HRMN 395: Plan to Change the Organization

86

4 Linking Pay to Performance via Merit Pay

The purpose of merit pay is to reward individual contributions from employees and to encourage their best performance possible. It is often included within the broader concept of “pay for performance.” In the past 20 years, much has changed concerning organizational performance management practices, and their handling of various forms of incentive pay. While some have called for the end of merit pay plans, according to a 2019 survey by Mercer, they remain one of the more widely used means by which US organizations determine employee pay increases. To paraphrase Mark Twain, the “death” of merit pay plans has been greatly exaggerated. The purpose of this chapter is to address how merit pay can serve to reward employee contributions and encourage individual performance. In theory, if all employees operate at peak efficiency relative to their capabilities, the organization will thrive.

The logic behind merit pay is straightforward: If pay is more contingent on performance, then employee motivation to achieve high performance is increased (see Figure 4.1). Three motivational theories are relevant here:

1. Reinforcement theory states that merit pay should motivate improved performance because the monetary consequences of good perfor- mance are made known – the better one’s performance, the greater the pay increase will be.

2. Expectancy theory states that merit pay should motivate improved per- formance because performance is instrumental to the attainment of a pay increase – improved effort to perform leads to increased pay.

3. Equity theory states that merit pay should lead to improved performance because a pay raise is seen as a fair outcome for one’s performance input – the more one contributes to the organization, the greater the pay increase.

C o p y r i g h t 2 0 2 0 . W i l e y .

A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .

EBSCO Publishing : eBook Collection (EBSCOhost) - printed on 9/11/2022 6:43 PM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS AN: 2734783 ; WorldatWork, Dan Cafaro.; The WorldatWork Handbook of Total Rewards : A Comprehensive Guide to Compensation, Benefits, HR & Employee Engagement Account: s4264928.main.eds

Book: WorldatWork, & Dan Cafaro. (2020). The WorldatWork handbook of total rewards : A comprehensive guide to compensation, benefits, HR & employee engagement. Wiley.

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Determining What to Reward 87

A successful merit pay program will do the following:

• Reward employees for achieving performance results and exhibiting behaviors aligned with the objectives of the organization, which ideally are linked directly to the strategic business plan and mission of the organization.

• Provide rewards commensurate with contributions, i.e., bigger pay increases for stronger performers.

• Be communicated easily to employees. • Be understood readily by employees. • Recognize “bottom-line” considerations and the organization’s ability

to deliver pay increases. • Be rational, structured, and administered in a logical manner. • Conform to legal requirements. • Use a well-founded, credible means of evaluating performance. • Conform with and support management philosophy.

All organizational incentives  –  including merit pay plans  –  should be planned carefully to achieve these goals. If an organization takes the time to design its merit pay plan carefully, it can establish a linkage between pay and performance.

DETERMINING WHAT TO REWARD

Before a merit pay plan can be designed, the first steps are to determine:

• What the organization values. • Which types of individual employee contributions should be rewarded. • The organization’s ability to pay. • The organization’s ability and willingness to communicate the plan. • The organization’s ability to administer the plan.

Some organizations make these determinations through the planning efforts of senior management, who refer to the overall business strategy and mission. Other organizations use a structured human resource planning

PPerformance Pay Motivation Improved Performance

FIGURE 4.1 Linking pay to performance.

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88 Linking Pay to Performance via Merit Pay

effort, which relies on formal performance-planning and goal-setting activities. Other organizations make informal determinations. Steps to start a merit pay plan are listed in Figure 4.2.

Without a clear understanding of the organization’s values and expectations, it is possible that employee contributions that are contrary to the organizational objectives will be rewarded. A successful plan requires that individual goals be aligned with the organization in terms of:

• Identity, which relates to whom the organization serves and what products and services are provided.

• Strategic plan, which relates to how the mission of the organization is accomplished.

• Objectives, which relate to what corporate goals have been established.

Once the link between individual and organizational objectives has been defined, merit pay can be used to align individual goals with those of the organization. When used properly, merit pay will reinforce the accomplishment of individual contributions that are in line with the identity, strategic plan, and objectives of the organization.

Merit pay also must be consistent with regard to the business environment of the organization. Business environment characteristics that support or detract from merit pay are shown in Figure 4.3.

Verify that key prerequisites are in place:

• Top management support • An established performance-management system that is reliable, valid,

fair, flexible, and credible

Conduct research to verify that merit pay is appropriate and workable for the organization:

• Review of prior merit pay theory and research • Collection of information on other employers’ experiences with merit

pay, focusing on those that are regarded as highly successful and highly unsuccessful as well as those that are similar in management style and organization

• Evaluation of the effectiveness of the merit pay program by establishing a baseline of employee attitudes and perceptions about pay

Form an employee task force to oversee the development of the plan and ensure workforce buy-in, with the following functions represented:

• Line management • HR professionals • Employees representing different “levels” in the organization • Nonexempt employees, if appropriate for the organization’s culture

FIGURE 4.2 Getting started on a merit plan.

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Documenting Performance Standards 89

DOCUMENTING PERFORMANCE STANDARDS

The second step in developing a merit pay plan is to devise a system that establishes and evaluates performance against individual objectives. Performance standards, also known as performance goals or objectives, are written statements that help determine the extent to which employees have contributed to the mission of the organization. These standards establish the basis on which employee contributions are evaluated, and they define the expected level of performance. A variety of rating systems are used to describe how successful an employee has been in attaining objectives. Some examples of common performance standards are shown in Figure 4.4. The past two decades saw an increase in organizational use of forced rankings, and then a rather abrupt decline. While this is a story for another setting, what has not changed is the need for clear performance standards to be set, and then for managers and others to make use of those standards to dif- ferentiate between levels of individual employee performance.

While establishing performance standards, it is critical to determine which standards best meet an organization’s needs. Objective standards –  such as quality and quantity of work performed – should be assessed as well as more intangible, subjective aspects of the job such as teamwork, coopera- tion, and customer service.

Documentation of work standards is an essential part of the performance evaluation process. This is most often done as an annual event in which supervisors and subordinates discuss goals and objectives for the coming

MERIT PAY

SUPPORT DETRACT

Little previous history of seniority-based raises

New or declining business

Emphasis on achievement Well-de�ned individual work

outcomes

Top-management support

Credible performance-management system

Cultural support for giving signi�cant rewards to some and small or no rewards

to others Cultural support for communication of

program tenets and characteristics High trust in management and human

resources

Unionized workforce

Highly task-interdependent employees

Egalitarian climate

In�ationary environment

Performance difficult to measure

Low trust in management and human resources

FIGURE 4.3 How business environment characteristics relate to merit pay.

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90 Linking Pay to Performance via Merit Pay

year while evaluating the prior year’s performance. In some organizations, determining and documenting work standards is a cooperative effort between managers and employees. Other options include the following:

• Have managers determine objectives and then communicate them to the employee.

• Have employees present goals to their managers for discussion.

However work standards are established, obtaining employee buy-in is essential. If employees cannot comprehend the standards or accept their reasonableness, they are unlikely to perform in a manner that is consistent with the mission of the organization. To help ensure that employees accept and act on performance standards, three actions should be taken:

1. Emphasize results and behaviors rather than traits. Performance standards should reflect what the person produces (results) or what the person does (behaviors) rather than personality characteristics (traits). For example, it is better to measure the quality of performance by using a result such as “number of customer complaints” or a behavior such as “is always courteous to customers” than it is to use a trait such as “is nice to people.”

2. Employees should participate in setting standards. For employees to act on performance standards, they must be committed to them, which means that they need to have a sense of ownership in the process. When employees are given an opportunity to help establish performance

Quality Demonstrates work quality by producing goods or services that meet or exceed preset, measurable standards (e.g., less than one defect per thousand items).

Interpersonal Teamwork Works well with others toward the accomplishment of goals. Earns respect and trust. Makes a contribution to the team's achievements. Shows consideration for the feelings and needs of others.

Planning and Organizing De�nes and prioritizes objectives. Installs a thorough, appropriate plan of action. Establishes procedures to monitor progress toward task completion. Can manage multiple projects, priorities, or deadlines to accomplish long- and short-term goals.

Problem Analysis Identi�es problems, secures relevant information and relates data from different sources to determine possible causes of problems.

Quantity Meets or exceeds speci�c production quotas within a given period of time.

Communications Effectively expresses thoughts verbally, in writing and nonverbally. Listens attentively and makes productive use of acquired information. Gains agreement and acceptance of plans, ideas, or activities being discussed while incorporating others' good suggestions.

Creativity and Innovations Conceives, encourages, develops, and applies imaginative concepts that improve operating procedures and efficiencies, or that make better use of company assets.

FIGURE 4.4 Examples of common performance standards.

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Establishing a Merit Budget 91

goals and objectives, they are more likely to feel as if they “own” the process and to protect their ownership interests by meeting the standards.

3. The standards should be flexible. It is the nature of work and organizations to be in a constant state of flux. Consequently, performance objectives and standards that are viable now may – because of influences outside the control of the employee – become obsolete. An organization should be willing to modify standards as shifting demands dictate.

ESTABLISHING A MERIT BUDGET

A fundamental feature of any merit pay plan is an established budget that has been endorsed by management. Every year that a merit pay plan is in effect, the budget process should consist of two key activities:

• Determine the size of the budget. • Allocate funds to business units within the organization.

Determining Budget Size

Salary-increase budgets are typically established each year based on many factors, including:

• Actual or anticipated organization financial results • Cost-of-living and/or inflation • Industry trends • Competitive factors such as retention rates and recruiting successes • Cost of labor and the competitive position of the organization’s pay in

the marketplace • Group (e.g., division or department) performance and needs

In most organizations, it is common to obtain or develop salary budget surveys each year that show expected increase rates for similar employers. WorldatWork and many of the major compensation consulting groups con- duct annual salary budget surveys and publicize their findings widely.

On the basis of survey information, and after taking into account the organization’s financial situation, senior management ordinarily will approve a not-to-be-exceeded “bottom-line” increase budget computed as a percentage of current payroll. Recently, merit-increase budgets have aver- aged approximately 3 percent annually.

Determining Budget Allocation

The next step in the budget process is to determine how funds are to be distributed to business units within the organization. A common method of allocating merit pay dollars is to use a uniform budget. Under this procedure,

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92 Linking Pay to Performance via Merit Pay

merit pay budgets are distributed to divisions or departments as a percent- age of “eligible payroll,” which is defined as the aggregate base salaries of all employees who are eligible to participate in the merit pay plan.

Eligibility may be driven by a calendar date. Some organizations include only those employees who have exceeded a minimum service requirement such as six months at the time of their expected date of increase. Other organizations will include all employees on payroll, but will prorate increases for those employees with a partial year of service.

Using the uniform-budget approach, every business unit in the organiza- tion shares proportionally in the amount of money available for salary increases. Figure 4.5 is an example of a uniform-budget allocation.

Use of uniform budgets fails to take into account that some business groups are more or less successful than are others. Furthermore, in organi- zations with geographically dispersed business activities –  some of which may be located in areas with different cost-of-living, inflationary, or competi- tive pressures with respect to the workforce –  a uniform budget may be inappropriate.

To respond to differing achievement levels of the various business units or the need to pay different wages in certain locations, some organizations use a flexible-budget approach. The flexible-budget method introduces a level of complexity into the budget process that is not present in uniform merit budgets. Unlike uniform budgets, flexible budgets require sound measures of business-unit performance and geographic pay differences to distribute budget dollars. Many organizations are ill-prepared to track or calculate these differences accurately. Figure 4.6 is an example of a flexible-budget allo- cation (budget percentages have been rounded). In this example, Marketing and Production were viewed as contributing more significantly to company performance in the prior year than other departments, and were allocated higher merit budget percentages. Additionally, Finance and Human Resources are located at headquarters, which has a lower cost of living, and were allocated smaller merit budgets.

  Department

Total Payroll Dollars

Merit Budget Percentage

Merit Budget Dollars

Finance $2,450,500 4.0% $98,020

Human Resources $1,750,900 4.0% $70,036

Marketing $4,375,055 4.0% $175,002

Production $7,980,250 4.0% $319,210

Totals $16,556,705 4.0% $662,268

FIGURE 4.5 Example of a uniform-budget allocation.

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Policy Decisions 93

SETTING MERIT PAY POLICY

The essential goal of a merit pay plan is to link pay to performance in a way that is consistent with the mission of the organization. To cement this link, pay increases must vary according to the level of an employee’s contribu- tions and efforts. There are two required conditions:

• Variations in employee performance must be measurable and measured. • Managers must be provided with the necessary “tools” to determine the

appropriate rewards.

These tools are to be found in the established guidelines or policies that govern pay increases as well as in the process for implementing these guidelines.

POLICY DECISIONS

Key factors in creating a merit pay policy are the size, timing, and delivery of merit increases.

Size: Absolute vs. Relative

The size of pay increases is a critical component in merit pay programs. Two conditions are necessary to motivate employees most effectively to meet and exceed performance standards for their positions:

• The absolute size of the merit increase must be significant enough to make a noticeable difference to employees (e.g., the increase must not be so trivial as to be deemed inconsequential). The failure to provide noticeable differences in pay is a common complaint made against many merit pay plans in action.

• The relative size of the increase must be significant enough that real differ- ences in performance are recognized by meaningful differences in rewards.

DEPARTMENT TOTAL PAYROLL DOLLARS

MERIT BUDGET PERCENTAGE

MERIT BUDGET DOLLARS

Finance $2,450,500 $75,966

$63,032

$188,099

$335,171

$662,268

$1,750,900

$4,375,055

$7,980,250

$16,556,705

3.1%

3.6%

4.3%

4.2%

4.0%

Human resources

Marketing

Production

Totals

FIGURE 4.6 Example of a flexible-budget allocation.

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94 Linking Pay to Performance via Merit Pay

A successful merit pay program will ensure that increases awarded to the “best” contributors will be substantially greater than increases awarded to average or below-average performers. If differences among pay increases are deemed by recipients to be trivial, the merit pay program will be under- mined because employees will not be motivated to improve their perfor- mance. For example, a merit pay program that provides 1 percent increases for “exceptional” performers is likely to be perceived by employees as not providing significantly different rewards. However, a merit pay program that offers an additional 4–5 percent increase for exceptional performance is more likely to alter employee behavior and be motivational.

Timing: Anniversary vs. Common Review

Another issue that must be addressed is the date merit-increase decisions are made. Survey data suggest that common review dates are used by almost two-thirds of organizations, while one-third stagger increases, mostly by providing them on anniversary dates.

Using an anniversary-date approach spreads the administrative burden (tasks such as completing performance reviews, making increase decisions, and processing pay increases) throughout the year for managers and human resources staff. Payroll increases also are staggered, reducing the financial impact that accompanies a single jump in salaries. Also, the anniversary-date approach focuses the performance evaluation and increase on an individual employee, ideally leading the employee to believe the process is focused specifically on him or her.

A disadvantage of an anniversary-date approach is that relative perfor- mance (e.g., comparative evaluations), may be hard to judge, particularly if performance is evaluated at different times for all employees. Another disadvantage becomes evident when conservative budget management accentuates the natural tendency of many managers to “save” money until year-end. When this occurs, employee increases at the beginning of the year may be smaller than increases at the end of the year, and the result may be to penalize some employees unfairly.

A common (i.e., annual) review date consolidates the administrative burden for management and human resources, and increases can become part of the yearly budgeting process. Further, because increases for all employees are determined at the same time, appraisal ratings for all employ- ees can be collected and relative performance can be factored into the deci- sion more easily. If the merit budget is based on business-unit performance, the linkage among business-unit performance, individual performance, and merit increases can be clearer with a common date.

Disadvantages of common review dates are that the workload may be onerous if the timing of the salary-increase program coincides with other major efforts (such as year-end financial closings, open enrollment for benefits, and departmental budgeting), and cash-flow implications for the organization may be extreme when all increases occur simultaneously.

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Policy Decisions 95

The decision concerning whether to use an anniversary-date versus a common-review-date approach to administer merit increases should be determined by the availability of performance data for employees and organizational units, and the availability of management and human resources. In organizations where budgets for salary increases are allocated based on organizational performance during a fixed period of time, employee and departmental performance also may be evaluated during the same time period. In such cases, a common review date might make sense. Anniversary-date increases might be more appropriate in organizations that stagger appraisals of performance or that permit little or no increase-budget variability among departments and in organizations that want to emphasize the individual’s performance against absolute standards instead of empha- sizing relative performance.

Another issue is whether to permit variability in time between increases in the pay program. In some organizations, the time between increases is not uniform for all employees; rather, performance differences are reflected not only in the size of increase but also in frequency. Excellent performance may be rewarded with larger and more frequent rewards. For example, top contributors might receive relatively large pay raises every 6 to 9 months, while average performers might wait 12 to 15 months for a lesser increase.

Delivery: Base vs. Lump Sum

Under traditional merit pay plans, merit increases are built into employees’ salaries for as long as they remain with the organization. Hence, the increases are permanent, and their values are compounded over time as additional increases are granted.

An alternative to base-salary increases is the use of lump-sum increases. Lump-sum increases are one-time payments made in lieu of a traditional base-pay increase, and they typically are delivered annually via the merit pay program. Similar to a “bonus” payment, a lump sum must be re-earned each year based on performance – it is not built into base salary. Often, lump-sum payments are provided to employees who are near, at, or over the maximum of their salary range (often called “red circle” employees).

The advantages of lump sum increases for the organization are clear: While retaining a pay-for-performance relationship, payroll costs over time are lessened because of the lack of a compounding effect. Also, the “sanc- tity” of pay ranges is protected because the number of red-circle employees can be controlled. In organizations where employees are at or over the max- imum of their grade, but are not permitted to receive increases, lump sums provide a mechanism to continue to reward and motivate strong but highly paid contributors.

There are fewer advantages of lump sums for the employee, though receiving the annual increase at once rather than having it paid out over 12 months – as is the case with a base-pay increase – may appeal to some. For long-term and highly paid employees, who may be near the top of their

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96 Linking Pay to Performance via Merit Pay

salary range with no room to grow, lump sums provide a means to continue to receive rewards.

Frequently, lump sums issued in lieu of merit increases are a concern for employees because their base pay will be less over time. Longer-term employ- ees approaching retirement typically exhibit the most concern. Many employers allay this concern by counting lump sum awards toward final average-earnings pension calculations. Similarly, such payments often are tied to benefits. For example, benefits such as life insurance, which are linked to salary, will reflect lump sum payments in addition to base salary. This solution addresses a number of issues:

• The motivational link between performance and reward can be maintained.

• The organization reaps the benefit that lump sum payments provide in controlling total compensation costs.

• Employee benefits entitlements are not seriously reduced.

However, caution should be used with this approach because employees may react negatively when their base salaries do not change or grow relatively slowly over time.

POLICY IMPLEMENTATION

A merit pay policy answers the following questions about salary increases: How much? When? How? How frequently? These decisions can be summa- rized in a simple compensation tool called a merit pay matrix. A merit pay matrix details the amount and timing of increases for various levels of performance at various locations in the pay grade. A merit pay matrix may be interpreted as an operational statement of an organization’s pay-for- performance theory or policy. It spells out the contingency between pay and performance in specific terms.

Merit pay matrices range from simple to complex, depending on the number of variables on which pay is made contingent. Generally, there are three alternatives for issuing merit increases:

• Based only on performance • Based on performance and position in range • Based on performance and position in range using variable timing

Performance

This method, which uses the simplest form of merit matrix (Figure 4.7), is most common in organizations without well-defined salary grade structures. Pay increases are granted based solely on performance, resulting in top performers receiving bigger increases than lower performers. Typically, salary increases are calculated as a percentage increase in base pay.

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Policy Implementation 97

Note: The matrices displayed in Figures 4.7, 4.9, and 4.10 use ranges of increases, rather than single percentages. This provides for more manage- rial discretion in awarding increases, and it more closely links pay and performance. In some companies, however, each cell of the matrix is occupied by only a single number.

Basing merit increases on performance alone ignores internal pay com- parisons. Within a performance class, higher-paid employees receive greater absolute increases, even though the merit percentage reward is the same. This has the effect of perpetuating pay inequities that might exist, and it may reward long-tenured and/or highly paid employees disproportionately.

An alternative is to calculate merit increases as a percentage of the employee’s salary-grade midpoint rather than their base pay. This approach provides larger relative dollar increases to employees within a performance class who are paid lower in their salary range than it does for employees who are high in their range (see Figure 4.8). Over time, inequities in salaries of employees in the same salary grade will be reduced as lower-paid employees are accelerated toward midpoint and higher-paid employees are “slowed down.” This method reduces some of the bias toward long-term/highly paid employees that may be inherent in a performance-only merit matrix.

The advantage of either approach to calculating merit increases based only on performance is that the method is:

• Simple to budget • Easy to administer • Straightforward to communicate

Performance and Position in Range

Larger organizations may have more complicated grading structures that base increases on both performance and position in range, which is commonly defined by quartiles, or, if greater precision is required, by compa-ratios. This practice is based on the concept that the midpoint repre-

Performance Rating

Fixed Increase Amount

Discretionary Increase Amount

Outstanding 8% 6–10%

Consistently Exceeds Standards

5% 4–6%

Meets Standards 3% 2–4%

Does Not Fully Meet Standards

0% 0–2%

FIGURE 4.7 Linking merit increases to base pay.

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98 Linking Pay to Performance via Merit Pay

sents a “competitive” or “fair” wage for a particular set of skills in the market- place, and that, over time, employees with a similar level of sustained performance should be paid an equivalent amount. Thus, a merit-increase guide chart similar to Figure 4.9 will cause employees with the same perfor- mance to converge, over time, on a target point (typically the midpoint) by awarding bigger increases to employees lower in their range and smaller increases to employees higher in the range.

Increase as a Percentage of Base Pay

Employee Current Pay Rate

Increase Percentage

Increase Dollars

A $25,000 4.0% $1,000

B $35,000 4.0% $1,400

C $45,000 4.0% $1,800

Increase as a Percentage of $35,000 Midpoint

Employee Current Pay Rate

Increase Percentage of Midpoint

Increase Dollars

Effective Increase

Percentage

A $25,000 4.0% $1,400 5.6%

B $35,000 4.0% $1,400 4%

C $45,000 4.0% $1,400 3.1%

FIGURE 4.8 Linking merit increases to salary-grade midpoints.

Position in Range Before Increase

Performance Rating

1st Quartile or Below

2nd Quartile

3rd Quartile

4th Quartile

Outstanding 8–9% 6–7% 4–5% 3–4%

Consistently Exceeds Standards

6–7% 4–5% 3–4% 2–3%

Meets Standards 4–5% 3–4% 2–3% X

Does Not Fully Meet Standards

0–2% X X X

FIGURE 4.9 Linking merit increases to performance and position in range.

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Policy Implementation 99

A merit-matrix approach has several advantages:

• The tendency is reduced to perpetuate tenure-based pay inequities and to continue to “overpay” (relative to market) highly paid employees.

• The approach is more likely to be deemed “fair” by the workforce because, over time, employees with similar performance in the same salary grade will tend to be paid comparably.

Basing merit increases on both performance and position in range introduces a level of complexity into the process not found in the simpler performance-only model. Of course, it is also more difficult to administer and communicate.

Performance and Position in Range Using Variable Timing

A more complex model for administering merit increases involves the con- cept of variable timing. The guide chart shown in Figure 4.10 demonstrates how the size and frequency of increase can be varied based on performance and position in range. In this model, top performers receive bigger and more frequent increases, while average and below-average contributors wait longer for smaller increases.

There are several advantages to this approach:

• Top performers will receive bigger rewards with greater frequency, yielding significant increases because of the compounding effect.

• During times of tight budgets, rather than issuing “below market” increases at regular intervals, “normal” increases can be granted at moderately delayed intervals. For example, rather than granting a 3.5 percent increase at 12 months, an organization may prefer to grant a 4.7 percent increase at 16 months.

Performance Rating

1st Quartile or Below

2nd Quartile

3rd Quartile

4th Quartile

Outstanding 8–9%

6–9 months 6–7%

9–12 months 4–5%

10–12 months 3–4%

12–15 months

Consistently Exceeds Standards

6–7% 8–10 months

4–5% 10–12 months

3–4% 12–15 months

2–3% 15–18 months

Meets Standards

4–5% 9–12 months

3–4% 12–15 months

2–3% 15–18 months

X

Does Not Fully Meet Standards

0–2% 12–15 months

X X X

FIGURE 4.10 Linking merit pay to position in range using variable timing.

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100 Linking Pay to Performance via Merit Pay

The disadvantages of variable timing are:

• It is much more complicated to administer. • It is difficult to track and maintain budgets. • It is difficult to monitor the consistency of application throughout the year. • It is more complex to communicate.

A successful merit pay plan requires more than well-developed policy state- ments and a conceptually sound design. It also requires administrative processes and procedures that are logical and easily understood. Some of the administra- tive issues that should be given consideration to ensure that a policy is implemented as intended are communication, training, and perceived fairness.

MANAGING A MERIT PAY PLAN

The merit pay “equation” is simple: Significant performance efforts yield signifi- cant rewards, which in turn motivate significant performance efforts. However, this equation relies on trust to enforce the contract between employees and the organization. Employees must trust the organization to fulfill its commitment that today’s efforts will be compensated fairly tomorrow, and the organization must trust that employees will be motivated by performance-based rewards.

As in any relationship, trust can be promoted through openness and candor, or thwarted through secrecy and obfuscation. Honest, open commu- nication between management, human resources, and employees serves as the means by which the messages of merit pay can be conveyed and reinforced.

Traditionally, many organizations have been unwilling to share much of their compensation-related data. Usually, these organizations have the mistaken belief that employees neither want nor need to know about such matters, and that providing “too much” information to employees somehow reduces management’s ability to exercise flexibility and discretion.

Today, more organizational leaders understand that no matter how carefully designed a compensation program might be, success requires adequate communication. Thorough communication permits employees to test the validity of the organization’s promises while conveying to them that the organization has nothing to hide. It also establishes opportunities for dialogue on issues of critical importance, enhances credibility by obtaining employee buy-in, and promotes overall trust.

A successful communication program requires a careful balance between an insufficient amount of information and too much information. Management should release enough information about the plan to demon- strate its faith in the process, but not so much information that its ability to exercise managerial discretion is impeded. Employees should be provided enough information about the merit pay plan that it serves as a performance motivator without breaching their right to privacy.

How much to communicate to employees will be influenced by many fac- tors, including the organization’s culture, management’s willingness to share information that traditionally may have been confidential, and the readiness

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Perception of Fairness 101

and ability of human resources to support the communications effort. Some of the key elements often introduced in a comprehensive communications program are:

• General information about the performance-appraisal program and process. • General information about the organization’s compensation program

(e.g., how pay is determined, how jobs are evaluated, and what the salary ranges are).

• More specific information about the merit pay program (e.g., salary-in- crease budgets, performance-rating distributions, and merit matrices).

• Size of an individual’s increase, minimum, and maximum raises grant- ed and average size of merit increases.

TRAINING

Implementation of a successful merit pay program requires managers to make two key sets of decisions:

• Evaluation of performance • Allocation of increase awards

An accurate, reliable, and credible performance-appraisal program is the foundation of a successful merit pay program, and it is imperative that man- agers and supervisors be capable of evaluating employee behaviors and results objectively and critically.

The skills required to appraise performance, assess employee contribu- tions, and assign rewards are not intuitive. To ensure adequate interpreta- tion and understanding of program requirements and consistent application of program tenets, training should be provided for all managers who are given the task of implementing the merit pay program. Training should include the following components:

• How to plan performance that links individual efforts and accomplish- ments to business plans and strategies.

• How to measure and evaluate performance fairly and consistently. • How to provide feedback through intrinsic (e.g., coaching and praise)

and extrinsic (e.g., pay increases and incentive payments) rewards. • How to use the merit matrix to allocate rewards. • How to communicate the assessment of performance and the alloca-

tion of rewards to employees.

PERCEPTION OF FAIRNESS

Program credibility is key to gaining a favorable response among employees to merit pay. Employees need to feel that increases and the process used to derive the increases are accurate and fair. To help ensure the perception of fairness, the merit pay program should incorporate the following tenets:

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102 Linking Pay to Performance via Merit Pay

• Relevant laws and regulations must be followed (e.g., Title VII of the Civil Rights Act, the Fair Labor Standards Act, and various tax laws).

• Employees should participate in setting performance goals and stand- ards, they should know what performance is expected of them, and they should be able to control the specific aspects of their performance on which their pay will be based.

• Employees should know and understand how the pay program works, and they should be encouraged to raise concerns, ask questions, and seek clarification on their increases.

• An appeals process should be established to provide employees with an opportunity to discuss their performance evaluation and their increase with an authority other than their direct supervisor.

HOW TECHNOLOGY ASSISTS PLAN ADMINISTRATION

The most conceptually and theoretically sound merit pay program is burden- some and inefficient to administer. Consequently, anything that contributes to simplifying planning and administration will help ensure the program’s success.

Computer technology can assist in the management of the merit pay plan in a number of ways:

• Budget planning can be facilitated by generating different increase- matrix models, testing various options and deriving forecasts of the economic impact of alternatives.

• Data can be probed to evaluate the effectiveness, impact and equity of the merit pay plan. Increases, performance distribution, and other fac- tors can be analyzed by department, position, organization, or individual.

• Employee records can be stored, monitored, and analyzed over time. • Data can be managed to formulate cost projections based on salary-

structure changes, the impact of inflation, and other financial factors. • Summary reporting can be streamlined for internal and external

purposes, tedious administrative tasks and reporting efforts can be automated, and productivity can be improved by reducing the amount of time, labor, and expense involved in managing the pay program.

EVALUATING A MERIT PAY PLAN

To ensure that a merit pay plan is operating as intended and is effective in meeting an organization’s compensation needs, systematic, post-implemen- tation evaluation of the plan should be conducted. This often-overlooked step is critical to the ultimate success and acceptance of the program. Many factors can be analyzed to assess plan effectiveness:

• Employee satisfaction with the pay program. • Employee job satisfaction.

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Merit Pay Advantages and Disadvantages 103

• Employee perception that pay is based on performance. • Employee acceptance of and trust in the performance-appraisal process. • Employee trust in management. • Employee and organizational performance (e.g., productivity improve-

ments). • Employee commitment to the organization as demonstrated through

reduced turnover and absenteeism rates. • Correlation between actual performance ratings and actual merit

increases.

Measurement of these success factors before and after implementation of a merit pay plan is likely to yield the most meaningful information, and it can be accomplished through various means: controlled empirical studies, employee-attitude surveys, focus-group discussions, and management and employee anecdotal feedback. Employee attitudes and perceptions ideally should be evaluated by collecting survey data from employees before the introduction of a merit pay plan, and again after the program has been introduced, and employees have received their first merit increases.

Some organizations attempt to gauge the success of newly introduced merit pay plans by measuring productivity and/or performance improve- ments over time and then correlating that information with appraisal ratings and salary increases. Also, turnover and absenteeism rates can be tracked and correlated with performance and salary increases. These data could be used to modify development of the plan, but it should be remembered that many other factors, including industry and economic trends, can also affect these factors. For example, high unemployment rates will tend to drive down turn- over rates, regardless of employee satisfaction with corporate pay plans.

Because employee perception of fairness is so important in determining the success of the merit pay program, one analysis that should be performed is to test how accurately, fairly, and consistently the program has been admin- istered throughout the organization. Some common employee questions that need to be addressed to demonstrate the fairness of a merit pay plan are:

• Does where or for whom you work mean more than how well you perform? Do some departments rate employee performance dispro- portionately high, and are some supervisors unfairly critical while others are unreasonably generous?

• Are all employees afforded a relatively equal opportunity for high per- formance ratings and commensurate increases? Is the plan free from racial, gender, and age bias?

MERIT PAY ADVANTAGES AND DISADVANTAGES

While merit pay remains a common means of determining pay increases, the potential drawbacks of the approach should be clear before implemen- tation. Once these drawbacks are recognized, an organization can appreciate

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104 Linking Pay to Performance via Merit Pay

the advantages of merit pay and how it will improve employee perceptions of work and rewards (see Figure 4.11).

As is true with any reward system, merit pay must be compatible with an organization’s culture and philosophy if it is going to be effective. For example, merit pay will not work for an organization that values tenure over performance. Also, merit pay may be inappropriate for organizations that are trying to empha- size group instead of individual performance. By rewarding individuals, merit pay can undermine the cooperation and interdependency that are needed in a team environment. However, it may be possible to preserve the best elements of a team environment while rewarding the highest-performing individuals by integrating group-based incentives with some form of merit pay system.

Merit pay will not work unless an organization has a sound system of meas- uring individual employee performance that is accepted by the work force. Even if a good performance-appraisal system exists, merit pay may be discouraging to “average” or “below average” employees, who typically will fail to qualify for high pay raises. By tightly linking pay and performance, merit pay also can deemphasize the intrinsic rewards and satisfaction gained simply from doing a job.

By linking a merit pay program with a sound communications strategy, an organization can clarify its performance expectations and create an atmos- phere of trust between employees and management. This atmosphere tends to increase overall employee satisfaction with work and pay, and it is likely to lead to improved individual performance.

The main reason an organization chooses a reward system is to enhance its competitiveness, productivity, and bottom-line results. Positive financial results are more likely when an organization places emphasis on employee performance instead of tenure, and highly motivated employees are more likely to be attracted and retained when their efforts are rewarded regularly. A merit pay system can help ensure that an organization’s rewards policy fits the performance-based philosophy it needs to survive and prosper.

MERIT PAY

ADVANTAGES DISADVANTAGES

Helps improve employee satisfaction with work and

pay as well as individual performance

Rewards performance rather than seniority or skills

Clari�es performance expectations

Attracts and retains highly motivated employees

Rewards individual performance, not group performance

Depends highly on a sound performance-appraisal system

Clashes with organizational emphasis on tenure

De-emphasizes intrinsic work rewards while possibly discouraging “average” and “below average” performers

FIGURE 4.11 Advantages and disadvantages of merit pay.

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Linking Results and Competencies to Business Strategy 105

LINKING RESULTS AND COMPETENCIES TO BUSINESS STRATEGY

A performance management system functions as a management tool to help ensure that employees are focused on organizational priorities and opera- tional factors that are critical to the organization’s success.

Organizations should operate from business strategies that include criti- cal, measurable success factors. These include:

• Financial success (e.g., return on investment, return on sales) • Productivity (e.g., cost per labor hour, units per day) • Quality standards and customer service (e.g., customer satisfaction

scores, waste, and reject indices) • Work environment (e.g., attitude survey scores, employee grievances)

An organization’s critical success factors form the basis for key result areas for the measurement of organizational, department, team, and individual performance. Key result areas define what is to be accomplished (e.g., the job’s end results, which in turn reflect the job’s primary purpose) and gener- ally are defined as key responsibilities, one-time or periodic projects, or annual objectives. Examples of key result areas are:

• Types and proofreads department correspondence and reports • Researches leading practices in the area of real estate acquisition • Develops and implements a new purchasing management system

In addition to key result areas, an organization may include the identifica- tion of competencies that focus on how results are to be attained.

Competencies generally are defined as the knowledge, skills, and abilities exhibited by individuals as they work to accomplish key result areas. Competencies may be developed universally for the organization, for job fami- lies or for individual jobs. Competencies often are selected to reflect an organi- zation’s values and may include some or all of the areas listed in Figure 4.12. These factors should be included in the performance management process and used as input when evaluating performance at the end of the assessment period.

While using competencies, it is important to identify specific behaviors associated with them. For example, associated behaviors for teamwork may be communicating openly with others and achieving win–win solutions

• Teamwork • Achievement orientation • Customer service orientation • Relationship building • Analytical thinking • Developing others

FIGURE 4.12 Examples of competencies.

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106 Linking Pay to Performance via Merit Pay

while working with peers. Generally, organizations identify 5–10 competen- cies to focus employees on key organizational priorities.

If an organization has developed comprehensive performance measures that are evaluated and used regularly to manage overall organizational per- formance, these measures should be included in the system so all employees can focus their priorities and energies on these strategies. For example:

• If an organization has established a company-wide quality or customer service performance measure, it should be incorporated into individu- al performance plans at all levels.

• If teamwork is a key organizational value, the performance manage- ment system should hold each employee accountable for behaviors identified with teamwork.

• If maintaining a positive environment and high employee morale are organizational priorities, managers should be held accountable for the environment and morale in their work units.

DETERMINING THE PERFORMANCE MANAGEMENT CYCLE

Any performance management system is an ongoing cycle. For most organiza- tions, the typical performance period cycle is one year, although this period may vary depending on business cycles and probationary periods for new hires, promotions, and transfers. The cycle also may be determined by the link to organizational measurements of success. For example, if financial measurements are included in the system, the performance cycle may be tied to the fiscal cycle. If an employee is involved in a project team with specific target dates for various stages, the performance management cycle may reflect the project’s schedule.

The design team should consider the typical performance management cycle within the organization. This cycle is likely to consist of three phases: planning performance for the upcoming period, coaching performance, and giving feedback throughout the period and evaluating performance for the just-completed period.

Phase I: Planning Performance for the Upcoming Period

Planning performance for the period includes defining key results for each position as well as establishing performance standards against which key result areas are measured. The design team should consider the most appro- priate approach to conducting the performance planning process, focusing on the roles that will be played by HR, immediate supervisors, and employees.

In many organizations, HR will be responsible for working with line man- agement to devise a framework for developing key result areas and perfor- mance standards. HR also typically is responsible for developing training materials to communicate the approach to line management and employees and for training line management and employees in the performance

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Determining the Performance Management Cycle 107

planning process. After training has been completed, HR often works with line management to ensure that performance plans are developed appro- priately. This function also may be accomplished by appointed performance planning teams that include employees from all levels of the organization who have been trained to help facilitate the performance planning process.

Because the performance planning process requires detailed knowledge of job responsibilities and performance expectations, line management should play a significant role in the process and be ultimately accountable for the performance plans of their employees.

The advantages of having managers and/or employees define key results and establish performance standards each period include:

• Managers and/or employees can structure each job to the individual’s and the department’s best advantage, increasing flexibility in what is measured.

• Managers and/or employees are more knowledgeable about their department’s day-to-day needs.

• Job responsibilities and standards can be modified to reflect special projects or assignments for the period.

At the same time, HR can play a key role by providing coaching and train- ing, and by ensuring consistency of key results and standards throughout the organization.

Typically, each position should list 5–10 key results that support the organ- ization’s business strategy. If more results are listed, they no longer are likely to include only “key” results of the job. If fewer results are listed, the full scope of responsibilities might not be closely defined.

In most cases, all key results do not have equal impact on the job. It is common practice to assign a weight of importance to each key result based on impact, frequency, and relative significance to the overall list of responsi- bilities as well as to the department and the organization. Weights may be determined informally and discussed when planning performance for the period. Weights also may be assigned to each key result, using:

• Percentage weighting (adding up to 100 percent) • Numerical weighting (1 = highly significant, 2 = significant, 3 = moder-

ately significant, 4 = insignificant, 5 = highly insignificant) • Word descriptions (critical, important, etc.)

The design team should decide how weighting will be handled, keeping in mind both the organization’s culture and the desired goals of the system. Results that best meet the organization’s overall goals generally should be assigned the greatest weight.

Phase II: Coaching Performance and Giving Feedback throughout the Period

An important step for the design team involves the concept of open, honest, positive, two-way communication between supervisors and employees throughout

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108 Linking Pay to Performance via Merit Pay

the period. The goal of a performance management system should be to improve employee performance, not to find an easier way to terminate an employee for poor performance. Therefore, a system should emphasize coaching and feedback from the supervisor as well as feedback and input from the employee throughout the performance period.

The design team should plan structured feedback throughout the period, including mid-period, quarterly, or monthly progress reviews. A more struc- tured feedback approach works especially well for poorly performing employees who require more frequent monitoring and coaching. Feedback, which should include constructive criticism, should be offered in a private, formal setting. In addition, the system should encourage supervisors to give informal feedback throughout the period. This is especially true for positive feedback, which may include verbal praise or even a brief suggestion to “Try doing it this way next time.” Employees should be encouraged to ask for frequent feedback from their supervisors.

Phase III: Rating Performance for the Just-Completed Period

One of the most challenging aspects of developing an individual perfor- mance management system is developing the approach for rating employee performance. When identifying an approach, it is important to focus on the characteristics of the organization and the objectives of the performance management system. For example, a traditional hierarchical organization tends to focus on judging employees’ past performance. An organization oriented toward total quality management might focus less on judging past performance and more on strategies to improve future performance.

PERFORMANCE RATING APPROACHES

Deciding on the number of categories in the rating scale is not without con- troversy. On the one hand, the more levels of performance that are identi- fied, the more accurately performance may be evaluated. For example, rating an employee on a scale with five performance levels (e.g., consistently exceeds expectations, exceeds most expectations, meets expectations, does not meet most expectations, does not meet any expectations) seemingly dif- ferentiates performance more accurately than does a three-point scale (e.g., exceeds expectations, meets expectations, does not meet expectations). On the other hand, how does one objectively differentiate performance at each of the five levels? If one is measuring units of production in a factory or words typed per hour, objectively identifying performance at all five levels may be possible. However, in a service-based work environment, it often is not feasible to implement performance standards at five levels. Evaluating performance then becomes the subjective judgment of the supervisor, and it is difficult to communicate so that employees understand the performance expectations at different rating levels.

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Performance Rating Approaches 109

For example, within a manufacturing operation in which five perfor- mance levels may be appropriate, making five units per hour may be consid- ered level-five performance, making four per hour may be considered level-four performance, and so on. When evaluating performance in this environment, there is little or no interpretation as to the performance rat- ing that should be given.

However, in an environment in which it is difficult to compare perfor- mance against established standards, such as a service or office environment, the question is whether it is acceptable for supervisors to make subjective judgments among the different levels of performance. Further, although most supervisors believe they can make this differentiation, they find it virtu- ally impossible to communicate these distinctions to employees in a way that employees can understand and accept. For example, if one of an administra- tive assistant’s responsibilities is to make travel arrangements through a travel agency, how will a supervisor identify and communicate the five levels of performance so they will be accepted by the employee?

In addition, it is a common perception among employees that it is unac- ceptable to be rated more than one level below the top rating. In fact, super- visors often rate employees one level below the top to minimize conflict and avoid spending a significant amount of time attempting to justify the perfor- mance rating. For example, in the five-point rating scale, a rating of “meets expectations” has the connotation of “average” and would generally be per- ceived as unacceptable, even though it is acceptable. Because of these perceptions and an increasing focus on improving future performance, the trend is toward using fewer rating categories when using rating scales – in many cases, as few as three. With the three-point scale, only one level of performance falls above “meets expectations” or acceptable performance.

When determining ratings levels, it is important to focus on definitions that compare performance to performance expectations, such as “consistently meets expectations” or “frequently exceeds expectations.” It is equally impor- tant to avoid ratings that compare employees, such as “average” and “above average.” Many organizations today favor not only fewer performance rating levels but also nonquantified ratings systems. Although it may be tempting to view performance management as an objective and precise process that can be weighted and scored, in most cases it is a subjective process based on super- visors’ judgments that are difficult to communicate. Many organizations have concluded, therefore, that performance management systems should include rating levels that are fewer in number and that are qualitative.

Using Summary Ratings

The design of a summary rating should focus on the objective of the system. With that in mind, the design team may consider three options:

1. Summary point scores. In a weighted and scored system in which the rat- ing of each key result is assigned a number (consistently exceeds

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110 Linking Pay to Performance via Merit Pay

expectations = 5; exceeds most expectations = 4; meets expectations = 3, etc.), the overall rating is a point score. The issue, then, is to convert the overall point score back into a rating category.

2. Summary labels. If the purpose of the system is primarily to judge past performance, and if the method for evaluating performance is fairly objective, then the use of rating categories, or “labels,” may be appro- priate. These labels may be the same as those used to rate each key result: “consistently exceeds expectations,” “exceeds most expectations,” “meets expectations,” and so on.

3. Summary statements. To reduce the subjectivity of performance manage- ment systems and increase the focus on continuous improvement, organizations have tended to move away from rating categories or labels toward summary statements that are behavior-oriented and more focused on future improvements. For example, suppose Joe’s perfor- mance occasionally fails to meet expectations for the job. Joe meets most standards and exceeds one of them, but he needs to increase his sales per month. This overall level of performance is acceptable this year because Joe is a new employee; however, he will be expected to increase his output next year. Assuming most employees generally meet performance expectations, it is much easier for the supervisor to focus on strategies for improving future performance when there are no summary labels. With this approach, the challenge for supervisors is to communicate the performance evaluation clearly to employees so there are no misunderstandings when employees are – or are not –  considered for promotions or transfers, or when they are terminated for poor performance.

Employee Responsibility

The role of the employee is an important aspect of the evaluation process. As organizations flatten and the scope of supervision expands, it becomes increasingly difficult for supervisors to interact with employees to judge per- formance. Looking at this situation along with organizational initiatives to empower employees, the design team should consider the extent to which employees may be involved in the evaluation process. This involvement may include these steps:

• Evaluate their own performance. • Complete a self-evaluation that includes identifying development plans

and career objectives. • Gather performance-related information. • Schedule evaluation sessions.

Employee involvement in performance evaluations can facilitate the eval- uation process. If used as part of a multirater assessment process, employee involvement can allow supervisors to function more as coaches and less as judges of performance.

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Multirater Assessment 111

MULTIRATER ASSESSMENT

One question for the design team to consider is who will rate performance. In an organization focused more on developing future performance, that development includes a high degree of involvement by those other than the supervisor, including the employees themselves. Under these circumstances, a technique known as multirater assessment, or 360-degree feedback, might be used. With multirater assessment, employee performance evaluations are compiled by several – usually five to nine – people who come in regular, direct contact with the employee, including peers, internal and external cus- tomers, supervisors, and subordinates. Most important, employees are able to evaluate their own performance.

The advantage of the technique is that the larger number of sources of evaluative input is likely to provide a more complete, well-rounded picture of the employee’s performance, and employees often view this picture as more credible than single-source assessments conducted only by the super- visor (see Figure 4.13).

The disadvantage is that the process involves greater administration to collect, compile and distribute feedback while ensuring the anonymity of evaluators and the confidentiality of results. Because one rater who deviates from the others can significantly affect an employee’s evaluation, many organizations opt to discard the highest and lowest ratings before compiling results. Further, it can be helpful to provide feedback to raters who deviate significantly from others so they may modify their techniques and provide more consistent evaluations in the future. With a multirater system in place, supervisors can assume greater roles as performance coaches rather than acting simply as performance judges.

Although research has indicated that it is possible to obtain more objec- tive performance feedback from multiple sources, the design and imple- mentation of a multirater feedback system often depends on the level of

Some Users Perceive Multirater Assessment as More: • Fair: less rating inflation, less adverse impact on diversity, and more pro-

cess and technology safeguards • Accurate: less bias and more balance • Credible: more believable because of respect for the opinions of multiple

work associates • Valuable: more specific feedback and greater distinctions among perfor-

mance criteria • Motivational: more encouragement for constructive behavior change

because of peer pressure and the desire to be recognized by the team

FIGURE 4.13 Advantages of using multirater assessments.

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112 Linking Pay to Performance via Merit Pay

employee trust that the feedback will be handled confidentially and that it will be used appropriately. Many organizations begin by providing perfor- mance feedback only to the individual employee. During this time, the sys- tem is focused on improving performance rather than rating performance. Once an appropriate level of employee trust has been established, the mul- tirater system can evolve so both supervisors and employees receive the information. Both can use it for evaluating performance and providing feedback for individual development (see Figure 4.14).

Rater #1

Rater #2

Rater #3

COMMUNICATION SKILLS

Keeps other informed of speci�c issues affecting them

Listens attentively to others

Participates effectively in meetings

DEVELOPING SUBORDINATES

Provides subordinates with detailed performance feedback on a regular basis

Empowers subordinates by delegating responsibility and authority whenever possible Provides subordinates with the resources needed to get the job done

LEADERSHIP

Leads by example

Considers customer/client satisfaction to be a top priority

Challenges people to extend themselves to the fullest

PROBLEM SOLVING AND DECISION-MAKING

Is open to new and creative suggestions when solving problems

Analyzes situations to get to the root cause of problems

Develops step-by-step solutions to problems

KNOWLEDGE AND TECHNICAL COMPETENCE

Keeps up to date with developments in his/her �eld

Is knowledgable about a number of �elds related to his/her specialty Is expert at performing the speci�c tasks and technical skills required of his/her job

EVALUATION Not

Satisfactory Highly

SatisfactorySatisfactory

1 2 3

1 2 3

1 2 3

1 2 3

1 2 3

1 2 3

1 2 3

1 2 3

1 2 3

1 2 3

1 2 3

1 2 3

1 2 3

1 2 3

1 2 3

FIGURE 4.14 Sample multirater evaluation questions.

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Linking Performance Management and Pay Delivery 113

LINKING PERFORMANCE MANAGEMENT AND PAY DELIVERY

Effective performance management should include both formal and infor- mal aspects. Formal aspects include appraisals and links to incentive plans, such as merit pay. Informal aspects include coaching, feedback, and links to employee development. When designing a performance management sys- tem, the design team should consider whether and how the system will be linked to employee compensation or to the determination of pay increases. Traditionally, an overall rating – either numerical or a rating summary – has been developed that determines a pay increase from merit guidelines. Although this approach directly links performance and pay, it may cause budget overruns unless the guidelines are based on an analysis of past per- formance rating distributions. Supervisors may overrate employees’ perfor- mance to justify larger merit increases for them.

When there is a direct link between the performance evaluation and merit pay increases, especially when the two are done at the same time, the performance evaluation system is likely to be perceived as part of the pay system. The evaluation often is focused on the “judgment” of past perfor- mance, instead of on a positive discussion of an employee’s strengths and weaknesses and on how performance should be developed in the future. Further, management may lower performance ratings in some cases to ensure that merit increases do not exceed budget, which obviously causes negative reactions from employees.

One solution may be to separate performance appraisal ratings and pay increases by deemphasizing the “judgment” aspect of point scores or over- all rating labels and shifting to a narrative statement that summarizes over- all performance. The performance appraisal may be further separated from the pay increase by changing the timing of the two activities or by changing the appraisal and pay cycles. For example, the performance eval- uation may be given on each employee’s anniversary date and pay increases may be given on a common date, perhaps based on the fiscal period. Another solution may be to provide a merit budget to department heads and require them to allocate pay increases to their employees on the basis of relative performance. Department heads then have to determine who their top performers are in order to allocate merit money without exceed- ing budget.

Organizations need to consider carefully whether or not pay will be linked to a performance rating, and if so, the impact this linkage will have on the operation of the overall performance management system. If the primary objective of the system is to determine ratings for pay increases, the system should be designed to differentiate performance levels. Organizations that are more interested in using performance management as a tool to develop their employees may want to separate the performance management and pay delivery systems to prevent either system from having a negative impact on the other.

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114 Linking Pay to Performance via Merit Pay

Although performance may be an important factor in determining pay increases, there may be other contributing factors such as the rate at which salaries are increasing in the marketplace, internal equity factors or an employee’s position within the salary range. When the two systems are directly linked, employees may assume there is a one-to-one relationship between performance and pay, and not recognize the impact of these other factors, which may be difficult to communicate. A pay system may be designed to target an employee’s pay at a certain position within the salary range that is consistent with the employee’s contribution to the organiza- tion. For example, employees who consistently meet expectations may have their pay targeted toward the middle of the salary range, while employees who consistently exceed standards may have their pay targeted toward the top. Once employees reach the middle of the range or the market value, future increases may be limited, or they may be delivered as variable pay in lump sums.

In general, the design of the performance management system should be compatible with the pay delivery system philosophy and should support that philosophy. At the same time, how performance management is linked, or not linked, to pay will send a strong message to the workforce about organi- zational priorities and values. The decision as to how performance manage- ment and compensation will be related should not be made lightly.

EBSCOhost - printed on 9/11/2022 6:43 PM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS. All use subject to https://www.ebsco.com/terms-of-use