstrated both positive and negative features that need to be carefully considered before you take the P4P leap.
What is “Pay-for-Performance”?
From a human resource management perspective, P4P programs are simply a means of providing financial rewards based upon performance or contributions. When considering P4P, most employers focus immediately upon base pay (or salary), although P4P can include other forms of compensation.
When applied to the administration of base pay/salary, the way P4P programs generally work is by awarding pay increases to employees based solely upon “performance”, and awarded in the form of “merit” increases (typically awarded annually), rather than on the basis of some other considerations such as cost-of-living, market trends and adjustments, general increases or other approaches where employees tend to be treated the same regardless of their talents, contributions or performance. The argument is that employers (and high performing employees) gain by differentially rewarding employees in favor of those that contribute the most!
Merits of “Pay-for-Performance”
At the conceptual level, P4P makes a lot of sense, most certainly from the employer’s perspective! In addition, they often appeal to an employee’s sense of fairness and equity as well, particularly to those who have exerted great energies to do well for their employer or made extraordinary contributions. Also, these P4P programs do not contribute significantly to fixed cost since most employers adopting these programs were going to award pay/salary increases anyway. In sum, P4P seems to be an approach for “how” we go about awarding pay increases with appeal (at least conceptually) to both employers and high performers.
Watch Out for the Sink Holes!
History has shown, however, that there are a number of serious problems and pitfalls associated with P4P programs when applied strictly to base pay and salary increases. These problems aren’t conceptual! Rather, they have to do with how these programs are designed and implemented, with the first couple problems based upon sheer economics:
1. Economic Decline: During the Great Recession and the years immediately following, employers as a whole provided little if any pay increases! Needless to say, the whole P4P concept falls apart when employers are not providing raises of any magnitude.
2. Raises in Relation to the Cost-of-Living: During the last couple of years an increasing number of employers have been giving raises. In fact, in the US average base pay/salary increases are projected at approximately 3.0{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7} for 20121. Moreover, most companies adopting P4P programs plan to provide as much as 5.0{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7} increases to high performers, 3.0{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7} increases to average performers, and little-to-no-increases to those performing at a less-than-average level.
At the same time, the Consumer Price Index2 is tracking at approximately 1.4{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7} for the preceding 12 months. At this rate, approximately half of the increase granted to the average worker will be completely consumed by increases in the cost-of-living. And, given the propensity of employers to shift rising health insurance costs (at least in part) onto plan participants, most employees (including “high performers”) are likely to see most of any “gain” they have realized through “merit” completely eroded in their paychecks.
The “net-net” of all of this leaves little to excite employees toward greater commitment, engagement and/or performance.
3. The Inherent “Zero-Sum” Game: In order to keep aggregate pay increases (and fixed salary costs) in line with market norms, P4P programs often require supervisors to rank employees, segregate them on the basis of “performance”, or use some form of “forced distribution” that requires comparing employees to one another. These “zero sum” strategies (i.e., robbing Peter to pay Paul) may be fine if we are talking about piece-rate production workers, commissioned sales reps, or others whose jobs strictly involve individual efforts. But the reality of today’s modern organization is that “interdependence” is often the name of the game, and most employees can accomplish little without the help of others. That being the case, it just doesn’t make sense to adopt a compensation strategy that inserts “competition”, and perhaps even “conflict”, within mutually dependent teams, work groups and departments when the culture desired is one based upon teamwork, cooperation, collaboration, and connectivity.
4. Subjectivity in the Evaluation Process: As hard as we may try, the reliably and validly of most performance appraisal systems is a real challenge since most performance evaluations are heavily laden with “subjectivity”. This is particularly the case with rating systems that require comparisons be made to other employees (i.e., average, above average, below average) and not against some objective performance standard.
5. When “Above Average” is the Real Average: Let’s face it, nobody shoots for being “average”. Moreover, none of us wants to see our hard work, efforts and contributions labeled as “average” let alone “below average”; it’s insulting and not going to be well received! As a result, the true “average” is usually a rating of “above average” to “good” when performance appraisals compare employees to one another. In these situations, P4P programs seem to undermine their own intent.
What Will Work?
The problems and pitfalls noted above do not mean that employers need to abandon all efforts to base pay and salary increases on the basis of contribution or merit. But they do pose significant challenges that any good system will have to overcome! Here are a couple of suggestions to make your P4P initiatives more successful when applying them to base pay or salary increases:
1. Use Objective Standards in Performance Measurement: P4P employers need to adopt performance measures that compare an employee’s performance against some objective standard (or set of standards) appropriate to the job, rather than relying upon comparisons of one employee to another. Yes, this may require some additional work on the part of managers and supervisors. However, clarifying what it takes to be a “top performer” in job-related behavioral terms will generally be worth the effort!
2. Eliminate the “Zero-Sum” Game: Assuming the value of high performance exceeds the cost of pay increases associated with those contributions; P4P employers should also ensure that each employee will be given the opportunity to excel against what is “doable” and “achievable” within their unique role. In addition, they need to be rewarded accordingly even if that means the majority is given top-level performance ratings. Doing so creates a “win/win” for both employers and their employees!
3. Insure Some Gain: For a P4P program to be truly successful, employees (particularly top performers) need to realize some fruitful “gain” against normal inflation and other factors which diminish the value of the rewards they receive for their achievements. Without the possibility of fruitful gain, P4P programs just seem to be a lot of “talk” with little substance to back them up.
4. Consider Adopting a Performance Management Matrix: Matrices similar to the illustration below have been successfully used by many companies to strengthen their P4P programs. Uniquely, these matrices are established to provide pay increases based upon both a) an employee’s performance (“merit”) and b) the incumbent’s current salary within an established salary range.
Sample Performance Management Matrix
Merit Increase Opportunity by Performance Level
Unsatisfactory
Improvement Needed
Meets Expectations
Outstanding: Exceeds Expectations
0{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
0.0-1.5{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
1.6-2.0{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
2.1-2.5{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
0{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
0.0-2.0{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
2.1-2.5{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
2.6-3.5{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
0{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
1.0-2.5{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
2.6-3.5{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
3.6-4.5{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
0{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
1.0-3.5{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
3.6-4.5{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
4.6-6.0{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7}
4th Quartile (or Above)
3rd Quartile
2nd Quartile
1st Quartile
Minimum
Midpoint
Maximum
Current Salary
The overall intent of these matrices is to make sure that the employee’s base pay/salary is commensurate with their competencies and contributions relative to those holding similar positions within the market. They do so by providing substantial pay increases for high performers whose current base pay is “low” relative to market norms, and offsetting those costs against relatively small increases (or no increases) for those whose current base pay is already “high” given both their performance and contributions.
Performance management matrices are rather elegant solutions and frequently popular with compensation “geeks” such as myself. However, they too have drawbacks. First of all, they require that you have a well-established salary structure that is competitive within your industry. Second, like other P4P programs they often rely upon subjective performance evaluations prone to all the pitfalls noted above. Finally, these matrices add a level of complexity that is often very difficult to explain to many employees.
Summary
Creating an effective P4P program can be a difficult challenge for some organizations since improving the objectivity of performance measures requires the ongoing commitment of managers and supervisors to make it work. In addition, abandoning the “zero-sum” strategy can result in increased uncertainty and unpredictability regarding future salary expenses, and this is often unpopular with many CFO’s! So, if the value to be derived by your organization in doing these things is questionable, perhaps you should rethink trying to apply P4P concepts to base pay and salary administration. Rather, you might want to look at other strategies for linking rewards to desired performance levels.
Think about your current program. Are your performance measures job-related and objective? Do you give each employee the chance to perform like a “star” and be appropriately rewarded based upon that performance? Are the raises you provide your staff sufficient for them to realize some fruitful gain?
Then, stay tuned to our October newsletter which will address additional strategies and options for linking formal rewards to desired performance.
1 2011-2012 Culpepper Global Salary Budget Survey 2 US Dept of Labor, Bureau of Labor Statistics, Consumer Price Index-All Items for 12 months ending July, 2012 (unadjusted)
About the Author
Jim Stodd is a Principal and Managing Director of JT Stodd & Associates. Jim has helped numerous clients develop the organizational architecture and infrastructure required to achieve their strategic visions and goals. In addition, he has assisted other organizations to build strategically-focused and highly successful human resource management programs by introducing forward- thinking approaches to talent management issues. Before starting an independent consulting practice in 2001, Jim spent more than 15 years in senior management positions where he was responsible for human resources, organization development and change management. In addition, he was associated with several leading professional service firms including Ernst & Young LLP, Hay Management Consultants, and First Transitions, Inc. Jim is a specialist in Strategic and Organizational Planning, Change Management and Human Resource Management. He currently teaches classes in those subjects at Louisiana State University and the University of Louisiana-Lafayette. Prior to that he taught at the University California-Irvine where he was a recipient of UCI’s “2010 Distinguished Instructor Award”.