There is no doubt that pay-for-performance can be an important contributor to organizational effectiveness. It can be a significant motivator of performance and can attract and retain the best performers. But in order to accomplish these important objectives, significant amounts of pay need to be tied closely to performers. When individuals perform well, their pay must go up, and when they perform poorly, their pay must stay the same or go down.
If pay is not high for good performers, not only will it fail to motivate, it will fail to attract and retain high performance. In times of high inflation, it is relatively easy to relate significant amounts of pay to performance simply by varying the size "merit" increases. Of course there is always the problem of whether performance can be measured, and whether individual managers are willing to give significantly different increases to their subordinates. But if there is a will and a way, pay can be significantly related to performance.
The situation is very different today because inflation is low. Merit salary increase budgets are typically in the two to three percent range. This often means that the best performer gets a one percent or two percent greater increase than an average performer. This, of course, is not an amount of money that will motivate and retain high performers. It may have a positive impact because of its recognition value, but it certainly is not a game changer.
A variety of research studies have shown that the difference between okay and outstanding performance needs to be closer to seven to 10 percent in order for money to be an impactful incentive. The implication of this is quite clear for the raises that organizations will be giving at the end of this year. Determining the size of them will, as usual, consume a considerable amount of time and require a great deal of effort on the part of managers and the HR department. Despite this, they will have little or no impact on the future behavior of individuals because the difference between the good performers and the rest will be so small. In short, it will essentially be a waste of time.
What should organizations do with respect to their next round of pay increases? The answer is simple. Change them into one-time payments or bonuses for this year. Yes, it will have the same impact on employees as would salary increases, but it can lead to a much more effective pay system over the next several years. This is a particularly important point because there is little reason to believe that inflation is going to increase greatly, and thus there is little reason to believe raises will get larger. The only way to vary the pay of individuals significantly is to use bonuses. By the second year, a bonus pool could average five percent and if inflation continues at its current pace by the third year, it could average seven percent or eight percent. Now we are beginning to reach a level of pay for performance that will have a significant impact.
Some organizations have already converted salary increases to bonus payments. But quite a few are still procrastinating, perhaps with the hope that inflation will give them more of a chance to give larger pay increases that are based on performance.
There are several reasons why a procrastination strategy is dangerous. Inflation may not pick up for a long time and as a result procrastinators will continue to lose the chance to significantly reward performance. When all is said and done, salary increases are a poor way to motivate performance. Even when they are large, salary increases run the risk of creating an annuity for individuals that does not represent their true market value or their current performance. They are paid for years of past performance not their current performance or their market value. Of course this could be solved by cutting someone's pay, but this is rarely done, and has a significant downside. In the case of bonuses, there is an automatic cut to someone's pay when they are given a smaller bonus. Overall, bonuses are always a more effective way to deliver pay for performance. Now is the time for organizations, if they haven't already, to create an effective bonus system.
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Crossposted from forbes.com