HR Group, founded in Edmonton Alberta in 1993, is a partnership of highly experienced management consultants who specialize in organizational effectiveness and human resource management, and promote participative, lean, and cost-effective management practices. All partners are Certified Human Resource Practitioners with extensive senior level experience in both the private and public sectors.

Pay for Performance

Reprinted from “Productive Workplaces” (May, 2010), the HR Group newsletter. 

“We don’t want to keep paying the same increase to all staff; we want to reward those that are truly productive and give less to those that are not.” What’s wrong with this common request by so many boards of directors of both public and private organizations? 

If there ever was a “motherhood” statement in the field of compensation administration it is “pay for performance”. How can one possibly argue that pay should not be tied to performance? One can’t, because compensation should be tied to performance. One shouldn’t reward those who don’t perform well. But putting such beliefs into practice raises some very important issues such as how do we successfully reward performance? How do we objectively measure performance? What constitutes good performance? How do we differentiate between various levels of performance? What rewards actually affect performance?

The main problem with paying for performance is that most people automatically assume that paying according to some measure of performance actually affects the level of performance. It does not. This has been shown to be true time and time again in one study after another. Most people equate pay for performance with the whole concept of performance management; you manage people’s performance through compensation. The greater the monetary carrot, the greater the performance. Therein lies a huge problem. Pay for performance is not a substitute for ongoing performance management.

Pay is not a real motivator; you either are productive or you’re not. If your employer pays too much below the average, or too much below what you are worth on the open market, then you move to another employer. Paying for performance, on the other hand, means that someone has to judge the level of your performance as compared to your colleagues. So you get paid a 5% bonus compared to a 3% bonus for someone who really isn’t up to your standard of performance. Does this make any difference to either one of you? Is the perceived difference even accurate? After tax, does the extra money amount to anything? Does the performance of the employee who only got 3% improve? There is an old saying in the field of compensation that the life expectancy of a wage increase is approximately two weeks before the recipient of the increase, regardless of their level of performance, is again thinking he or she deserves more.

According to a recent article in Workforce (2008, pp.33-39) entitled, “Compensation & Salary Forecast – Where’s the Merit-Pay Payoff?” by Fay Hansen, “Survey reports show years of flat merit increase budgets that barely meet inflation rates and bear no relationship to productivity growth or profitability trends. The major salary budget surveys point to 2009 merit increases averaging 3.6 to 3.8 percent, with the highest performers receiving 5.6 to 6 percent. In effect, for the vast majority of employees, merit increases are unevenly distributed cost-of-living and market-adjustment increases couched in the language of performance rewards.”

Jeffrey Pfeffer, noted author and consultant and professor of organizational behavior at the Stanford Graduate School of Business, is quoted in the article as saying that, “The evidence is overwhelming that individual pay for performance does not improve organizational performance except in very limited cases. Why do people, when confronted with the facts, turn their backs on them?”

Many, however, continue to insist that raises must be based on some form of performance appraisal and that only partial increases or none at all should be granted to those who are rated as substandard performers. There are several problems with this practice. Are performance appraisals accurate? Why do we retain substandard performers in the first place? Why are we, in effect, condoning poor performance by accepting it at all? What is being done to ensure that the employee performs at the desired level?

“We’ve already abandoned merit pay,” Pfeffer says. “Merit pay is not based on merit. Performance evaluations are biased; overwhelming studies show this. Even if merit pay was based on merit, the pay increases are not enough to motivate employees, but they are enough to irritate them.”

Withholding pay will do nothing to the performance of an employee who requires coaching and training or, failing that, requires termination or placement in a position in which they can perform well. We have repeatedly seen and written that annual performance appraisal is a highly ineffective management practice; withholding pay increases based on such appraisal is equally ineffective. Employee performance and behavior must be dealt with separately outside of any compensation practice. If the employee is not performing up to the level desired, the answer is not to pay less, but to bring the employee’s performance up to the required level.

“Individual performance pay plans cost a lot of money and upset everyone,” Pfeffer says.   “Effective management is a system, not a pay plan. The mistake is that companies try to solve all their problems with pay.” The Workforce article points out that, “Perhaps more important, when companies overestimate the power of financial rewards to affect behaviors, they neglect critical skills development and strong leadership, which Pfeffer and other experts agree play a more central role in raising organizational performance.”

We wholeheartedly agree that performance should be rewarded, but compensation is not an effective tool for influencing “individual” performance. On the other hand, since teamwork and ownership are desired behaviors today, then compensation should reflect “team and organizational” performance.

This is why so many companies are rewarding performance, not on an individual basis, but on a team or company wide basis. The private sector can do this quite well with any number of compensation options such as bonuses, stock options, and gain sharing. They can do it well, because they have an objective yardstick, which is the amount of profit earned. It is true that a company can have a mediocre year despite the efforts of all staff, but profit earned is still an appropriate yardstick. The company is in business to make money. If it does, then share the rewards; if it doesn’t, then there are no rewards to share.

According to Workforce, “Pfeffer notes the existing evidence points to group bonuses, profit sharing, and gain sharing, which is a form of profit sharing, as more effective forms of performance-based pay than merit pay or individual incentives.” “Group plans are more collective and recognize the interdependent nature of work today,” he says. “Most employees look at their total compensation and want to see that they share in the success of the organization.”

Individual performance must be attended to through ongoing daily performance management. Through proper training, coaching, mentoring, and career planning which recognizes the employee’s potential and achievements. If the individual is not performing well and good performance management is not rectifying the situation, then the poor performance should be recognized not with less pay, but with termination. The object is to have everyone performing at a high level and deserving of a full increase, not to play some useless statistical game with the bell curve and a limited salary increase budget that cannot be appropriately distributed to all staff in the first place.

The public sector on the other hand is a far more difficult area in which to pay for performance as there is no readily available and objective measure of performance; there is no profit or loss. If the public sector is in business to provide service, then it is quality of service that must be the yardstick that is used to measure performance. How do we measure service and who does the measuring? From our perspective it is the customer that is the logical one to do the measuring. Overall they can probably provide relatively accurate and objective feedback, but the public sector may frequently not provide optimum levels of service because of budget constraints, for example. Some municipalities have a policy that all snow will be cleared within 24 hours to pavement level. This is nice if you can afford it. Other municipalities, on the other hand, have policies that state snow levels will be tolerated up to a certain maximum depth of the ruts on residential side streets. Needless to say, if there is lots of snow, many residents are not happy with the snow clearing despite the fact that they don’t wish to pay higher taxes to pay for improved service. And what happens if the municipality, because of budget constraints, just cannot afford to pay any more regardless of how good the service is? Many smaller ones today even have difficulty in paying the market average.

The public sector is then left with the option of introducing pay for performance based on the same factors that the annual performance appraisal is based on. Factors such as demonstrated initiative, responsibility, leadership, and teamwork. But if annual performance appraisal is a useless process, then tying compensation to it only makes it all the more so. The issues remain the same. What is the difference between average and superior? How can you measure it? Is the measurement truly objective and accepted by all concerned? Are the differences significant enough? Are the resulting pay differences meaningful and do they affect performance? And, of course, is anything being done to try and bring everyone up to the same level – the pay difference certainly will not.

Many use a quantitative system so as to have the entire process appear objective and quantifiable; the same as the profit factor in the private sector. But this is usually just a case of smoke and mirrors. How do you quantify a performance factor such as “initiative”? How do you determine the various levels of this factor, such as average, superior, and poor, as well as the points that are attached? Is the factor, for example, worth a total of 50 points out of 300 or 75? Someone has to assign the appropriate weight to the factor as well as to the various levels. In other words the subjectivity is built in. Then there is the whole question of who is doing the rating. This is usually the same person or group that was doing the old ratings in the first place. If everyone got relatively the same increase before, then you can be sure that everyone will get the same pay for performance. Nothing changes except for the perception.

Many simply institute some form of pay for performance to pacify the public’s negative opinion regarding public sector pay increases, which are usually automatic regardless of performance. Yet the end result is the same – poor performance is not dealt with and some staff, therefore, are being paid above their worth and contribution. A public sector job is still all too often a “safe” job with “tenure” and one that is based primarily on “seniority” rather than ability to contribute. It is not the compensation system that is to blame; it is the inherent lack of performance management.

There is nothing inherently wrong with having salary ranges that are based on fair market comparison, where the employee is able to move up the range with annual increments until they reach the accepted maximum or market job rate. The reason for the range is to recognize that there is a learning curve to any job; the higher the level of responsibility the greater the learning curve. The issue is not with giving an annual increase up to the maximum job rate. The issue is giving any increase at all to someone who is not performing well. We repeat that it is not the compensation system that is to blame; it is the inherent lack of performance management.

Cost of Living (COLA) increases, on the other hand, are not meant to be related to performance. They are usually based on the Consumer Price Index (CPI) and meant to ensure that all salary ranges and individual salaries remain competitive with the general market. Not having any provision for such increases or blending them in with so called merit increases only serves to destroy the organization’s competitiveness and ability to attract and retain well qualified staff.

The whole question of performance must be dealt with as a performance management issue and not a compensation issue. Yes, of course, you should reward performance, but you can do that in many other more meaningful ways than compensation. Don’t misunderstand. Compensation is important in that you have to ensure that your total compensation plan is competitive enough in the first place to attract and retain well qualified staff. But assuming that your compensation is competitive, what is far more important in motivating staff is the creation of a workplace culture that fosters and promotes good performance – a workplace culture that provides coaching and mentoring and fosters overall learning. A culture where responsibility and accountability as well as opportunity for participation is provided to all staff and one in which poor performance is not accepted and is dealt with through appropriate performance management. Good performers resent having to work alongside those that are not and yet get relatively the same increase.

The same principles apply to both the public and the private sector, even if pay for performance is more readily implemented in the private sector. Pay for performance, for example, does not work well even in a corporate team environment, unless all members of the team are fully productive.

Pay for performance is not a substitute for ongoing performance management.

References

Hansen, F., 2008. Compensation & Salary Forecast – Where’s the Merit-Pay Payoff? Workforce Management. November 3, 2008.