Pay Changes: Making Sense Of The Nonsense

It looks like 2017 will be another year when employees will get small "merit" pay increases. There is no evidence that inflation is picking up, and every indication that corporate budgets for pay changes are going to be 3% or less. In the past several years, this has meant that employees are told that they are getting merit increases, but rarely does anyone get more than a 4% or 5% increase or less than a 2% increase. As a result, performance is not very effectively rewarded in most situations. It clearly raises the question of: "Are employees being properly paid with systems that yield these kinds of pay increases?"

The best way to answer this question is to look at what organizations can potentially gain by changing the pay of their employees. The answer here is clear: performance motivation and retention of their best employees. Significant pay increases can motivate employees to perform and they can result in a more attractive workplace, thus improving performance and turnover. But, in order to accomplish this, there must be significant changes in what individuals are paid and the differences must be based on performance and the labor market. Clearly, a few percent difference in the amount of a pay increase is unlikely to prove to be a powerful retention device or motivator of performance.

Now is a good time for organizations to look at their pay systems and consider how they can redesign them so that they will increase the pay of individuals who have increased their market value and to significantly reward individuals who have performed well. The best way to accomplish this is to base changes in people's pay on their acquiring new skills and on their performance. There is one significant difference, however, between how employees should be rewarded for gaining skills and how they should be rewarded for performance. In the case of performance, it is typically best to reward them with a bonus payment. In the case of acquiring new skills, a change in their base pay is usually more effective. The difference here is based on the fact that individuals continue to have the skills even if future pay increases do not directly depend on having them. On the other hand, highly motivated performance may not continue unless there is a continuing need to earn a significant new pay for performance reward.

Essentially, what needs to happen here is that base pay needs to depend on how much skills are rewarded by other organizations in the labor market. The position of individuals' pay in the labor market should be reviewed every six to 12 months, and where appropriate base pay increases given so that their pay rate matches or exceeds what others pay for similar skills.

The situation is different with respect to pay for performance. Here it is important to assess performance effectively and generate a bonus based on how well an individual has performed. Depending on the organization, the size of the bonus pool available for individual rewards may be made contingent on the organization's profitability or other organizational performance measures. In most cases, this should fund bonuses that are distributed based on the performance of individuals. The bonuses paid to the best performers should be at least 9% or 10%.

In the long term, a system which bases performance rewards on bonuses and base pay adjustments on skill acquisition is likely to be effective in both high and low inflation environments. It should be effective in motivating performance because there should always be rewards for performance and retention. Since it creates the possibility of moving people's base pay in concert with the labor market, ensuring that they will not be easily attracted by higher paying jobs elsewhere, it should be effective in retaining effective employees.

In summary, it is time to move away from classic merit increase programs, which are still dominant in most U.S. organizations. They simply are ineffective, time consuming and likely to be more counter-productive than productive. They don't respond effectively to changes in the labor market or operate as motivators of performance. In fact, it may be that the civil service type pay, which is based on seniority and position, is superior to the type of salary increase programs that most organizations operate, but that's for another post.