Compensation Done the 'Right' Way

December 1, 1999
In today’s highly competitive marketplace, both employers and employees are acutely aware of the important role reward and recognition practices play in attracting and retaining talent. It’s obvious from the incredible amount of benchmarking being done that companies spend significant time and resources searching for best practices.

When it comes to pay programs, mounds of data are gathered and analyzed in the hopes of finding that special base pay or incentive plan—the plan that’s proven to be effective in ensuring the "right" competitive position, keeping critical talent happy and motivated while improving performance.

Unfortunately, many companies are disappointed when they don’t obtain the results they were expecting after implementing a plan that has been touted as a "best practice" by another company. Rather than achieving the results they were hoping for, their "best practice" ends up as just another ineffective human resources program or failed attempt.

While there’s no doubt benchmarking is critical in the overall design process, it’s most effective as a tool to help companies understand the competitive landscape. To truly achieve a best practice it takes more than copying interesting competitor practices.

In their ongoing study of best practices in the United States, Santa Clara, California-based Saratoga Institute has found that best practices more typically occur when a specific design approach is followed, regardless of the plan type or the specific elements of the plan.

A plan is likely to become a best practice when it:

  • Meets the original objective for which it was designed.
  • Drives desired, positive results relative to company culture and strategic business objectives.
  • Addresses the specific needs, business philosophies and operating environment of the implementing organization.

When it comes to strategic compensation design, there are additional factors that are fundamental to achieving a best practice pay plan:

  • Rewards must be linked to business strategy.
  • Plan objectives must be clearly articulated (participants must know what is being rewarded and why).
  • Behaviors motivated by the plan must support company culture and values.
  • Payouts must be related to actual business performance and results.
  • Plan design must be adaptable to changing business conditions.
  • All elements of the plan, including expected performance and results, must be clearly communicated and fully understood by participating employees.
  • Participating employees must be involved in the design process.
  • Participants must believe the plan has value.
  • All elements of the plan must be regularly reviewed for effectiveness in meeting stated objectives and achieving desired results.

To develop pay practices destined to become "best in class," an organization must first recognize the importance of building reward and recognition practices within a framework that ultimately addresses both the extrinsic and intrinsic aspects of employee recognition and reward.

This framework begins with the organization’s strategic business objectives and then considers company culture, values, and performance measurement capabilities as critical elements in the overall design strategy. Programs are designed to motivate performance aligned with critical business objectives and reward contribution and results in ways that are meaningful to employees and consistent with company values.

While there are a variety of pay systems considered best practices in today’s market, here’s an outline of several innovative design approaches—those we believe are most likely to result in best practices when implemented using a strategic design approach.

Market-based Career Band System to Manage Base Pay
This approach to base-pay management has proven to be most effective in non-hierarchical organizations that desire flexibility in managing individual base-pay levels and are committed to performance-based rewards.

The system is designed to pay within a broad competitive range and encourage career growth and development within professional disciplines.

Market-based pay bands are established to recognize significant variations in skill, competency and responsibility levels throughout various levels of career and job progression.

There are two major components to the system:

  1. Career progression "level guidelines" identify the specific skills, competencies and responsibilities that are associated with each level in a career ladder.
  2. Broad pay bands provide the framework for the progression of competitive pay from entry to senior levels in a career ladder. Pay bands are sub-divided into "pay zones," reflecting competitive compensation for each level identified in a specific career ladder.

The implementing organization decides the appropriate number of career levels (typically three to five per job family excluding the various levels of executive management specific to the organization) and identifies the critical factors and competencies that make jobs (and people!) valuable to the company.

These factors and competencies are then defined at each career level and for each discipline in the organization. Competitive market data is analyzed to determine competitive pay levels for job levels within various disciplines.

The pay bands and related zones replace traditional salary ranges. Instead of a pay structure with 20 or more salary ranges, an organization choosing this approach can expect to have fewer than 10 pay bands with three to five zones in each band. Competitive pay levels are more closely managed to an employee’s career level than to their grade midpoints.

Salary increases within zones are based on performance against established level criteria associated with a specific zone.

Promotion to a higher pay zone occurs as a result of a significant increases in job scope, skill level and/or position impact as defined in the level criteria.

From an employee perspective, this approach provides clear definition relative to the skills and competencies required for advancement, and provides a consistent perspective among various disciplines relative to career growth.

Performance Shares Approach to Incentive Pay Design.
Performance shares—or "results sharing," as it is often called—is a design strategy that can be particularly effective in addressing the ultimate purpose of incentive pay: increasing employee ownership and accountability for business results and sharing the rewards (or losses) with those who are responsible for making them happen.

Actually, performance shares is not a particularly new way of approaching incentive compensation. The basis of the design has its roots in gainsharing plans that have been around in manufacturing environments for decades.

However, the differences between "Scanlon" or traditional gainsharing plans and today’s performance-sharing plans are found in certain aspects of the design and certainly in the broad scope of their use. Performance-share plans have been found to be highly effective in a variety of environments from manufacturing to service firms to technology companies.

The primary objective of a performance-shares plan is to focus employees on critical business objectives and to share with them the gain or loss that results from achievement against pre-established performance goals. The performance objectives or measures can be production oriented, process oriented, sales and revenue oriented, focused on driving the culture to a new level, or a combination of all of these.

What’s most important about these share plans is their effectiveness in focusing employee performance on things that matter most to the organization and in encouraging employee accountability for results.

Plan design for performance shares typically looks something like this:

  • Performance measures and achievement targets are established at the company level and then tiered down to the department and individual level.
  • The incentive pool is determined by the amount of profit or expense reduction the company has committed to "share" with employees at various levels of performance achievement.
  • Each job level or category (i.e., management, professional, non-exempt) is assigned a range of performance shares to be earned based on achievement against specific performance targets.
  • All individuals in each job category are eligible to earn up to the maximum number of shares that’s established for their range. The opportunity to earn doesn’t vary among individuals in the same category, although actual achievement often does.
  • At the time of payout, all performance shares are valued equally based on the size of the available pool and the total number of shares available for award to all eligible participants.
  • Employees are awarded shares based on achievement against pre-established performance targets and in recognition of their contribution to the company’s success.
  • The calculation used to determine share value is explained to all employees on the same basis. This promotes understanding of how performance achievement against financial and other business objectives impacts the size of the incentive fund.
  • Performance-share value will vary from performance period to performance period based on company performance and the resulting size of the incentive fund.

Many incentive plans are designed to pay employees a percent of pay if they achieve specific levels of performance. Employees are typically told the percent of pay they’re eligible to earn at various levels of achievement.

When payout time comes, that percent of pay is often reduced based on company performance (actual size of the incentive fund) rather than individual performance. When this happens, the employee’s first reaction can be fairly negative since they perceive the size of their award to be inconsistent with their level of contribution.

It’s hard to reconcile why their outstanding performance is rewarded with a less than outstanding payout—even if company performance is to blame. As a result, the company incentive plan turns quickly into a disincentive plan.

With performance shares, the actual number of shares that are awarded for outstanding performance is the same regardless of the size of the fund. As a result, the employee is fully acknowledged for his or her individual contribution regardless of the size of the incentive fund. The value of the shares may vary, but not the number of shares employees earn in recognition of their performance.

It’s a funny little psychological twist, but it does seem to work—employees still feel recognized and appreciated for their individual contribution because they’ve focused on earning a number of shares rather than a percent of pay.

Making the award value secondary to the recognition of performance addresses our intrinsic need to be acknowledged for our work. In its purest sense, incentive compensation is based on motivational theory, and performance or results "sharing" is a highly motivating design approach in this regard.

So, as you continue your search for compensation practices that are best for your organization, just remember they won’t be the quickest, easiest or cheapest to implement! But, if you have the commitment and resources to do it right, strategically designed pay is a powerful tool for aligning individual and company performance and for ensuring reward and recognition of employee contributions to the things that matter most to company success.

Workforce, December 1999, Vol. 78, No. 12, pp. 75-78.