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Why Merit Systems Fail

Posted by Chuck Csizmar | Posted in Articles, Universal Compensation | Posted on 21-04-2012

Tags: , ,


It’s likely that your pay-for-performance program has a fatal flaw built into it; an inadvertent side effect of the design that, if ignored by management will almost certainly guarantee failure.

But no one wants to talk about it.

Instead, what you’ll hear is a steady drumbeat of, “Oh yes, we have a pay for performance program.  Employees are rewarded on the basis of their performance.”  But what if those merit increases won’t be enough to move an employee from low in their salary range up to the midpoint, the “going rate?”  What if merit increases alone won’t assure competitive pay?

The problem

Over time increases to the external marketplace will outstretch the company’s ability to reward performance – to keep pace.  The company can’t keep up with increasing market values and often enough new hires will find themselves paid more than current experienced employees.

The company usually describes their midpoint as associated with the market “going rate.”  Given that, then any employee who has performed their job responsibilities for a set period of time without performance criticism will reasonably expect that their pay rate should at least equal that market rate.

That sounds like a fair and reasonable expectation.

When that doesn’t happen though, when individual pay remains below midpoint / market, the employee’s disappointment over perceived unfair treatment can fester into lower morale and disengagement, which in turn often leads to separation.  If the employee is a high performer, the company has just suffered a significant loss.

Doesn’t happen here, you say?  Then test yourself.  Ask Human Resources how their pay-for-performance system works over time, over several years.  Ask them how they’re going to move a new employee’s pay from the minimum or low end to the midpoint value.

I wonder what they would say.

Look at the numbers

Let’s look at an example: say you’re hired at the bottom of the salary range, at $80.  The midpoint is $100 and the maximum is $120 (typical salary range width).  Your compa-ratio is 80%.  After three years with the market / midpoint rising at approx. 2.5% per year, the $100 has become $107.70.  Meanwhile, let’s say you’re performing well, receiving 4% annual increases.  After three years your pay is now $90, and your new compa-ratio is 83.6%.

If you believe that three years of satisfactory (or better) performance has brought you to a point where you are thoroughly familiar with the job, and therefore should be paid the “going rate,” guess what?  You’re still over 16% below the company’s midpoint.  You’re nowhere near competitive pay.

And if you’re fortunate enough to receive a promotion?  Chances are your present 83.6% compa-ratio will likely have you starting the new job similarly low in your new salary range.  So the self-defeating process starts once again.

But what if you’re not promoted?  How many more years will it take to get you to competitive pay?  Are you willing to wait that long?  Or will you become another statistic in the company’s turnover rate?

The causes that make the effect

This doesn’t need to happen, but all too often does.

•     When a company is caught up in an “everyone deserves a raise” mentality, there isn’t enough money left over to properly reward the higher performers.

•    Many companies don’t provide significant reward differentials between performance levels.  Is 1% or 2% enough between your stars and “Joe Average?”   Are you motivating through pay, or simply administering?

•    When managers fail to consider employee contributions vs. the evolving competitive market.  When decision-makers ignore external realities and instead focus solely on internal balance (equity).

•    Merit budgets are not designed to address the issue of “market creep.”  It’s as if the company presumes that the external marketplace isn’t moving ever higher.

With the above as backdrop an organization’s internal pay practices can easily become disconnected from an employee’s market value.

Not many companies recognize this inherent flaw in their pay-for-performance program.  Individual managers may notice the inherent weakness, but most organizations tend to turn an official blind eye.  Granted, most don’t have the extra money that would be required to jumpstart employees to match their growing marketability.  They don’t have the money to be fair to everyone; it just costs too much.

Instead, they prefer to take one year at a time, all the while telling employees that the merit system works.

That’s where the cynical viewpoint of some employees is created, suggesting that quitting and getting rehired is a sure way to get the money you deserve.  It’s a risk, but I’ve seen that tactic work.
What can you do?

Build a ring fence and maybe they will stay

Develop a Ring Fence: identify your key employees and make sure that they are both competitively paid as well as appropriately paid for their value to the organization.  Build a protective “fence” around these employees, similar to “franchise players” in professional sports.  These are the ones you can’t afford to lose – so keep track of their compensation packages.

Then every year review your entire staff.  Who is paid properly and who is not.  Having this knowledge is half the battle, halfway toward a solution.  Because from this point individual corrective tactics can be devised.

Caution: you may have to forgo some increases for “so-so” employees.  Can you do that?

The merit pay process usually works well for one full cycle, but for the long term the mechanics don’t provide the compensation level that the employee is worth.   Management touts their merit reward programs as a one-time event, but over time employees will see the fly in the soup, that unless one gets promoted on a regular basis the “system” actually works against you.

But no one wants to talk about it.

Comments (2)

Great comments regarding to pay-for-performance cutlure. As to our company’s salary structure, my idea is the increase of base pay based on the assessment of responsibilities/competecies and performance, amount of variable pay only based on the performance. I don’t believe few merit increase could motivate the higher performer, instead variable pay can achieve this objectives. Of course, we still need to consider the performance factor when to generate the merit increase scheme. But it’s not most major. I think we should pay more attention on the staff who has the potential to be promoted due to their capability, or who has the competency we need and so on. It’s because generally the incentive scheme doesn’t cover such employees.

I totally agree on this with you. I believe that this economic crisis has allowed this flaws to be perceived more clearly. Pay for performance and Merit Matrix are designed for rising economies. There is no way that the Compensation systems can keep it up when the downturn arrives, and so the employees and managers lack of tools to deal with it.

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