Ten Essentials of Pay for Performance

In The Compensation Report: 1991, "A Consultant's Report on Compensation Issues," leading compensation expert Robert E. Sibson outlines ten essential elements that every good pay for performance system should include.

In a performance culture salary for individuals is based solely on performance. Salary levels or increases are never, therefore, based on seniority, education, attendance, attitude or loyalty. Unless a company has a performance culture --a system that rewards high performance --a pay for performance plan will be difficult to institute and to maintain.

Pay for jobs should be based on competitive market needs. Pay increases for individuals holding those jobs should be based only on performance. The philosophy behind payroll practices must be equal treatment for all, with pay differences for individuals based only on their performance on the job.

Pay for performance increases must be distinguished from pay increases for any other reason --for example, cost of living increases. If pay for performance is to be effective, it must be clear to employees when they are being rewarded for improved performance by a salary increase over and above any general, across the board increase based on wage inflation in the market. Otherwise there is no incentive to improve performance and the system fails.

This means that the company must be prepared to grant general increases to all employees --a policy that is hard to sell in many instances. Nonetheless, there is a need to grant general increases and a logic to doing so. Companies set their pay rates in response to the marketplace because that is fair to employees and because having competitive pay for jobs makes good business sense. Accordingly, as the market increases, it follow that the same sense of fairness requires pay to rise commensurate with the marketplace increase. Productive performance is then rewarded on its own on an individual-by-individual basis.

A company cannot reward productive performance unless there is a way to measure changes in performance. There must, therefore, be a performance appraisal system that can clearly and reliably identify the performance level of each worker. The information should be recorded and used as a factor in determining performance pay increases.

The first step in setting up a performance appraisal system is to develop a common definition of performance; a definition that is related purely to personal productivity and work excellence. In addition, a system should be worked out that will get highly valid performance ratings.

Individual managers know the level of performance of their employees and, therefore, know when an employee's performance improves sufficiently to warrant a performance salary increase. Because the manager is in the best position to determine when an employee is deserving of a salary increase based on performance, that manager should be given the authority to make salary-reward-for-performance increase decisions without review before the fact --a difficult system for many companies to adopt. Failure to delegate such authority to line managers has been shown to contribute to the failure of pay for performance systems.

While some managers will be better than others in performance management, poor performance management can be quickly identified and those managers can be improved or replaced.

Pay for performance increases should never be restricted by control devices. A critical connection exists between performance increases and improvement in productivity. If an employee knows they can do no better than a specific level of increase, they may not continue to improve their productivity once that level is reached.

Sibson recommends using no salary increase budgets and no forced distribution mechanisms. Expected distribution techniques, however, may be used for monitoring purposes only.

Companies should set minimum pay for performance increase levels. Sibson usually recommends a seven percent minimum increase figure. This requirement recognizes that performance improvement cannot be judged more finely than in seven-percent increments. Since pay is matched to performance, salary reward for performance should also be given in minimum increments of seven percent. Sibson concludes that salary increases are based on something other than performance if performance cannot be judged in increments of less than seven percent. Further, increases should be structured in increments of five percent or more because performance differences cannot be judged in increments of less than five percent.

Companies should gather information about the performance spread in all job levels and link pay for performance to that performance spread. The pay spread (salary plus bonus) between outstanding work and acceptable work should match the difference between the output of outstanding performers and the output of performance that is acceptable only. The pay spread should include salary, bonuses and long-term income.

A sound compensation system should be structured so that extra performance can be rewarded at each salary level. To do otherwise is not only inequitable, it is bad business practice and could discourage excellence.

Salary levels and salary increases for marginal performers must also be considered. Managing pay for the marginal worker is not easy. It means smaller increases than are often expected and requires more years of zero increases for some employees than a supervisor may feel comfortable with.

If a company's pay structure is generally geared to market average, then the actual salary paid to individuals who are acceptable but below standard performers should be less than market average. In compensation terms, the outstanding performer's salary reward should be at the 93rd percentile or higher (or rapidly approaching that position) compared to market average. The acceptable performer, on the other hand, should be at the 25th percentile of market average.

Any salary system must contain a method for self-monitoring. In order to have an effective pay for performance program, a computer-driven personnel database must be designed that will provide managers/decision makers with needed information regarding the performance of each individual. The system, however should operate as a monitor only --the decision to reward performance should be made only after combining computer data with human intelligence, on a case-by-case basis.

A pay for performance system requires the company to have open communication with employees about the system. In return, the system demands that employees have confidence that the company actually does reward for performance. That confidence is instilled when pay increases reflect a pay for performance policy.

Accordingly, if the company is compelled to grant an increase for reasons other than market inflation or performance, the increase should be identified for what it is in a full disclosure.