Some people think that awarding these kinds of annual raises no longer make sense.
One of these people is Dow Scott, Ph.D., an HR Professor at the Quinlan School of Business at Loyola University. In his article "Blending General Increases With a Pay-for-Performance Policy", Dr. Scott says that merit increases "have marginal motivational value" and contribute "little to the retention of talented employees."
What's wrong with merit increases in pay? Dr. Scott sees five problems:
- increases of 2 to 4 percent per year are too small to make much of a difference;
- managers who give these kinds of increases are "extremely reluctant" to distinguish between high performers and good performers;
- tenure is the typical driver of pay increases, leaving many older employees overpaid for their contribution;
- folding across-the-board increases into base pay every year permanently ratchets up pay levels, and increases in company performance may not keep pace;
- pay ranges are so wide that modest increases and annual adjustments make it nearly impossible for employees to progress from the bottom to the top of the range.
What's the solution? Base pay adjustments should relate to the market. According to Dr. Scott:
Adjustments in base pay can still occur, but only to account for changes in the price the marketplace pays for a particular position -- not for increases in the cost-of-living or individual performance.
Scott believes that adjusting base pay in response to market conditions "sends the message to employees and their managers that their wages or salaries are pay for the responsibilities and capabilities required to do the job."
Short-term and long-term incentives should be used to reward performance. This has the dual advantage of (1) creating a line of sight between performance and reward, and (2) not permanently ratcheting up base salary.
How do you transition out of a merit increase program? Simple, according to Scott: convince managers and employees that it's not a very good way to reward performance. He states that good communication, combined with employee and manager involvement, leads to little push back from employees on moving away from these kinds of systems.
When it comes to the argument for eliminating merit increases, I can see both sides. It goes without saying that when market conditions for a given job in a given labor market change, adjustments to base pay are needed. I agree that a 2 to 4 percent annual increase is unlikely to inspire dramatic improvements in performance and engagement. There's no doubt that merit increases permanently ratchet up base pay, and there's also no doubt that lower incentive pay this year relative to last year is a lot easier for employees to swallow than a cut in base pay. I'm 100% behind the idea of creating clear lines of sight between pay and performance.
On the other hand, we all know that compensation budgets are tight, and there's no guarantee that a switch to incentive pay will generate more than a 2 to 4 percent increase in total pay anyway. I also have to question the simplicity of convincing everyone that merit increases (which may have been in effect for years) aren't a good way to reward performance. Pay evokes a visceral response, and even though our logical selves understand the argument, our emotional selves may have a hard time with it.
From an economic perspective, moving from annual merit increases to incentive pay eliminates some risk for employers because they aren't locked into ever-increasing costs of labor. But the risk doesn't just vanish - it gets shifted from the employer to the employee. The result is more uncertainty among the workforce about their likely earnings stream. Depending on which school of economic thought you belong to, this could be a significant impediment on the road to economic recovery.
Stephanie R. Thomas is an economic and statistical consultant specializing in EEO issues and employment litigation risk management. Since 1999, she's been working with businesses and government agencies providing expert quantitative analysis. Stephanie's articles on examining compensation systems for internal equity have appeared in professional journals and she has appeared on NPR to discuss the gender wage gap. Stephanie is the founder of Thomas Econometrics Inc., the host of The Proactive Employer radio show, and author of the upcoming book Compensating Your Employees Fairly: A Guide to Internal Pay Equity. Follow her on Twitter at proactivemployr.