Your Merit Pay Program Has a Fatal Flaw

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Apr 20, 2018

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 how the pay-for-performance system works over time, over several years. Ask how a new employee’s pay will move 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 approximately 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?

Causes and effects

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?

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.

This was originally published on the Compensation Café blog.

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