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Pay for Performance: No Merit in Merit Pay

By Stephen Miller  6/25/2007
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Pay for performance as commonly practiced is broken, and HR needs to take the lead in fixing it. That was the message delivered by Jim Finkelstein, president and CEO of consultancy FutureSense Inc., and Barry MacLean, compensation solutions practice leader for Vurv Technology, during their June 25 Annual Conference session, “Pay for Performance: Idle Words of an Idea Whose Time Has Come.”

“Pay for performance can be a powerful driver of organizational change and success, with one condition: You don’t confuse it with traditional merit pay systems,” said MacLean, who urged attendees to “drop the use of merit increases and merit matrixes altogether.”

 Added Finkelstein, “Pay for performance is at best a driving cultural value; at worst, it’s bureaucracy on steroids.” It’s hard to find employees who are truly motivated by merit increases, he commented. “How many are really engaged and excited to walk into a performance review?”

 It’s not that tying rewards to results is the wrong goal. In fact, the pay system should seek to change behavior and to move people forward in their careers. But, as Finkelstein noted, 80 percent of employees are rated in the 3-4 range on a 5-point scale. This is because it is difficult for managers to justify with higher-ups giving an employee the highest rating or to tell an under-performer that he or she will be getting a lower increase because their work is below par.

At annual evaluations, 80% of employees are rated
in the 3-4 range on a 5-point scale.

Moreover, while the average salary increase for the past 20 years has been 4 percent, most of that is structural change to keep employees’ salaries competitive with the market. And, he said, no matter how much employers disingenuously claim this isn’t so, employees know it is. “The 1.45 percent difference between structural change and merit budget is the real merit budget,” said MacLean.

So, what does that 1.45 percent mean to a typical employee who makes $75,000 after taxes on a yearly basis? “It’s enough to buy a grande latte on the way to work each morning,” MacLean said. “You might as well just tell your employees, ‘Thanks a latte.’ ”

When it comes to motivating behavior, Finkelstein noted, any bonus of less than 5 percent is usually viewed as insignificant, and it takes 15 percent to 20 percent “to make it happen.” End-of-year bonuses are often far removed from the actual achievements employers are trying to reward, and so-called spot bonuses given throughout the year are usually so small they’re viewed as insulting. “It takes a lot of pennies raining down on your desk to make a difference,” MacLean said.

For motivating behavior, it takes a bonus of
15% to 20% “to make it happen.”

The duo touched on several other merit pay problems, including high performers who languish in the middle of their pay ranges as they receive increases equal to the “budget amount,” often less than the ranges’ annual adjustment. Another source of resentment: the continuing inequity between two top performers, one brought in at the minimum of the range and both receiving the maximum allowable increases from the merit matrix.

Starting Over

MacLean and Finkelstein propose a pay system built around market-anchored target pay as warranted by the employee’s competency, performance and potential. They advised HR pay managers to:

• Determine the gap between the current salary and target pay.

• Make salary adjustments
based on the gap analysis and available budget.

“Let’s get the salary right relative to employees’ level of contribution, and, where there is a gap, use available funds to close it,” said MacLean.

This approach means making hard choices in order to allocate available funds where they are most needed to correct the pay gap. “You’ve got to cull the herd,” Finkelstein added. “If you don’t cut [merit pay for] people who aren’t performing, you can’t pay for performance.” But the result will be to reward top performers more effectively over time, retaining the talent that is actually driving success.

Stephen Miller is manager of SHRM Online's Compensation & Benefits Focus Area.

Related Articles:

(Due to SHRM's 2009 website redesigned, some article links may no longer work. Enter article title into the Search function to locate these articles)

More Pay for Performance but Message Not Getting Through , SHRM Online Comp & Benefits Focus Area, June 2007

The Problems with Pay-for-Performance Plans (and What To Do About Them) , SHRM Online Comp & Benefits Focus Area, January 2007

Rewarding Employee Contributions, Not Their Job Titles: A Base Pay Strategy , Comp & Benefits Focus Area, January 2007

Performance Reviews: Large Pay/Performance 'Perception Gap' Needs Countering , Comp & Benefits Focus Area, December 2006

How Kimberly-Clark Ties Pay to Performance , HR Magazine, November 2006

Employers Focus More on Performance-based Rewards , SHRM Online Compensation & Benefits fits Focus Area, September 2006

Does Merit Pay Really Reward Performance? , SHRM Online Comp & Benefits Focus Area, October 2004

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