Compensation and Salary Forecast Lackluster Performance

November 13, 2007
Despite its universally respected reputation for business innovation, Microsoft Corp. relied on a performance management system that basically remained unchanged for 15 years until 2006, when waves of employee and managerial discontent pushed the company to overhaul the process.

    "The primary area of pain was that employees thought the system was not transparent and did not motivate them," says J. Ritchie, Microsoft's general manager for compensation, benefits and performance management. "The old system set up managers in a way that did not allow candid conversations about an employee's performance."

    Microsoft implemented deep changes in May 2006, and its March 2007 employee opinion survey showed that employees see a stronger link between pay and performance. But other companies across the country still face sweeping condemnations of their performance management systems from employees, managers and C-level leadership.

    A critically important 2007 survey from Towers Perrin found that most base pay, incentive and performance management programs are not effective tools for talent management. Moreover, the limited incremental changes companies make in their compensation and performance programs year after year do little to close the substantial gap between these programs and business needs.

    "The business consequences of this gap are, for some organizations, a huge missed opportunity, and for others, a matter of survival," says Ravin Jesuthasan, managing principal and practice leader at Towers Perrin. "Labor costs are a significant portion of expenses for any organization and a very substantial portion for some, but companies continue to spend on pay programs without any evidence of business relevance."

    To boost the effectiveness of their pay plans and establish links to business needs, more companies will have to follow Microsoft's plunge into improved performance management systems. And in many cases, from the most sophisticated systems to the most basic, that means scrapping the performance review process and starting all over again.

Clearing the obstacles
    Microsoft's 78,565 employees generated revenue of $51.12 billion for fiscal year 2007, which ended June 30, continuing a long pattern of enviable growth and profitability. But the company's performance management system fueled widespread dissatisfaction among employees and managers.

    Employees receive two ratings in performance reviews—one based on current performance and used to determine merit increases, and one for potential or future performance that's used to set stock awards.

    Under the old system, managers assigned current performance ratings of 0 to 5 in half-point increments based on a forced distribution. Because current performance ratings not only determine annual salary increases but also come into play when employees apply for another position within the company, the forced distribution approach was a sore spot.

    "We also discovered that the old system was not fully effective in creating teamwork because of the forced distribution," Ritchie notes. Consequently, Microsoft trashed its 0-5 rating scale and adopted a three-point "commitment" scale of "exceeded," "achieved" and "underperformed," with no forced distribution.

    "Distribution under the new system is about what we expected," Ritchie reports. In the last full cycle, 37 percent of employees received a rating of "exceeded," 58 percent received an "achieved" rating and 5 percent were rated "underperformed." The general rule is that the top group receives a merit increase 50 percent higher than average performers.

    Like other companies, Microsoft has controlled costs with a relatively flat salary budget.

    "For the 2007 salary budget, we kept pace with the U.S. market with a 4 percent increase, and we anticipate that we will move with the market for 2008," Ritchie says. During Microsoft's fiscal year, labor costs rose 15 percent, driven by a 10 percent increase in headcount and a 5 percent increase in salaries and benefits for existing employees.

    Microsoft's merit increases do not provide sharp differentials for high and low performers, but greater differentiation occurs with stock awards incentives. Microsoft earmarks 40 percent of the total stock awards budget for the top 20 percent of employees.

    In 2006, as part of the performance management overhaul, Microsoft bumped up the budget for stock awards by a hefty 15 percent. "We also gave managers more flexibility to reward top performers," Ritchie notes.

    Although the company abandoned forced distribution for the current performance ratings, it retained forced distribution for the future performance ratings. Under the required distribution, 20 percent of employees are ranked as top performers, 70 percent are in the middle position and 10 percent are in the bottom.

    All Microsoft employees are eligible for stock awards and 93 percent received awards in the last cycle; 7 percent did not because their performance was too low.

    "Reward differentiation is important, but employees place more value on a good feedback system," Ritchie says. "Most important is that our employees feel the performance review process is more transparent under the new system. They feel there is a stronger link to rewards and we see more pay satisfaction." Voluntary turnover stands at 6 percent, well below industry norms.

    Based on feedback from managers, Microsoft also addressed technology issues as part of the performance management overhaul. Microsoft managers conduct an average of 10 employee reviews during each June-August annual review period, plus "check-ins" during the January-March midyear career discussions and ad hoc discussions throughout the year. The company calculates that managers conduct more than 182,000 reviews and check-ins each year.

    In 2006, the company installed a fully automated system based on Microsoft technologies. The new system eliminates Word documents sent through e-mails and stored on local hard drives, and provides instead a solution with a centralized architecture.

    Although Ritchie believes the results of the March 2007 employee survey provide evidence of the success of the performance management changes, he notes that Microsoft will continue to review the results. "When we launched the 2006 changes, we launched it as a first version," he says. "We will embrace feedback; we are very self-critical."

Instilling discipline
    At Microsoft, the impetus for performance management change came from a bottom-up demand for a new system. But at Wayne Farms, it came from a top-down directive for basic steps toward rebuilding a system that existed on paper but had been routinely ignored.

    Headquartered in Oakwood, Georgia, Wayne is the fourth-largest poultry producer in the U.S., with revenue of $1.1 billion in 2007. The company annually processes 250 million chickens—1.8 billion pounds of poultry—with 9,275 employees at 13 plants across the Southeast. The company's performance management system covers 975 salaried employees.

    The system calls for annual reviews and ratings that follow a typical bell curve designed to yield 10 percent of employees with a top rating of 1; 15 percent rated 2; 50 percent rated 3; 15 percent rated 4; and 10 percent rated 5. But when David Malfitano joined Wayne as vice president of human resources in 2003, he pulled down the data on performance ratings and found that 19 percent of employees were rated 2 and 81 percent were rated 3.

    No employees received ratings of 1, 4 or 5. "We were not managing performance," he says.

    Wayne's performance management system also called for annual reviews on employees' anniversary dates, but many never received one. "And because the system was based on anniversary dates, there was no way to get a cost structure or a real picture of performance," Malfitano says.

    With support from the CEO to rebuild the system, Malfitano set a new requirement for mandatory performance reviews by all managers, including the CEO, on the company's fiscal anniversary. "We tracked every manager and every employee until we had a complete set of quality reviews," he says.

    Malfitano considered but rejected the idea of forced distribution. Before he joined Wayne, he worked for HR and tech outsourcing company EDS, serving as director of global human resources for the $2.5 billion General Motors account.

    "We tried forced distribution at EDS, and it was a disaster," he notes.

    Instead, he now insists that managers identify employees in the top 20 percent for performance and those in the bottom 10 percent before compensation planning occurs.

    "This is an exercise," he says. "We hold up the mirror and look at how well managers are using the ratings and the recommended salary increases. Managers can see exactly what they're doing and make adjustments."

    Change is slow. For the fiscal year 2007 cycle, less than 1 percent of employees received a rating of 1; 21.4 percent received a 2; 71.5 percent received a 3; 3.7 percent received a 4; and none received a five. "This is a work in progress," Malfitano notes.

    "The past four years have been about instilling the discipline of performance management. Design has less to do with success than implementation and achieving what you intended, which in our case was to provide employees with honest feedback and to link pay to performance."

    The salary-increase budget at Wayne has remained flat at 3.5 percent for 2007 and the previous few years, but the company has established sharp differentiations in merit increases. Employees rated 4 or below receive no increase. Employees rated at the top performance level receive increases of up to 8 percent. The 0 percent to 8 percent range puts teeth into the system. "This is real execution," Malfitano notes.

    Executives and senior leaders in each facility—a subset of 123 employees—are eligible for annual incentives based on the company's return on net assets, with a target that ranges from 12 percent to 20 percent depending on industry and business conditions. For fiscal year 2008, the target is 12 percent. The incentive payouts may hit 25 percent to 50 percent of base pay for senior leaders and 10 percent for lower-level managers.

High-touch vs. high-tech
    At Wayne, the change in performance management hinges on the hard work of meeting with each manager to review ratings and salary increases and to coach them through the difficult task of talking to employees about their performance. The process is taking years, not months, but results are tangible. "We've raised the bar for performance and accountability," Malfitano says.

    Jesuthasan notes that in each of the performance management surveys Towers Perrin has conducted in the past 12 years, companies consistently report that they plan to focus on improving the effectiveness of managers in performance management. "But this keeps getting put off in favor of design changes or technology im- provements," he says.

    The 2007 survey found 90 percent of companies have made major technology changes during the past three years and continue to focus on a "high-tech" rather than a "high-touch" approach to performance management change. Jesuthasan notes it's easier to implement technology than to teach managers how to have meaningful discussions with employees, but ignoring this need leads to ineffective performance management systems.

    "The changes that are needed with respect to coaching managers are messy and require strong senior leadership support," Jesuthasan says. The deep change and the high-touch focus needed to prepare more managers for effective performance reviews generally require additional resources. Jesuthasan notes that some HR managers are initiating this conversation with senior leadership.

    C-level executives are demanding more change in performance management, particularly since CEOs have put the talent agenda at the top of their priorities. "So we are seeing more pressure," Jesuthasan says. "But C-level leadership is calling for change that is more systemic."

    To some extent, the low levels of effectiveness reported for performance management and compensation systems and management's tolerance for these low levels reflect the absence of clear models for driving performance. If the same high levels of ineffectiveness appeared year after year in other business functions, heads would roll.

    "When you talk about effectiveness in other functions, such as finance or marketing, there are standard measurements and a common decision science," Jesuthasan says. "But this is not true in HR. The decision science is evolving. However, we've seen more progress with this over the past three to four years than in the past 15."

    In the meantime, workforce management executives can remove the obstacles that preclude effective performance management and give managers the support they need to conduct honest reviews and reward top performers. In many cases, that means scrapping long-standing programs and sitting down for one-on-one coaching with the front line.

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Workforce Management, November 5, 2007, p. 39-45 -- Subscribe Now!