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Master the Compensation Maze

June 1, 1993
Today's employers could learn something from investors: If you feel strongly about something, put your money where your mouth is.

Don't just talk about the beauty of employee empowerment: Pay employees for their empowered contributions. Don't hold up teamwork as the highest ideal, unless you reward people for their contributions to the team. And don't proselytize about skills development, unless you're willing to give employees a financial incentive to acquire those skills.

In other words, don't restructure, retrain, flatten, rightsize, empower or espouse the benefits of changing the organization unless your compensation plan supports those initiatives. All the sermons in the world won't convert your employees to a new way of thinking if you ignore the basic reason they come to work each day—their paychecks.

Let's face it, compensation probably is the least glamorous function of the human resources department. Start talking about job descriptions, salary grades and merit raises, and you'll lose all but the most fervent business professionals. But as the role of HR has changed, so has the role of compensation. Why? Because the old ways of paying people no longer work.

Narrowly defined job descriptions and pay scales might have worked in yesterday's industrial workplace, when it was important to detail exactly how the cog fit into the wheel, but not any longer. We're in the information age now, and the quality of our products and services relies on how well individuals perform, not on how well their jobs are defined.

"Employers are becoming more focused on managing individuals than in the past," agrees Mike Guthman, a partner with Hewitt Associates in Rowayton, Connecticut. "In the past, everything revolved around jobs. We grouped tasks, called it a job, evaluated it, put it in a salary grade and the job was unchanging. People would do that job, progress and move on to another one, but the job would stay where it was."

Today, downsizing and the eradication of middle management have left fewer job slots and promotional levels for employees to advance toward. To keep good employees, jobs have to allow room for growth, and people have to be motivated by things other than their titles. Consequently, we're starting to see tremendous changes in the way that jobs are evaluated and people are compensated.

None of these changes is more significant than the effort underway by many companies to make employees think of themselves as business partners by sharing with them both the financial risks and rewards of doing business. In the lexicon of compensation, this effort is known as variable pay. It represents an attempt to motivate and reward individuals by linking the size of their paychecks to certain measurable accomplishments.

Variable pay can put everyone's pay at risk, not just senior management's.
"Companies don't want people to just show up," explains Jill Kanin-Lovers, senior vice president of worldwide compensation and benefits for American Express Travel-Related Services in New York City. "They want them to be engaged in their work, and one way to do that is to pay them directly for their contributions."

With variable pay, a percentage of an employee's paycheck is put at risk. This means that if certain business goals aren't met, the pay rate will not rise above the base wage or salary. In the past, only senior executives and sales personnel were subject to variable pay. Today, in progressive organizations, everyone's pay faces risk.

Now the idea isn't to go around and ask for salary refunds from employees who aren't high performers. Few, if any companies, put an employee's actual salary at risk. Instead, the trend is for companies to put a percentage of potential pay at risk. Let's say, for example, that an employee making $30,000 a year could increase his or her salary to $36,000 by meeting objectives, such as lowering costs, raising productivity or increasing customer satisfaction. The extra $6,000 would be paid in a bonus at the end of the year, with the base salary remaining at $30,000 the next year.

All 68,000 employees of Chicago-based Ameritech Corp. are compensated using a variable-pay approach, according to Harry Malone, director of compensation. "We believe strongly that everybody has to have an element of their compensation at risk that's related to their individual performance as well as to the performance of the company," he says. "We believe that when the company does well, our employees also should do well. Conversely, if they aren't contributing to the company's success, their compensation ought to reflect that as well."

Every Ameritech employee has a set of target incentives, Malone explains. The higher they are in the organization, the greater their percentage of at risk pay will be. This ranges from a low of 5% of pay to a high of approximately 35%. In all cases, a portion of the incentive amount is based on the performance of the employee's business unit, with the remainder based on individual performance.

"Most people have a split of 60% for team achievement and 40% for individual achievement," says Malone. "For instance, if I have a $10,000 target incentive for my position, $6,000 of that incentive will be based on how well my unit performs, and $4,000 will be based on how well I perform. Exceptional performance can even result in payouts in excess of the targets. We communicate very, very clearly what those targets are," Malone adds, "and we communicate throughout the year how individuals and business units are progressing."

In the four years that Ameritech employees have been subject to variable pay, about 70% of them have gotten some form of payout. How has the company benefited? "The link between company performance and individual compensation has made our employees much more aware of company goals and what they need to work toward," Malone says. "Everyone's objectives are aligned."

Not all variable-pay programs look like Ameritech's. Irvine, California-based Taco Bell Corp., for example, is much more aggressive in the amount of an employee's pay that's put at risk (see "Variable-pay Program Increases Taco Bell's Profits"). Appleton, Wisconsin-based Aid Association for Lutherans uses a gain-sharing approach in which an employee's variable-pay amount is based entirely on how well his or her team performs (see "AAL Uses Varied Approach To Compensate Teams"). American Express uses a 50-25-25 split as a basis on which to award bonuses. For example, 50% of your bonus would be based on how well the company performs, 25% would be based on the progress of your specific business unit, and the remaining 25% would be based on your individual achievements.

Variable-pay programs also can include profit sharing, merit increases, small-group incentives and organizationwide bonuses. "Basically, anything that isn't fixed pay is variable pay," explains Hoyt Doyel, principal of Effective Compensation Inc. in Lakewood, Colorado.

According to a 1990 survey conducted by The Conference Board in New York City, about 75% of companies that have variable-pay programs considered the programs a success in encouraging productivity improvements. These programs aren't without challenges, however. If you emphasize team awards, for instance, you risk alienating individual achievers. Individual incentives may conflict with an orientation toward high-performance work teams. And long-term employees who are comfortable with the old merit raise and pat-on-the-back approach to compensation may resent having to prove themselves each year.

Generally speaking, Doyel says the most-successful variable-pay programs are those that put a significant amount of an employee's pay at risk. "How much harder are you going to be willing to work for a 3% increase?" he asks. "Furthermore, the closer you can relate results to what an individual can truly influence, the greater the motivational impact. Profit-sharing plans are nice, but they're nothing more than a warm handshake, because individuals usually are insignificant in their ability to make a difference on the bottom line of the entire company."

Regardless of the variable-pay approach that a company chooses, the beauty of these programs is that compensation for all levels of employees is tied much more directly to company profitability. "This allows companies to grow, and to shrink their payroll expense, in response to the imperatives of the business," Kanin-Lovers says. "This way, we don't have to respond to business problems by firing people, which is part of what happened in this recession. Payroll departments got so swollen with fixed costs that we had to let people go to control the expense."

Moreover, when individuals are rewarded for their contributions through variable-pay programs, the empowerment mantra really starts to mean something. Employees know that they're valued when the skills that they bring to the job mean more than the job itself.

Skill-based pay compensates employees for their skills, not for their job titles.
Another effort to recognize—and encourage—individual achievement comes in the form of skill-based pay programs. According to the Scottsdale, Arizona-based American Compensation Association, skill-based pay is one of the fastest-growing innovations in the U.S. The association estimates that more than half of all Fortune 500 companies use skill-based pay with at least some employees.

Skill-based pay is an effort to pay employees for the number of skills they possess, rather than for the specific job they may be doing at any given time. Pay increases are given when the employees add to or improve their skill sets, rather than when they have achieved a certain level of seniority or management responsibility. This way, employees can receive pay increases based on their own readiness.

Some companies call these programs knowledge-based pay systems, but the difference is really semantics. According to Peter LeBlanc, national practice director for work and reward system redesign for Sibson and Company in Chicago, a more appropriate term might even be person-focused pay system.

"The only way to understand this is to know that the traditional approach to pay is job-based," he explains. "In a job-based pay system, employees must wait for a job opening to take place before they can get promoted. With skill-based pay, once employees have learned a new skill and have demonstrated that they can progress another step, they're eligible for another pay increase." This gives employees a tangible incentive to acquire new skills.

Skill-based pay programs are most common in manufacturing environments that rely on continuous-process technologies. As a result, most of the employees covered by these plans are non-exempt workers. This has happened for two reasons. One, it's easier to identify skill sets needed by direct-labor employees than it is to identify skills needed by supervisors and knowledge workers. Two, more manufacturing companies are organizing around high-performance work teams in which employees are expected to learn each others' jobs.

"The old 'fair day's wage for a fair day's work' concept was based on the time when you punched the time clock," LeBlanc says. "People came to work and were asked to do one thing well routinely." But today, in an effort to turn downtime into productive time, companies want employees to know how to perform many different jobs. If one worker is out sick, companies want another to be able to pinch-hit. "That's one of the reasons we're seeing such an emphasis on teamwork. It's the main reason we're seeing such a dramatic shift to skill-based pay," LeBlanc says.

So how does an employer decide what a certain skill is worth? Most companies assign prices to skills based on their relative worth to the organization, rather than on how long it takes an employee to learn a skill.

At Northern Telecom's Meridian PBX Plant in Santa Clara, California, managers decided to price each skill block equally, instead of making value judgments about which skill might be harder to learn or more distasteful to perform, explains LeBlanc, the company's former assistant vice president of compensation.

"We knew in our hearts that employees would chase after the skills that they already could perform or that they found the most agreeable," he says. "So we said that the first three skill blocks that an employee acquired would be worth 50 cents an hour, per skill, regardless of which three skills were learned first. The next four skills were worth 65 cents more an hour, per skill. And the final three skills would be worth 75 cents per skill."

This way, employees judged the relative worth of each skill, rather than the company judging for them. Northern Telecom identified the skill blocks needed, based on the actual work performed at different work stations. One station, for example, involved the operation of a complicated wave solder machine, whereas another was a relatively easy manual-assembly operation.

As one might expect, employers must make training opportunities available to employees for a skill-based pay system to work. "The number-one cause of failure is a lack of commitment to training," LeBlanc says, "because from the employees' viewpoint, the only thing standing between them and their next pay raise is training availability. If training isn't available, the pay-for-skills system can become a demotivator."

Skill-based pay systems are fraught with other challenges, as well. First, making the transition from a traditional system is tough, especially when there are highly paid employees who possess only one or two skills. What do you do, for example, with employees who make $12 an hour, but their skill sets are only worth $8? LeBlanc suggests that an employer can do three things in this situation.

"First, you can cut their pay, which not a lot of progressive employers would do. Second, you can give them a time requirement to learn the skills they're missing. And three, you can hold the base where it is, but offer those employees a one-time bonus for every new skill they acquire until their hourly rate corresponds with their skill level."

The second concern with skill-based pay plans is that employees will rush to develop new skills and then plateau on the pay scale. Research conducted by the American Compensation Association supports this, revealing that it takes an average of just three years for a worker to maximize his or her salary in a skill-based pay system. "[T]he reality is that any pay system tops people out," LeBlanc says.

So once employees have achieved all the pay increases they can, what will keep them motivated? The answer, for many employers, is to institute a variable-pay program that provides bonuses for extraordinary individual or group performance. In fact, variable-and skill-based pay programs can work extremely well together.

The third challenge with skill-based pay is that it can swell payroll expenses. "Having a skill in reserve is worth something to the organization," Doyel explains, "but you wouldn't want to have 500 people holding that skill in reserve, because those skills are costly. You have to protect the organization."

Although skill-based pay plans are found predominantly in blue-collar environments, there currently is a movement to find a way to evaluate the skills and knowledge of nonexempt workers. This movement is called competency-based pay. A competency is a trait or a characteristic that's required by a job holder to perform that job well.

Take salespeople, for example. An employer interested in a competency-based system would take a look at their five or six most-successful salespeople and learn what it is that those people do well. It might be managing accounts, conducting competitive research or making good technical presentations. Once the elements that predict sales success were identified, employers would categorize those elements as competencies, and all sales employees would be compensated based on how well they show those competencies.

"We have the intellectual capacity to figure out how to measure people's behaviors and how those behaviors impact results," says LeBlanc. "But until now, organizations haven't been willing or able to invest in that kind of research. Fortunately, this is changing. Not many companies have gotten to the point of actually paying for competencies, but that's certainly coming."

In the meantime, employers are looking at other ways to boost the productivity and performance of white-collar workers. One of the ways that's getting a lot of attention is broadbanding.

Broadbanding decreases job classifications and increases salary ranges.
Unfortunately, there's no single, tidy definition of broadbanding. Basically, banding refers to the clustering of jobs into wide categories or groups of jobs for the purposes of managing employee career growth and administering pay. According to Lincolnshire, Illinois-based Hewitt Associates, the bands are implemented as an alternative to the traditional approach of maintaining numerous but narrow salary grades. For example, a company with a traditional compensation structure may have 30 salary ranges, each possessing a different job title. Under a banded structure, those ranges might be joined together in nine bands with wider salary ranges and no job titles at all.

There's real debate in the compensation community about whether broad bands should be developed for the purpose of salary administration, or whether bands are better-suited for career development.

"I believe it's a mistake to think about bands as being like salary grades, only bigger," says Guthman. "Bands aren't a good compensation program. But if employers are broadbanding because they want to change the way they think about jobs as part of an overall organizational development initiative, then bands are terrific."

In Guthman's view, bands should be organized around job competencies that are at approximately the same organizational level. This allows managers more autonomy in setting pay rates. It also eliminates unnecessary distinctions between jobs so that it's easier to move people around in the organization.

"Since organizations are flatter and the promotional opportunities are reduced, we need to find a way to get people to change jobs at what used to be called laterals," says Guthman. "In a lot of organizations, employees never took a lateral, much less a downgrade, even if it was the right thing for their careers and the right thing for the company. People would rather have a higher grade than have a dollar of pay. Broad bands can help organizations break this focus on grades, in an effort to get people to take the right job for the company and their careers."

In other words, the individual who starts in manufacturing, for example, can be more easily persuaded to get some cross-functional experience in marketing because he or she won't have to take a lesser grade to make the move. With today's emphasis on total-quality management and teamwork, this kind of cross-functional knowledge is essential.

Reducing numerous salary grades into a few job bands also takes the pressure off the job-evaluation system. With fewer vertical grades, employees theoretically will spend less time worrying about their next promotion and more time worrying about how to get the job done. "By having much-larger categories, we tend to focus less on them. Human nature says that if you're in a narrow box, you'll want to get out of it," agrees Doyel.

Aetna Life and Casualty Co. of Hartford, Connecticut, is in the process of moving to a banded structure that the company calls job families. In keeping with Guthman's vision, Aetna has decided not to attach salary grades to the bands, but rather to use them as career-management tools for employees and their managers (see "Managers Make Pay Decisions Through Job Families."). Companies, such as Aetna, that use bands to support a new organizational culture, are in the majority, according to a survey conducted by Hewitt Associates in 1992. This survey revealed that the concept of broadbanding is being driven more by organizational issues than by compensation issues.

So why is broadbanding so often referred to as a new approach to compensation? What about those companies that do apply salary guidelines to the job bands?

RJR Nabisco Inc., for example, went to a banded structure at its corporate headquarters in New York City to give managers more flexibility in making salary decisions. "We put seven salary grades with three pay ranges apiece into four broad job bands," explains Lewis Nerish, vice president of total compensation at RJR Nabisco. "But we also attached salary ranges to each of those new bands." Why? "Because we felt that managers needed some guideposts to help them make salary decisions. After all, budgets will always be with us."

Like Aetna, however, the main reason that RJR Nabisco pursued broadbanding was to deemphasize the importance of titles and to increase the likelihood that employees would be willing to make cross-departmental transfers. Furthermore, the banding effort at both companies represents an effort to pay individuals for what they actually contribute, instead of relying on a narrow salary grade to make pay decisions.

Decentralizing compensation departments pushes responsibility down to managers.
Whether broad-banding, skill-based pay and variable-pay programs are a response to the changes in organizational structure or an effort to create those changes remains to be seen. What is apparent, however, is that the changes in compensation are creating some major management challenges.

"It's about a whole lot more than just delivery of pay," explains Elizabeth Hawk, senior compensation consultant for Monsanto Co. in St. Louis. "What we're talking about is organizational performance and how employees influence that performance. Delivery of pay is almost tangential."

In building the link between pay and performance, one of the first things that many companies realize is that one department can't make all compensation decisions effectively. "At some point, there are compensation issues that reach beyond the responsibility of any one unit," Hawk says. As a result, many companies are decentralizing their compensation function to put more responsibility for pay decisions in the hands of managers. The thinking behind this is that managers are better-equipped to evaluate an employee's performance and to determine what that employee is worth to the organization.

Monsanto began to decentralize its compensation function in 1986 as part of an effort to give more autonomy to each of its four major operating units. With interests in agricultural chemicals and other chemicals, such as pharmaceuticals and alternative sweeteners, the company realized it would be better off if it let managers make business decisions based on their specific industries.

"We didn't want to 'Monsantoize' our subsidiaries. We wanted them to have autonomy in terms of developing a business strategy, identifying the competition and determining what actions were necessary to influence that strategy," Hawk says. "As part of this effort, we said that each operating unit could develop a compensation strategy and incentive plan that fit its business imperatives. We made the decision early on that it was appropriate for incentive-pay plans to come from a bottom-up approach."

Today, about 60% of Monsanto's 32,000 employees are in some form of incentive or variable-pay plan. Although the philosophies of the plans don't differ much, the performance standards and incentive amounts differ significantly from unit to unit. A manufacturing plant, for example, might measure employee performance based on productivity, cost, safety and environmental issues. A sales group, on the other hand, could measure employees based on sales volume and new-product introductions. One group might offer a 5% incentive to employees who meet their targets, whereas another might go as high as two times an employee's base salary. "There's no such thing as a typical incentive-compensation plan at Monsanto," says Hawk.

A decentralized approach puts more responsibility on managers to determine how to evaluate and motivate employees, whereas under a traditional compensation plan, managers could attribute their decisions to some vague human resources policy. "This made HR departments accountable for decisions that managers should have been accountable for," Kanin-Lovers explains. "By decentralizing compensation, we're forcing managers to manage."

But decentralization also changes the role of compensation professionals. "A compensation function traditionally has been a controlling function because it's allocating scarce resources," Doyel says. "It's hard for compensation departments to give up that control." But in the new world of pay for performance, compensation managers must become advisors who create guidelines rather than policy.

New compensation strategies won't work unless they're communicated to employees.
One of the most-important new roles of today's compensation department is communication. "Companies now are beginning to realize that if they want their compensation plans to work, they have to make sure they're understood and that there's buy-in, not only from managers, but from all employees," explains John Rubino, senior manager of consulting for Ernst & Young in New York City.

The new openness in compensation is essential if employees are truly to become partners in a business. To shed the extraneous employees and keep the star performers, companies have to share authority and power with their employees. "To do this," Rubino says, "employers have to provide more information on how the business is run, and that includes information on how pay is determined."

How much should a company tell employees about their compensation plan? Open communication doesn't mean posting pay levels on the bulletin board. A person's individual pay is private and should be kept private. However, open communication does mean explaining how and why the company developed a certain plan.

"Some companies go all the way, giving their employees copies of the pay scales in each salary grade, listings of the jobs that fit into those salary grades and the minimum and maximum pay levels for each grade," says Rubino. "Other companies think that's too much—that employees only need to know how their base salary is determined. My personal view is, the more communication the better, but this depends a great deal on organizational culture."

At a minimum, employees must know:

  • How their jobs are evaluated
  • What compensable factors determine the ranking of a job
  • What competitors pay for similar jobs
  • What measures are used to determine incentive payouts.

How do you communicate this information best? Through brochures, videos, the company newsletter, small-group meetings and whatever other means are available, according to Rubino. "I personally believe that meetings are the best way of communicating. Whether it is a one-on-one meeting between managers and employees, or a small-group meeting with an HR director and 20 or 30 workers, human contact gives people the chance to ask questions and get responses," Rubino says.

So how do we know that these various compensation strategies work?
How can HR professionals determine if a particular approach to pay is right for their company?

"The assessment of results is probably one of the areas in which compensation folks have the most room for improvement," says Hawk, who is involved in a results research project for the American Compensation Association. "Our work suggests that there are three overall categories of results measurement."

The first category is financial, in which a company looks at what's paid out in salaries and compares that figure with what it received in dollarizable performance improvements. The second category involves taking a look at the impact of salary and incentive plans on such things as teamwork, quality improvement and employee initiative. Finally, the third category is simply how satisfied the managers are with the plan. "This is a very subjective measure," Hawk agrees, "but an important one nonetheless."

In evaluating the compensation package, employers might also want to review their turnover rates, according to Doyel. "If your turnover rate is too high, something's wrong with the company. It may be compensation, or it may be something else. But your compensation program should be looked at pretty closely. Similarly, if your turnover rate is too low, your compensation program may be too generous."

The changes underway in compensation are exciting because they represent an effort by corporate America to stop looking at pay in isolation and to look instead at how compensation fits into the big picture of organizational development and success. When you consider how much money is tied up in payroll expense, you begin to sense the enormous impact that a successful compensation program can have on the bottom line. It's incredible to think that we've gotten this far without an obvious link between compensation and business strategy.

"If your company believes that the work force is an important part of generating successful results, and you aren't supporting that belief with your pay plan, you aren't going to get all the bang for your buck," says Hawk.

Personnel Journal, June 1993, Vol. 72, No.6, pp. 64a-64o.