Merit Pay's Fatal Flaw

It's likely that your pay-for-performance program has a fatal flaw built into it; an inadvertent side effect of the design that, if ignored by management will almost certainly guarantee failure.

But no one wants to talk about it.

Instead, what you’ll hear is a steady drumbeat of, “We have a pay for performance program.  All employees are rewarded on the basis of their performance.”  But what if those increases won't be enough to move an employee from low in their salary range up to the midpoint, the "going rate?"  What if merit increases alone won't assure competitive pay?

The Problem

The company usually describes their midpoint as associated with the market “going rate.”  Thus any employee who has performed their job responsibilities for a set period of time without performance penalty will reasonably expect that their pay rate should at least equal that market rate.

When that doesn’t happen though, when individual pay remains below midpoint/market, the employee’s disappointment over perceived unfair treatment can fester into reduced morale and disengagement, which in turn often leads to separation.  If the employee is a high performer, the company suffers a significant loss.

Doesn't happen here, you say?  Then test yourself.  Ask Human Resources how their pay-for-performance system works over time, over several years.  Ask them how they’re going to move a new employee's pay from the minimum or low end to the midpoint value.

Look At The Numbers

Let’s look at an example: say you’re hired at the bottom of the salary range, at $80.  The midpoint is $100 and the maximum is $120 (typical salary range).  Your compa-ratio is 80%.  After three years with the market/midpoints rising approx. 2.5% per year, the $100 has become $107.70.  Meanwhile, let’s say you’re performing well, receiving 4% annual increases.  After three years your pay is now $90, and your new compa-ratio is 83.6%.

If you believe that three years of satisfactory (or better) performance has brought you to a point where you are thoroughly familiar with the job, and therefore should be paid the “going rate,” guess what?  You’re stuck at 83.6%, while the moving "market" remains at 100%.

And if you’re fortunate enough to receive a promotion?  Chances are your present 83.6% compa-ratio will likely have you starting the new job similarly low in your new salary range.  So the self-defeating process starts once again.

But what if you’re not promoted?  How many more years will it take to get you to competitive pay?  Are you willing to wait that long?  Or will you become another statistic in the company’s turnover rate?

Cause And Effect

This doesn’t need to happen.

• When a company is caught up in an “everyone deserves a raise” mentality, there isn’t enough money left over to properly reward the higher performers.
• Many companies don’t provide significant reward differentials between performance levels.  Is 1% or 2% enough between your stars and “Joe Average"?   Are you motivating through pay, or simply processing increases?
• When managers fail to consider employee contributions vs. the evolving competitive market.  When decision-makers ignore external realities and instead focus solely on internal balance (equity). 
• Merit budgets are not designed to address the issue of "market creep."  It's as if the company presumes that the external marketplace isn't moving at all.

With the above as a backdrop, an organization's internal pay practices can easily become disconnected from an employee's market value.

Not many companies recognize this inherent flaw in their pay-for-performance program.  Individual managers may notice the danger, but most organizations tend to turn an official blind eye.  Granted, most don’t have the extra money that would be required to jumpstart employees to match their growing marketability.  They don't have enough resources to be fair to everyone; it just costs too much.

Instead, they prefer to take one year at a time, all the while telling employees that the merit system works.

That’s where the cynical viewpoint of some employees is created, suggesting that quitting and getting rehired is a sure way to get the money you deserve.  It's a risk, but I've seen that tactic work.

What can you do?

Develop a Ring Fence: identify your key employees and make sure that they're both competitively paid as well as appropriately paid for their value to the organization.  Build a protective “fence” around these employees, similar to “franchise players” in professional sports.  These are the ones you can’t afford to lose – so keep track of their compensation packages.

Then every year review your entire staff.  Who is paid properly and who is not.  Having this knowledge is half the battle because from this point individual corrective tactics can be devised.

Caution: you may have to limit or even forgo some increases for "Joe Average" employees.  Can you do that?

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The merit pay process usually works well for one full cycle, but for the long term, the mechanics don't provide the compensation level that the employee is worth.   Management touts their merit reward programs as a one-time event, but over time employees will see the fly in the soup, that unless one gets promoted on a regular basis the “system” actually works against you.

But no one wants to talk about it.

Chuck Csizmar CCP is founder and Principal of CMC Compensation Group, providing global compensation consulting services to a wide variety of industries and non-profit organizations.  He is also associated with several HR Consulting firms as a contributing consultant.  Chuck is a broad based subject matter expert with a specialty in international and expatriate compensation.  He lives in Central Florida (near The Mouse) and enjoys growing fruit and managing (?) a clowder of cats.

Creative Commons image, "Employee," by South Methodist University

Comments

[EJames Brennan]

Great presentation on the toxic effects of short-term thinking on a long-term issue, Chuck! You showed the nasty results of limited thinking about pay budgeting.

Those inexorable failures come from ignoring the pay progression needs detailed in the old article http://www.compensationcafe.com/2013/01/solving-the-pay-progression-dilemma.html. Afraid it involves more math than most HR people like, but it fully explains exactly why the disasters you described keep happening.

[Joe Thompson]

Chuck,

I can hear the rejoinder now: "But, developing a Ring Fence isn't 'fair' - that would mean that you are treating people differently!"

I jest, of course, but it is interesting to me that the mantra of fairness is so often used to defend demonstrably poor practices. It is not fair, some would argue, that those in the Ring get more than "Joe Average." The same people tend to argue against differentiating performance levels, too, in my experience. These are often the voices that ask "Why can't we all be rated as 'Significantly Above Average'?"

When did "fair" come to mean "the same"?

[Shawn Miller]

I would say that the market is finally changing to the point where even average performers have more choices. If there are external opportunities and these folks are not pleased with being left “outside the fence” they too may move on.

Maybe the next thought will be that budgeting for employee pay needs to be moved up the priority list.

[Molly]

Thanks, James, for perpetuating a myth that "most" HR people don't like math -- or whatever. You don't do any of us in this profession any favors with that comment. Why tear down a profession so closely linked (the same) as yours?

I've been in HR/comp/benefits long enough to know the problems of "merit pay" -- have known it since I was in college nearly 30 years ago. The issue, most often, is with senior leaders/business owners, who refuse to listen to the sound advice (which includes math examples) of their HR/comp leaders.

Good article outlining the mechanics of the issue - now we just need fearless HR people to confront it head-on.

[Lisa Williams]

Cheering Molly.

Yes, my experience has been with senior leadership. They want to control costs, after all labor is the most expensive line item. Then add in not all managers will review the same and throw in turf protection and you get a messed up comp plan.

On the flip side with the EEOC watching comp, folks go to the old stand by of the easy route, all get the same.

[E. James Brennan]

Aw, gimme a break, Molly! ;-) Doesn't HR typically attract a "people person" versus a "number-cruncher"? Ann Bares wrote http://www.compensationcafe.com/2011/10/what-hr-wants-to-do-not-compensation-benefits.html about career preferences, plus I've also published research results here about the different KSAs required in sub-fields of our profession. Recruiting, negotiating and employee relations do seem to be more popular choices than the actuarial, mathematical and statistical aspects of "personnel" work.

HR is a big wheel with many spokes, and I've worked in all of them; but I never completely understood all the subtle interactions until my compensation and total rewards years. It's all fun.

[Scott B]

There's really only a few solutions to this age-old problem. 1) Hire higher - "easy" but costly, and maybe not always justifiable in terms of ROI. 2) Promote frequently - hard to do for a large group. 3) Build Chuck's ring around high performers and give very small or no increases to Joe Average. Choice #3 is fraught with peril in today's litigious society - document carefully and thoroughly. Plus, if a lot of your Joe Averages leave due to no increases, you'll put a lot of extra burden on those in the ring, and risk burning them out.

If you can't pay all your average or better performers at- or near-market, you'd better give them other reasons to stay. Some do this through company culture and/or through other areas of total rewards, like really cheap medical insurance, generous PTO plans or tuition reimbursement without claw-backs.