Should We Eliminate Merit Increases?

Do you give your employees merit increases? If you do, have you thought about why you do it?

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.

Comments

[Jacque Vilet]

I agree Stephanie. I don't think I would want to risk keeping base salaries status quo in this environment. Even if there is still not a lot of turnover right now, companies are anxious to keep the employees they have --- especially since they say they can't find the "talent" they want on the outside.

[E. James (Jim) Brennan]

Relying only on contingent compensation to differentially reward your best workers is a chancy tactic that can backfire. If your consistently best producer has an off year but does not carry a strong base pay (like at a 110% market ratio) forward and their TC is permitted to sag to 95% or 100% of the MRP, they may get disgusted and accept the next offer that acknowledges their usual lead status. The Federal General Pay Schedule operates the way Dr. Scott seems to prefer. While it is sometimes effective in retaining competent workers, it is not renowned for its ability to activate excitement. Yes, adequate differentiation is quite problematic when so little money is available for increases, but P4P is the horse what brung most progress in the last sixty years and will be quite difficult to abandon.

That said, his observations are valid, but there are many other preventive and contingent options besides the wholesale revolution that would be required to eliminate the traditional effect of cumulative merit performance sustained over many years on base salary. Easier to start fresh that way than to convert a normal pay program where contrary expectations had been established.

[John A Bushfield]

Dr. Scott has put his finger exactly on where the future of reward and recognition is headed. The only component he left out is total transparency with regard to who makes what, and his suggestions make that exercise easier to accomplish.

Sure, change is risky. Sure, current economic conditions are dicey and uncertain, and attracting and retaining top talent is challenging. So what's new? Strap yourself in and put your tray tables into their full upright and locked position, 'cause what we're experiencing ain't going away anytime soon.

Annual merit programs and P4P philosophies may have worked in the past, just like buggy whips were once a very effective transportation accessory.

Dr. Scott, while minimizing the difficulty of execution, has it right, and I applaud his views.

[Marilyn]

Clearly Dr. Dow Scott is living in an academic world and has never had to administer such a program. For those of us in the compensation trenches, determining increases by position is a tremendous amount of effort and I certainly don’t have a bevy of comp analysts to review competitive practice for every job, every year.
We’ve gone away from the “merit” concept this year for the first time and trying to focus managers on building employee engagement for all the reasons cited in the article. So I guess we are on the cutting edge. It’s been a hard pill to swallow for some of our managers and I’m not sure they’re buying it. It has to be backed up with LOTS of manager training on how to recognize and reward performance with other means besides an annual increase.
Only time will tell…

[Earl Sweatshirt]

Per 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."

That's a doozy there. Other companies grant merit increases to their employees, you fall behind the competition and have to give a base salary adjustment to catch up. Great idea! Is the adjustment performanced based? He didn't say so! Back to the drawing board with this great idea! What you have here is a defacto merit increase plan.

[Dan Walter]

Merit (from freedictionary.com)
a. Superior quality or worth; excellence: a proposal of some merit; an ill-advised plan without merit.
b. A quality deserving praise or approval;

"Congratulations! You are at the top of your group. We are so impressed that we are going to give you a 3% raise!"

I can't imagine why that message is not compelling.

There is a problem. The time-tested merit increase, as performed by most companies, is not the solution. Some companies will be able to enact Dr. Scott's ideas successfully, others will need to find different solutions. Very few can confidently argue that the status quo is truly effective.