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10. Pay−for−Performance Plans

Chapter Ten Pay-for-Performance Plans Chapter Outline What Is a Pay-for-Performance Plan? Does Variable Pay Improve Performance Results? The General Evidence Specific Pay-for-Performance Plans: Short Term Merit Pay Lump-Sum Bonuses Individual Spot Awards Individual Incentive Plans: Types Individual Incentive Plans: Advantages and Disadvantages Individual Incentive Plans: Examples Team Incentive Plans: Types Comparing Group and Individual Incentive Plans Team Compensation Gain-Sharing Plans

Profit-Sharing Plans Earnings-at-Risk Plans Group Incentive Plans: Advantages and Disadvantages Group Incentive Plans: Examples Explosive Interest in Long-Term Incentive Plans Employee Stock Ownership Plans (ESOPs) Performance Plans (Performance Share and Performance Unit) Broad-Based Option Plans (BBOPs) Your Turn: Understanding Stock Options Appendix 10-A: Gain Sharing at Dresser Rand Appendix 10-B: Profit Sharing at 3M

WHAT IS A PAY-FOR-PERFORMANCE PLAN? What’s in a name? The answer is . . . confusion, at least if we are talking about pay-forperformance plans. Listen long enough and you will hear about incentive plans, variablepay plans, compensation at risk, earnings at risk, success sharing, and others. Sometimes these names are used interchangeably. They shouldn’t be. The major thing all these names have in common is a shift in thinking about compensation. We used to think of pay as primarily an entitlement—if you went to work and did well enough to avoid being fired, you were entitled to the same-size check as everyone else. Pay-for-performance plans signal a movement away from entitlement—sometimes a very slow movement— toward pay that varies with some measure of individual or organizational performance. Of the pay components we discussed in Chapter 9, only base pay and across-the-board increases don’t fit the pay-for-performance category. Curiously, though, many of the surveys on pay for performance tend to omit the grandfather of all these plans, merit pay. 285

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EXHIBIT 10.1 Use of Different Variable-Pay-Plan-Types Percent of Companies with Plan Type of Plan

1996

Special-recognition plans Stock option plans Individual incentive plans Cash profit sharing Gainsharing plans Team awards

1997

1998

1999

2002

43 25 23 20 18 13

51 46 35 22 20 17

59 43 39 23 18 15

34 40 38 18 11 8

44 21 17 22 16 13

Source: 2002 data are form IOMA, “Latest Data-What’s Hot and Whats Not in PFP,” Pay for Performance Report, May 2002, p. 11. And IOMA, “Variable Pay Popularity,” Pay For Performance Report, January 2003, p. 8; 1996–1999, data are from IOMA, “The Goods and Evils of Variable-Based Pay,” Pay for Performance Report, July 2000, 12.

Maybe the problem is that merit pay is out of favor right now.1 One survey of 250 companies reports that 30 percent are thinking about eliminating merit pay and another 10 percent already have.2 Despite this unrest, merit pay is still a pay-for-performance plan used for more than three-quarters of all exempt, clerical, and administrative employees.3 While more innovative pay-for-performance plans may get more and better press, there is still no widespread evidence of their adoption, as Exhibit 10.1 suggests. Exhibit 10.1 illustrates the wide variety of variable-pay plans in use today. What used to be primarily a compensation tool for top management is gradually becoming more prevalent for lower-level employees too. Exhibit 10.2 indicates that variable pay is commanding a larger share of total compensation for all employee groups. The greater interest in variable pay probably can be traced to two trends. First, the increasing competition from foreign producers forces American firms to cut costs and/or increase productivity. Well-designed variable-pay plans have a proven track record in motivating better performance and helping cut costs. Second, today’s fast-paced business environment means that workers must be willing to adjust what they do and how they do

EXHIBIT 10.2 Base versus Variable Pay

Percent of Total Compensation Today Employee Group

Base

Nonexempt Exempt Executive

98 92 76

1

Expected in 3 Years Variable 2 8 24

Base

Variable

96 87 71

4 13 29

Adrienne Fox, “Is Merit Pay Dead?” HR Magazine, 48(1) (2003), pp. 12–18. Management Association, “Survey of Merit Pay,” Compflash, January 1994, p. 8. 3American Management Association, “Merit Raises Remain Popular among Fortune 1000,” Compflash, December 1994, p.6. 2American

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it. There are new technologies, new work processes, new work relationships. All these require workers to adapt in new ways and with a speed that is unparalleled. Failure to move quickly means market share goes to competitors. If this happens, workers face possible layoffs and terminations. To avoid this scenario, compensation experts are focusing on ways to design reward systems so that workers will be able and willing to move quickly into new jobs and new ways of performing old jobs. The ability and incentive to do this come partially from reward systems that more closely link worker interests with the objectives of the company.4

DOES VARIABLE PAY IMPROVE PERFORMANCE RESULTS? THE GENERAL EVIDENCE As the evidence pointed out in Chapter 9, pay-for-performance plans—those that introduce variability into the level of pay you receive—seem to have a positive impact on performance if designed well. Notice that we have qualified our statement that variable-pay plans can be effective—if they are designed well. In the next sections we talk about issues in design and the impacts they can have.

SPECIFIC PAY-FOR-PERFORMANCE PLANS: SHORT TERM Merit Pay A merit pay system links increases in base pay (called merit increases) to how highly employees are rated on a subjective performance evaluation. Chapter 11 covers performance evaluation, but as a simple illustration consider the following typical merit pay setup: Well Above Above Average Average Performance rating Merit pay increase

1 6%

2 5%

Average 3 4%

Below Well Below Average Average 4 3%

5 0%

At the end of a performance year, the employee is evaluated, usually by the direct supervisor. The performance rating, 1 to 5 in the above example, determines the size of the increase added into base pay. This last point is important. In effect, what you do this year in terms of performance is rewarded every year you remain with your employer. By building into base pay, the dollar amount, just like the Energizer bunny, keeps on going! With compounding, this can amount to tens of thousands of dollars over an employee’s work career.5

4Jeffrey

Arthur and Lynda Aiman-Smith, “Gainsharing and Organizational Learning: An Analysis of Employee Suggestions over Time,” Academy of Management Journal, 44(4) (2001) pp. 737–754. 5Jerry M. Newman and Daniel J. Fisher, “Strategic Impact Merit Pay,” Compensation and Benefits Review, July/August 1992, pp. 38–45.

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Increasingly, merit pay is under attack. Not only is it expensive, but many argue it doesn’t achieve the desired goal: improving employee and corporate performance.6 In a thorough review of merit pay literature, though, Heneman concludes that merit pay does have a small, but significant, impact on performance.7 Interestingly, some of the most exciting experiments with merit pay are taking place in the public sector. The Office of Personnel Management (OPM), a huge federal bureaucracy, proposes to introduce pay for performance into the white-collar pay system.8 While it will take a near miracle to change the culture and management processes needed to facilitate merit pay (e.g., a performance management system that is accepted as fair), the OPM seems intent on shaking up the system. Meanwhile, at the state level, public schools in Cincinnati, Denver, and Philadelphia are leading the way to merit pay for teachers. In Cincinnati, for example, teachers are held accountable for things they control: good professional practices. Teachers argue they should be held to standards similar to doctors: not a promise of a long healthy life but a promise that the highest professional standards will be followed. To assess teacher professional practices, in Cincinnati six evaluations are conducted over the school year, four by a trained teacher evaluator (essentially a trained teacher) and two by a building administrator. The size of pay increases is directly linked to performance during these observational reviews.9 If we want merit pay to live up to its potential, it needs to be managed better.10 This requires a complete overhaul of the way we allocate raises: improving the accuracy of performance ratings, allocating enough merit money to truly reward performance, and making sure the size of the merit increase differentiates across performance levels. To illustrate the latter point, consider the employee who works hard all year, earns a 6 percent increase as our guidelines above indicate, and compares himself with the average performer who coasts to a 4 percent increase. First we take out taxes on that extra 2 percent. Then we spread the raise out over 52 paychecks. It’s only a slight exaggeration to suggest that the extra money won’t pay for a good cup of coffee. Unless we make the reward difference larger for every increment in performance, many employees are going to say “Why bother?”

Lump-Sum Bonuses Lump-sum bonuses are an increasingly used substitute for merit pay. Based on employee or company performance, employees receive an end-of-year bonus that does not build into base pay. Because employees must earn this increase every year, it is viewed as less of an entitlement than merit pay. As Exhibit 10.3 indicates, lump-sum bonuses can be considerably less expensive than merit pay over the long run. 6Jonathan

Day, Paul Mang, Ansgar Richter, and John Roberts, “Has Pay for Performance Had Its Day?” McKinsey Quarterly, 25(2), 2002, pp. 6–54. 7Robert Heneman, Merit Pay: Linking Pay Increases to Performance Ratings (Reading, MA: AddisonWesley, 1992). 8Howard Risher, “Pay-for-Performance: The Keys to Making It Work,” Public Personnel Management, 31(3) (2002), pp. 317–332. 9Cincinnati Federation of Teachers, “Teacher Quality Update,” www.cft-aft.org/prof/tqa_comp3.html, (August 2000). 10D. Eskew and R. L. Heneman, “A Survey of Merit Pay Plan Effectiveness: End of the Line for Merit Pay or Hope for Improvement,” in Strategic Reward Management, ed. R. L. Heneman (Greenwich, CT: Information Age Publishing, 2002).

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EXHIBIT 10.3 Relative Cost Comparisons

Merit Pay Base pay Year 1 payout 5% New base pay Extra cost total Year 2 payout 5% New base pay Extra cost total After 5 years. . . . Year 5 payout New base pay

Lump-Sum Bonus

$50,000 (2,500) 52,500 2,500 ($2,625 = .05 × 52,500) 55,125 (52,500 + 2,625) 5,125

5%

5%

3,039 63,814

$50,000 (2,500) 50,000 2,500 (2,500 =.05 × 50,000) 50,000 5,000 2,500 50,000

Notice how quickly base pay rises under a merit pay plan. After just five years, base pay is almost $14,000 higher than it is under a lump-sum bonus plan. It should be no surprise that cost-conscious firms report switching to lump-sum pay. Twenty-six percent of companies report using lump-sum merit pay today.11 It also should be no surprise that employees aren’t particularly fond of lump-sum bonuses. After all, the intent of lumpsum bonuses is to cause shock waves in an entitlement culture. By giving lump-sum bonuses for several years, a company is essentially freezing base pay. Gradually this results in a repositioning relative to competitors. The message becomes loud and clear: “Don’t expect to receive increases in base pay year after year—new rewards must be earned each year.” Consider the bonus system developed by Prometric Thomson Learning call centers, which register candidates for computerized tests. The centers have very clear targets that yield specific employee bonuses, as shown in Exhibit 10.4.

Individual Spot Awards Technically, spot awards should fall under pay-for-performance plans. About 34 percent of all companies use spot awards.12 And an impressive 74 percent of companies in one recent survey reported that these awards were either highly or moderately effective.13 Usually EXHIBIT 10.4 Customer Service Bonus Scheme at Prometric Thomson Learning Call Centrers Performance Measure

Minimum Performance

Average call wait Average talk time Attendance Quality Total Bonus