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Can Pay for Performance Really Work (live copy)

July 29, 2001
At a time of economic slowdowns and uncertainty, a compensation concept suchas pay for performance is particularly tempting and increasingly popular. Arecent survey by Hewitt Associates LLC found that nearly 8 in 10 companies havesome kind of variable pay system, up from fewer than 5 in 10 in 1990. It's anunderstandable trend at a time when revenues slump, stock options shrivel, andacross-the-board raises just aren't feasible for many organizations.

The question for HR people who wonder if they shouldfollow suit is this: does pay for performance really work? The answeris that while pay for performance can work, it's not the solution for everyorganization.

The range of opinion about pay for performance is broadand deep. Its proponents say that rigorous, long-term pay-for-performance systemsoffer effective methods of helping companies continually improve the workforcewhile getting and keeping the best people. Opponents argue that incentive payplans tend to pit employees against one another, erode trust and teamwork, andcreate what critics call dressed-up sweatshops.

Sometimes, it's bad even while it's good. Lisa Weber,executive vice president of human resources for MetLife, calls the shift toa pay-for-performance model "absolutely gut-wrenching. Some people hateit."

But after MetLife placed all employees on a ratingscale that is subject to change based on the performance of specific goals andcore behaviors, the company's return on equity jumped from 7 percent in 1998to 10.5 percent in 2000. "It's been tough, but it's been fabulous,"she says.

The concept of pay for performance isn't new. Eversince ancient Mesopotamians were paid by the basket for picking olives, there'sbeen some form of performance-based pay. In the modern era, the term is usedfairly loosely: commissions and bonuses are often thrown into the definition.

For the purposes of this story, pay for performancemeans a variable pay approach that is anchored to a measurement of performance,whether that's how many hours an attorney bills every month or a more subjectivestandard -- how well a manager fosters teamwork, for instance. Often, evaluationsare based on best-to-worst forced ranking systems -- known to many employeesas rank and yank -- which are thought to provide a way of identifying and rewardingstrong performers and encouraging everyone to work harder and smarter. Truepay for performance is more formalized than an occasional attaboy bonus. Itis variable compensation that must be re-earned each year and doesn't permanentlyincrease base salary.

What makes it work?
When it is measurable and objective: Pay forperformance is not limited to such environments as assembly lines or the pieceworkarena. It can translate to any business, including banks, accountants, and legalfirms, says Niki Somerset, a management consultant in Virginia Beach, Virginia,who has helped many businesses move from a straight salary plan to a performance-basedprogram. "Incentive pay has always been quietly done in boardrooms,"she says. "If you've got 250 attorneys in 30 cities, you've got to setprojections, people have to be productive. Billable hours are the ticket."

MetLife measures employees and managers by comparingeach person to others who are on the same level. Employees are measured on a1-to-5 scale. The company then calculates which employees are at the top, inthe middle, and at the bottom. Employees who rate a 3 receive about 65 percentmore in bonuses than those who earn a 2. A person rated 3 might receive a bonusof $6,900, whereas one who was rated 2 would get $4,200.

The company is concentrating a great deal of attentionon the most senior 250 of the organization's 46,393 employees, says Weber. Theyare evaluated on their individual performance results and on questions suchas: Do they show partnership? Do they demonstrate teamwork? Do they create heroes?How dedicated are they to learning and development?

Synygy, Inc., the largest provider of incentive managementsoftware and services, implemented its own plan a couple of years after thecompany was founded in 1991. Company spokesman Oliver Picher describes it asa bonus program that ranges in amount from 5 to 100 percent of an employee'sbase salary and is paid quarterly. Evaluation ratings are set by a "mentor"(supervisor), and also by coworkers who use an appraisal system called OPTIC:Ownership, Professionalism, Teamwork, (Continuous) Improvement, and Client Focus.

Employees are rated on a 1-to-5 scale. Objectives areset at the beginning of the quarter and at the end, and everyone in the companyparticipates -- whether clerical worker or top executive. As director of publicrelations, Picher says, he is evaluated on responsibilities that apply to hisspecific job, such as the number and quality of press releases and their impact,and the contacts he's made with specific people and organizations.

When it is designed for whole-company success:Pay for performance is often criticized for tilting a company toward one measureand away from another. Individual goals can pit workers against each other.A plan that focuses only on output will invariably suffer in the area of quality.

At MetLife, the focus is on individual performance,but "it's not OK to step on people's toes," Weber says. "Youmust rate high on partnership and teamwork. If you're a great performer buta terrible team player, you won't do well."

Financial results shouldn't be the only measure forpay-for-performance success, says Margaret Bentson, principal compensation managerat Hewitt Associates, San Francisco. Customer service should also be considered,with a scoring system that might include such factors as on-time delivery, reductionin the number of returned products, and client satisfaction surveys. "Theidea is to marry the fortunes of the employee to the performance of the company."

When employees have a sizable stake in the action:At Nucor Corporation, the largest steel producer in the United States, the secretto success is to give huge bonuses of 100 or even 150 to 160 percent, says JamesM. Coblin, vice president of human resources. "That's when employees catchfire."

The Charlotte, North Carolina, company -- which employs8,000 people at 22 plants in nine states -- has the highest productivity, thehighest wages, and the lowest labor costs per ton in the American steel industry.The average pay in the year 2000 was $63,000 for a steel mill employee. Coblinsays the program succeeds because every employee can see how the incentive arrangementaffects his wages each week.

During the down times, of course, there's also sharing.The company doesn't lay people off, Coblin says. Rather, the plant shuts downits production lines for a day or two a week. Salaried executives still work;hourly employees aren't required to. About 80 percent of Nucor's employees areon this production-incentive plan. Other employees also have performance-basedcompensation.

When the whole organization is involved: "Tomake it work, the most important thing is the involvement of the whole company,"Somerset says. "Even if there's only a 1 percent profit, it should be dividedamong everyone, including the administration. Everyone is part of the team-building."Nucor, for instance, gives non-production employees other awards -- from freedinners for outstanding work to one share of stock for every year of employment.

Involvement of another kind has been a key to successin Colorado's Douglas County School District, which has one of the oldest andmost extensive pay-for-performance programs in the country. The program works,in part, because of the enormous effort that was invested in developing thesystem over a two-year period, says Douglas Hartman, the district's HR director.That built confidence among teachers long before the plan was implemented, hesays.

Another reason for the success of the plan, now inits eighth year, is that the school district funds the program internally. "Weare not dependent on outside grants or legislative programs," Hartman says."That's one of the big reasons it's been a success in attracting, retaining,and rewarding the best teachers. Our plan is consistent and reliable."

When there are clear expectations: At MetLife,"there is a lot more honesty in this process," Weber says. "Itforces a level of openness. People meet expectations and know where they stand.The message is this: it pays to be a high performer." Weber credits thecompany's new pay-for-performance program as "the driving force behindour cultural transformation. We have created an environment where the top performerscan thrive. No one here is 'entitled' to anything." Since the new pay systemwas instituted, turnover has dropped and is now 12 percent, Weber says. It isonly 6 percent among the top performers.

At Synygy, "everyone knows there's an evaluationand who gives it," Picher says. "There are no surprises. What's importantis that you have to evaluate people on a regular basis. People have to knowwhy you're doing it so they can make adjustments and their job is under theircontrol."

When there is commitment to training and support:"Pay for performance requires more of a commitment to training or it willnot work," Somerset says. "And it may require more administrativesupport."

When does pay for performance fall short?
When it pits employees against each other: Thisis the biggest problem with pay for performance, says Stanford University professorJeffrey Pfeffer, who has researched the subject extensively and declares payfor performance "a myth."

"A company's success is not a consequence ofwhat an individual does. It's a consequence of what the system does," saysPfeffer, the Thomas D. Dee professor of organizational behavior at the StanfordBusiness School.

"These programs do more damage than good,"agrees Marc Holzer, a Rutgers University business professor and president ofthe American Society for Public Administration. He's watched agencies and schoolstrot out various compensation schemes, try them out, keep them, change them,and abandon them.

"They set up competition between people. Theyemphasize the individual rather than the team. Virtually all innovations aregroup efforts. Yes, the exceptional person should be rewarded. But that exceptionalperson is dependent on others, on support services, which is often ignored."

"Incentive pay is toxic.... By the early nineties,I was spending 95 percent of my time on conflict resolution instead of on howto serve our customers," says Pat Lancaster, the chairman of Lantech, amanufacturer of packaging machinery with 325 employees, who is quoted by Pfefferin his book TheHuman Equation: Building Profits by Putting People First (Harvard BusinessSchool Press, 1998). What the system bred wasn't profits, Lancaster told Pfeffer,but greedy rival gangs of workers.

The competitive aspects of pay for performance havemade it a hotly contested issue in public agencies, including some school systems.New York Mayor Rudolph Giuliani proposed an individual merit pay program lastyear, drawing the ire of United Federation of Teachers/New York president RandiWeingarten. She says Giuliani's plan would worsen potential teacher shortages."Classrooms aren't factories, and teachers don't do piecework," shesays. "To do their work well, educators need to collaborate -- not compete-- with their colleagues."

Pfeffer says evidence indicates that incentive compensationmay be more effective at a divisional or organizational rather than an individuallevel. "Profit sharing, stock ownership, gain sharing, and group bonusesseem more consistently to produce positive results than do individually basedincentive schemes."

When it pushes one outcome to the detriment of others:Highly competitive pay systems tend to promote far less beneficial qualities,Pfeffer says. "Sears tried it and got in trouble." As he explainsin his book, "Sears abandoned a commission system at its automobile repairstores when California officials found widespread evidence of consumer fraud,with employees recommending unneeded repairs to unsuspecting customers, forexample."

Pfeffer says organizations that have tried and subsequentlyabandoned performance-for-pay plans cite problems that include overly aggressivesalespeople who alienate consumers, and high turnover rates.

Despite past problems with its commission system inthe company's auto repair stores, Sears spokeswoman Peggy Palter says, "Thatwas just a small part of our business." The company is still very muchin favor of pay for performance, she notes, "and has been very pleasedwith the results." Over the years, Palter says, Sears has continued toupdate and improve its compensation system, and has developed different approachesfor different parts of the company -- the credit and retail divisions, for example."We now incent on customer service scores," she says, adding thatcustomer service improvements have been rapid because of bonus pay for performance.

When it is too subjective: Weber says that subjectivityin ratings is the most controversial part of MetLife's process. "If onemanager rates an employee 3, but his boss rates the same person 2, there's alot of blaming. The manager goes back to the employee and says, 'I rated you3, but so-and-so only gave you 2.'"

At Enron, a Texas energy company, workers are dividedinto five categories, from "superior" (5 percent) to "needs improvement"(15 percent), according to a recent Time magazine story. Enron's widely citedapproach, for example, which attempts to create a rating system that is lesssubjective and arbitrary, doesn't depend on the views or whims of any individualsupervisor. Workers can turn in self-assessments and choose up to seven colleaguesand clients to write evaluations on their behalf. And anyone in the companycan voluntarily submit a review of anyone else's performance.

When it is so subjective that it opens the companyto allegations of bias: Former and current employees at Microsoft, Ford,and Conoco have filed lawsuits, alleging that the forced-ranking systems usedby those companies to award bonuses and weed out underperformers were biasedagainst some groups of workers: white males over blacks or women, for example,or younger managers over older ones.

Can you make it work?
If you are going to embark on a pay-for-performanceplan, look at these generally accepted principles:

  • Success depends on the willingnessof individual managers to make objective assessments of their employees.

  • Managers must be willing to differentiatebetween performances that meet expectations and those that exceed -- orfall short of -- expectations.

  • Competency-based systems should measurean employee's performance against a set of core behaviors that have a provenimpact on business.

  • Payouts should be made quarterlyor at least more often than annually.

  • There must be follow-up evaluations.

  • The plan must be communicated clearly,frequently, and simply.

  • Success depends on training, reinforcement,and company-wide commitment.

A Hewitt Associates study released last year gives pay for performance mixedreviews. More companies are using the incentive plan now than in 1990, but only22 percent said they believe that pay incentives work. Twenty-one percent ofthe companies surveyed said they did not think it helped; 57 percent said it"somewhat helped." An earlier Hewitt survey, conducted in 1995, foundthat among the 61 percent of organizations in the sample that had adopted variablecompensation plans with budgets of $5 million or more, 48 percent of the plansfailed to achieve their goals.

In his book, Pfeffer relates that, despite their popularity, most plans sharetwo attributes: They absorb vast amounts of management time and resources, andthey make everyone unhappy.

And yet MetLife is thrilled with its program, Weber says. "It's toughstuff," she adds. "But I go out on tour and I ask people all overthe country to raise their hand if they're satisfied with the plan. Everyoneraises his or her hand. It's not all about money. It's how you feel inside.We still have work to do on the program. To make something an institution, youhave to change hearts as well as minds."

Whatever HR professionals decide to do about pay for performance, Pfefferurges them to keep this in mind: "Many studies strongly suggest that thisform of reward (individual incentive pay) undermines teamwork, encourages ashort-term focus, and leads people to believe that pay is not related to performanceat all but to having the 'right' relationships and an ingratiating personality."

That suggests that the only way pay for performance can work is if it rewardsteamwork and long-term focus, and is designed to be as objective and fair aspossible. Some proponents obviously think that's possible. Critics like Pfefferthink the idea is inherently flawed, and that it ignores another reason peoplework: "for meaning in their lives."

"In fact," he adds, "people work to have fun." Companiesthat ignore this fact are "essentially bribing their employees and willpay the price in a lack of loyalty and commitment."

Jay Schuster, a partner in Schuster-Zingheim and Associates,Inc., in Los Angeles and co-author of PayPeople Right! (Jossey-Bass, 2000), has argued with Pfeffer about payfor years. "Pfeffer is right. People do work for more than pay," hesays. "But what they are concerned with is this: a compelling future, apositive workplace, individual growth, and total pay.

"The organizations that do indeed truly reward people consistently forperformance outperform those that don't," Schuster adds. "My senseis, if you're not going to pay for performance, what are you going to pay for?"

It is a question that has no easy answer. But most of those close to the issuewould agree with Pfeffer when he warns that the one thing above all others thatcan potentially inflict the most damage on an organization is to tamper withits pay system. When considering such a major decision, the first principlefor the HR professional to address should be this: First, do no harm.

Workforce, August 2001,pp. 28-34 -- SubscribeNow!