The End of the Merit Increase?

Pay for performance is here to stay, but merit increases - possibly the longest running and most prevalent form of performance pay - may be on the path to extinction.  At least that was the conclusion of a number of experts in sessions I attended at this week's WorldatWork conference.

Prevailing sentiment suggests that the future of pay for performance lies in variable pay - and I would be hard pressed to argue with this conclusion.  Base salaries - particularly base salary increases - have shown themselves to be less-than-ideal vehicles for rewarding performance.  The pace of salary growth in recent years is certainly one reason - salary increase budgets of 3% to 4% have made it difficult to carve out meaningful performance rewards.  Even more important, though, is the fixed nature of salary expenses.  As Jay Schuster of Schuster-Zingheim pointed out during the forum "Has Pay for Performance Lost its Meaning?", merit increases are "the gift that keeps on giving."

Unlike merit increases, the variable pay slate can be wiped clean each year, allowing more room and opportunity for experimentation ... and for mistakes ... and for reactions to unanticipated course changes.  This helps create flexibility and agility in reward plan design, enabling organizations to adapt to a fast-changing business environment. 

But it gets even more interesting.  Along with the consensus on the rise of variable pay came some interesting predictions from Ken Abosch of Hewitt Associates in his session "Projecting the Future of Variable Pay".  Ken predicts that salary increase levels may not regain much momentum going forward from today's low point, with employers increasingly investing their discretionary reward dollars in variable pay opportunities rather than salary increases.  If true, this would bring about a real paradigm shift in our salary management practices and programs.  For me, it raises a host of questions, including:

• Would the salary range design and architecture commonly used today continue to make sense if regular salary growth slows down over the longer-term (e.g., would we move toward more narrow salary ranges or some completely different base pay management approach)?

• If regular salary increase budgets stay small, what other approaches and practices would we use to keep pay current with employee skill and competency development relative to the external market for their capabilities?  Would merit increase give way to more skill and competency based increase approaches?

• Would we see more complexity and variability (and less "one size fits all") in variable pay design as this reward moves to a more central role in an individual's compensation package?

• Historically, salary increase levels have been mostly consistent across different income levels.  If this shift plays out, would we see that change?  It seems unlikely to me that we could ... should ... slow down salary growth as much at lower levels than in the professional and managerial ranks.

What's your take? 

Comments

[E James (Jim) Brennan]

Expect more attention on entry rate as the governing metric. More market-sensitive, more elastic, more easily demonstrated as valid than an average or median and much more relevant in terms of maturity curve distance from it, progressions above it and less emphasis on mids and maxes. The minimum market-clearing threshold rate is both more important and more relatively significant than "the norm" which is always problematic and arguable.

[Margaret O'Hanlon]

I think everyone is hoping for an new cycle of creativity in business. Once the engine on the turnaround starts humming, companies will take the time to be introspective again, and spend energy working to truly differentiate themselves. All of which is by way of saying that I think the next wave of pay strategies will need to communicate and support new business strategies of change and creativity.

It's likely that ompetency development will play a crucial role is this transition, so I do expect a renewed focus on some form of competency-based pay. If so, I hope that we develop better tools to illustrate and reward competency development. Our illustrations of behavior change are not yet job-specific enough for most employees to apply easily.

As for narrowing base pay and increasing pay at risk, this was a trend after the last downturn, but the change didn't hold -- except in companies that were clear that their business strategy was best supported through leveraged measurement and results, and who were willing to maintain this discipline company-wide.

[Chris Young]

Great post, Ann - it will be exciting to see where this goes!

I've featured your post in my weekly Rainmaker 'Fab Five' blog picks of the week (found here: http://www.maximizepossibility.com/employee_retention/2009/06/the-rainmaker-fab-five-blog-picks-of-the-week-1.html) to share your thoughts with my readers.

Be well Ann!

[Ann Bares]

Jim:

Interesting. That makes sense to me, but few surveys track it and few salary structures are designed around it (to my knowledge) ... and these things don't turn on a dime. Perhaps a shift on how we manage the competitiveness of our salary programs is on the way?

Margaret:

Competency-based pay can be an administratively overwhelming approach, so it will be interesting to see whether this drives us to create more streamlined and easily managed methodologies.

You may be right that these trends were present after the last downturn, but I sense we may be turning a bigger corner this time. Time will tell, I guess!

Chris:

Thanks for the comment and the feature in your "Fab Five" - always an honor. Readers, be sure and click through to see Chris's other selections - a great array of posts on topics from teamwork to communication to leadership!

[Robert A. Roth]

I have worked for several CFOs who have made the same arguement over the years. One imparticular always stated that our employees suddenly did not wake up and become 4% more purductive the day merit increases went into effect, so how were actually going to pay for all this increase in fixed cost?

Certainly there is room for other alternatives in how we spread the fixed costs across the various employee groups.

[Steven Zawalick]

So, let me get this straight, you propose to fix a system where employees are not motivated by small annual increases in pay with a system where some get larger increases and others get pay cuts? I think this will result in exacerbated politics, denominational drama, and a seriously upset minority whose behavior could well affect the majority. If you are really interested in addressing the future of compensation, this discussion should be about inflation. Once this economy gets traction, costs are going to overheat and take off like a rocket.

Robert Roth posted "I have worked for several CFOs who have made the same argument over the years. One in particular always stated that our employees suddenly did not wake up and become 4% more productive the day merit increases went into effect, so how were actually going to pay for all this increase in fixed cost?"....

How are we paying for these increases in fixed costs? By increasing the price of our goods and services. Duh! This is what the consumer price index is all about folks.

THE bottom line, is that your employees at large are just not going to be motivated by tiny overall raises and that should be no surprise. This results in job shopping, turnover, and knowledge transfer issues. Folks are moving around because it's the only way to get ahead in an economic business culture based on careful bean counting and cost clipping.

What we should be doing is capturing the costs associated with this worker unrest and trading the mayhem of employee turnover with higher raises, establishing a partnership with our employees. This will create a stable, dedicated, and motivated workforce...a gateway to untold profits.

[BG]

It just makes sense to move to this type of arrangement, but the trick is to structure it so that the long term (good for the company) is emphasized over the short term (good for the employee). Easier said than done.

[Ann Bares]

Robert:

Part of the challenge of the 4% merit increase is that it not only must address performance and productivity, but also competitive salary growth. Which is one of the many reasons we are now considering alternatives.

Thanks for the comment and perspective!

Steven:

Please get this straight - I am not proposing anything here (certainly not the "fix" you describe), I am sharing general trend information featured at the conference and asking questions about what it might mean and do. And your point about the potential negative impact of tiny overall raises is one of the things my questions mean to address.

That higher raises are necessarily the gateway - or the only path - to partnership and untold profits is probably a matter of opinion, and the topic of what could be an interesting debate.

[Derek Irvine, Globoforce]

Great post. One of my favorite quotes on merit pay is from Jeffrey Pfeffer (Organizational Behavior Professor at Stanford’s Graduate School of Business and quoted in Workforce Management)

“Typical pay increases are not enough to motivate employees, but they are enough to irritate them. … Even when companies create seemingly significant pay differentiation between low and high performers, the actual cash increase is insufficient to sustain performance – or it drives the wrong behaviors. … Effective management is a system, not a pay plan. The mistake is that companies try to solve all their problems with pay.”

Over on my blog, I wrote about how to motivate employees when merit increases are cut. For the whole post, go to: http://globoforce.blogspot.com/2009/02/motivating-employees-when-merit.html

In summary, though, strategic recognition accomplishes these additional critical goals not fully possible through merit pay:
• Telling employees how their efforts matter – how they are not just working for the company, but with it.
• Encouraging cooperation and teamwork
• Encouraging people to notice and acknowledge stellar efforts of their peers
• Offering a “360° review” performance mechanism
• Offering a means for constant feedback throughout the year
• Making the rate of reward equivalent to rate of effort, employee by employee

[Ann Bares]

Derek:

Thanks for sharing the great Jeffrey Pfeffer quote. The use of pay to resolve management problems is also a pet peeve of mine - and I run into it all the time. If there is an upside to these times when pay dollars are scarce, it is that it forces managers to manage - and to use coaching, recognition and other non-financial means to address employee performance needs.

[E James (Jim) Brennan]

Excellent specific points in that last comment. I learned many score years ago that my generalist background was critical to my success as a compensation consultant (when I did that), because it was usually necessary to prove that the problem was NOT pay before I could proceed to the correct appropriate fix. The knee-jerk response to all problems is to throw money at them, hoping that some will stick to patch over the hole. Long story short, one should never prescribe before first conducting a diagnosis. The more you know about comp, the better you can identify the real issues, which are rarely related to the amount of pay.

[Juliana]

Two things I can contribute to this thought:

1. Higher pay for performance mix would work better in a high trust environment (potentially difficult to implement in Asia) where 'he is the boss's pet' thought is still prevalent and even less legislation to curb pay disparity issues.

2. What if a department which limited pool is staffed with the best employees with limited set budget. While it's easier said then done, making ranking could be counter productive in this situation when everyone is working hard to achieve the goals and we penalize the people who aren't born with the special 'something'. That would send the really wrong msg. But then again, our current system is not exectly perfect either.