Module 1
Pay Model and Compensation Strategy Alignment
A. Compensation
Why should you care about compensation? Do you find that life goes more
smoothly when there is at least as much money coming in as going out? (Refer, e.g., to
the lyrics for the Beatles’ song “Money.”1 To exaggerate a bit, they say something like:
Money doesn’t buy everything, but if money can’t buy it, I can’t use it.) In the movie, It’s
a Wonderful Life, George Bailey is in a difficult spot. An (inexperienced) guardian angel
by the name of Clarence has been sent to help George. When Clarence implores George
to let him help, George asks if he has $8,000 on him. Clarence replies “No, we don’t use
Of course, it is the same for companies. It really does help to have as much money
coming in (actually, more is better) as going out. Until recently, production workers at
Chrysler received total compensation (i.e., wages plus benefits) of about $76 per hour.
U.S. workers doing the same jobs at Toyota received $48 per hour, and the average total
compensation per hour in U.S. manufacturing was $25 (and $3 in Mexico--not
surprisingly, many new automobile supply and assembly plants have gone to Mexico in
recent years). It is one thing to pay more than your competitors if you get something
more (e.g., higher productivity and/or quality) in return. But Chrysler was not. So its
“strategy” was not sustainable. Chrysler ended up going through bankruptcy, being
bought out by Fiat, and then reducing worker compensation costs as part of its strategy
for a return to competitiveness. Specifically, Chrysler took steps (as part of its bankruptcy
plan) to bring its hourly labor costs down to about $49.2 (Fiat Chrysler is now part of
Stellantis.)
Novartis is a health care solutions company based in Switzerland that includes
medicines, pharmaceuticals, and eye care. The U.S. Justice Department announced a
$678 million settlement with Novartis over improper inducements to persuade doctors to
prescribe Novartis drugs, including Lotrel for hypertension. It is the largest whistleblower
settlement under federal law. The key whistleblower was Ozzie Bilotta. According to
NBC News, when he began working at Novartis, it was his dream job. But, “he never
thought he’d be bribing doctors and wearing a wire for the feds.” He ended up taking this
sort of “drastic action” because he felt it was necessary to change how the pharmaceutical
industry operated. Novartis subsequently changed its sales compensation such that pay no
longer depends only on sales. It also now depends on an evaluation of whether sales were
achieved in a way that is consistent with the Novartis Code of Ethics. There is also an
Anti-Bribery Policy document that includes directing employees to “Always ask yourself
before offering, giving, or promising anything of value to any person if what you are
considering could be viewed as having an illegitimate purpose. If the answer is yes, you
must not proceed.”6 Novartis has also increased its investment in data collection and
analytics to monitor compliance with its Code of Ethics.
How people view compensation affects how they behave. It does not mean the
same thing to everyone. Your view will probably differ depending on whether you look
at compensation from the perspective of a member of society, a stockholder, a manager,
or an employee. Thus, we begin by recognizing different perspectives. All dollar amounts
are in constant (also called real) dollars (i.e., adjusted for price changes/inflation). At the
top, we start with Panel A, economic output (GDP) per Employed Person, a measure of
national productivity. We see that productivity has increased by 52 percent since 1990.
As a general rule, increases in productivity are necessary to generate increases in income
and wealth for most of the population. We also note that the level of productivity in the
United States in 2020, $127,378, is the highest among the 30 largest economies in the
world. Panel B shows that (real) average annual earnings have increased 23 percent since
1990. Panel C moves from individual earnings from work to household income from all
sources, including earnings, but other sources also (e.g., employer contributions for
health care premiums, unemployment compensation, business income, capital
income/gains, among others). We provide two sets of household income, before and after
taxes (generally higher at higher income levels) and (means-test, meaning based on
income) transfers (e.g., Medicaid; Children‘s Health Insurance Program; these transfers
are generally higher at lower income levels). We see that income overall (All) has grown
by 45 percent since 1990, before transfers and taxes and 51 percent after adjusting for
taxes and transfers. Growth in economic output is the basis for growth in overall income
(and wealth). However, the way income and wealth is distributed is also important.
However, one well-known study on this issue by Kahneman and Deaton has
sometimes been incorrectly (and/or incompletely interpreted) to mean that money only
matters up to a point.12 For example, based on the study, $75,000 (let’s call it more like
$95,000 adjusted for inflation) has been identified as the magic amount of annual income
that makes people happy and paying them more had severely diminishing returns such
that annual income beyond $75,000 did not increase their happiness any further.
However, that result is based on asking people about the emotional well-being
(“happiness) they experienced yesterday. Perhaps not surprisingly, having had a
“headache” yesterday or reporting “zero social time with friends or family yesterday,
including telephone and email contact” had much larger effects on the emotional well-
being/affect they felt yesterday than did whether their annual income was above $75,000.
In contrast, when asked about life evaluation on a scale ranging from 0 (“worst possible
life for you”) to 10 (“the best possible life for you”), there was almost no diminishing
return to higher income (measured on a log scale, equivalent to using percentage
increases in income).
As Kahneman and Deaton put it, there is “a fairly steady rise in life evaluation” in
proportion to increases in income “over the entire range.” Even returning to “happiness,”
Deaton and Kahneman caution: “Our data speak only to differences; they do not imply
that people will not be happy with a raise from $100,000 to $150,000, or that they will be
indifferent to an equivalent drop in income.” In summary, the Deaton and Kahneman
findings can be interpreted to mean, first, that increases in income that help people avoid
poverty or the threat of poverty (or what is called financial precarity) have a major
positive impact on both happiness and life evaluation. Second, these increases in income
have diminishing returns for increasing happiness (as measured by emotional well-being
the day before) beyond $95,000 in today’s dollars. Third, it would be a mistake to think
that reducing anyone’s pay to $95,000 would do anything but make them unhappy.
Fourth, higher pay is associated with higher life satisfaction and that association
continues beyond $95,000.
Benefits given as part of a total compensation package, like wages/salaries, may
also be seen as a reflection of equity or justice in society. As we will see, private sector
employers spend about 42 cents for benefits on top of every dollar paid for wages and
salaries. (State and local government employers pay even more: 62 cents in benefits on
top of every wage dollar.)13 Individuals and businesses in the United States spend $3.6
trillion per year, or about 17 percent of U.S. economic output (gross domestic product) on
health care. page 8 14 Nevertheless, as we will see, many (over 30 million) of people in
the United States (over 8 percent of the population) have no health insurance.15 (Prior to
implementation of The Affordable Care Act of 2010, over 48 million were uninsured.)16
A major reason is that the great majority of people who are under the age of 65 and not
below the poverty line obtain health insurance through their employers, but small
employers, which account for a substantial share of employment, are much less likely
than larger employers to offer health insurance to their employees. As a result, the great
majority of uninsured in the United States are from working families. (Of the uninsured,
85 percent have a full-time worker in the family and another 11 percent have a part-time
worker in the family.)17 Given that those who do have insurance typically have it
through an employer, it also follows that whenever the unemployment rate increases,
health care coverage declines further. (Some users of online dating services provide
information on their employer-provided health care insurance. Dating service “shoppers”
say they view health insurance coverage as a sign of how well a prospect is doing in a
career.)
Job losses (or gains) within a country over time are partly a function of relative
labor costs (and productivity) across countries. People in the United States worry about
losing manufacturing jobs to Mexico, China, and other nations. (Increasingly, white-
collar work in areas like finance, computer programming, and legal services is also being
sent overseas.) Exhibit 1.2 reveals that annual salary cost per employee (these numbers
do not include benefits) in Mexico is $17,594, or about one-quarter of the $65,836
average salary in the United States. China’s estimated annual salary of $12,430 is less
than one-fifth of the U.S. rate. However, the value of what is produced also needs to be
considered. Productivity in China is also roughly one-fifth that of U.S. workers, whereas
Mexican worker productivity is about onethird of the U.S. level. Finally, if low wages are
the goal, there always seems to be somewhere that pays less. Some companies (e.g.,
Coach) are now moving work out of China because its hourly wage, especially after
recent increases, is not nearly as low as in countries like Vietnam, India, and the
Philippines.18 However, for other companies—such as Foxconn, which builds iPhones
and iPads for Apple—even with increases in wages in China, labor costs remain very low
in China compared to those in the United States and other advanced economies.
Stockholders are also interested in how employees are paid. Some believe that
using stock to pay employees creates a sense of ownership that will improve
performance, which in turn will increase stockholder wealth. But others argue that
granting employees too much ownership dilutes stockholder wealth. Google’s stock plan
cost the company $600 million in its first year of operation. So people who buy Google
stock (stockholders) are betting that this $600 million will motivate employees to
generate more than $600 million in extra stockholder wealth.
Employment costs in the form of compensation are often the largest single
operating cost for an organization. Thus, for companies whose business strategy depends
on low product/service cost to compete for customers, they also may focus on keeping
compensation costs low. As we will see shortly, that is certainly true of Walmart. It
certainly seems to have worked in the eyes of customers as it is year after year the largest
company in the world in terms of revenues. As a different example, we will see that
Costco’s business strategy is less exclusively cost-based. They are concerned about
employment costs, but their business strategy depends on paying higher wages to attract
and retain employees more successfully than Walmart does, as well as employees who
can provide a higher level customer experience. Compensation also increasingly comes
into play for customers who want to purchase from a company that acts with
responsibility with respect to environmental, social, and governance (ESG) issues. This
can take a variety of forms in the employment and compensation area. For example,
customers may base their buying decisions on how they believe the company’s
employees are treated and/or how workers employed by other companies, but part of the
company’s supply chain, are treated. For example, Apple has supplier responsibility
standards and an extensive system to monitor supplier adherence to these standards,
including in the area of employment.
For managers, compensation influences their success in two ways. First, it is a
major expense that must be managed. Second, it is a major determinant of employee
attitudes and behaviors (and thus, organization performance). We begin with the cost
issue. Competitive pressures, both global and local, force managers to consider the
affordability of their compensation decisions. Labor costs can account for more than 50
percent of total costs. In some industries, such as financial or professional services and in
education and government, this figure is even higher. However, even within an industry,
labor costs as a percentage of total costs vary among individual firms. For example, small
neighborhood grocery stores, with labor costs between 15 percent and 18 percent, have
been driven out of business by supermarkets that delivered the same products at a lower
cost of labor (9 to 12 percent). Supermarkets today are losing market share to the
warehouse club stores such as Sam’s Club and Costco, which enjoy an even lower cost of
labor (4 to 6 percent), even though Costco pays wages that are above average for the
industry. And, now Amazon has entered the grocery business by purchasing Whole
Foods, which is expected to cause further cost reductions and disruption.
The pay individuals receive in return for the work they perform and the value they
create is usually the major source of their financial security. Hence, pay plays a vital role
in a person’s economic and social well-being. Employees may see compensation as a
return in an exchange between their employer and themselves, as an entitlement for being
an employee of the company, as an incentive to decide to take/stay in a job and invest in
performing well in that job, or as a reward for having done so. Compensation can be all
of these things.
B. Incentive and Sorting Effects
Pay can influence employee motivation and behavior in two ways. First, and
perhaps most obviously, pay can affect the motivational intensity, direction, and
persistence of current employees. Motivation, together with employee ability and
work/organizational design (which can help or hinder employee performance),
determines employee behaviors such as performance. We will refer to this effect of pay
as an incentive effect, the degree to which pay influences individual and aggregate
motivation among the employees we have at any point in time.
However, pay can also have an indirect, but important, influence via a sorting
effect on the composition of the workforce.31 That is, different types of pay strategies
may cause different types of people to apply to and stay with (i.e., self-select into) an
organization. In the case of pay structure/level, it may be that higher pay levels help
organizations attract more high-quality applicants, allowing them to be more selective in
their hiring. Similarly, higher pay levels may improve employee retention.
In other words, although perhaps less obvious, it is not only how much but how
an organization pays that can result in sorting effects.32 Ask yourself: Would people who
are highly capable and have a strong work ethic and an interest in earning a lot of money
prefer to work in an organization that pays about the same amount to all employees doing
the same job, regardless of their performance? Or would they prefer to work in an
organization where their pay can be much higher (or lower) depending on how they
perform? If you chose the latter answer, then you believe that sorting effects matter.
People differ regarding which type of pay arrangement they prefer. The question for
organizations is simply this: Are you using the pay policy that will attract and retain the
types of employees you want? Keep in mind that high performers have more alternative
job opportunities and that more opportunities, all else being equal (e.g., if they are not
paid more for their higher performance), translate into higher turnover—which is likely
to be a significant problem if it is the high performers who are leaving, especially if high
performers in particular roles create a disproportionately high amount of value for
organizations.
Some research looks at “stars.” For example, one study used data on individual
security analysts in investment banks and found that newly hired “stars” from other firms
generally did less well in their new firms, but their performance decline was less when
moving with other members of their team, rather than alone.36 Thus, there are
implications. First, star performance may be somewhat firm-specific. Second, a firm
cannot necessarily “buy talent” and be sure that talent will perform at the same level as at
its previous firm. Third, to the degree that is the case, the firmspecificity may stem at
least partly from the additional value created by being part of a well-functioning team.
Other research on stars, this time in the hedge fund industry, finds that, compared to other
members of their team, stars get more credit when things go well and more blame when
things go poorly. Thus, working “in someone’s shadow” can be a plus when things don’t
go well, but can lead to less credit when things go well. The pay model that comes later
in this chapter includes compensation policies and the objectives (efficiency, fairness,
compliance) these are meant to influence. Our point here is that compensation policies
work through employee incentive and sorting effects to either achieve or not achieve
those objectives.
In English, compensation means something that counterbalances, offsets, or
makes up for something else. However, if we look at the origin of the word in different
languages, we get a sense of the richness of the meaning, which combines entitlement,
return, and reward.38 In China, the traditional characters for the word “compensation”
are based on the symbols for logs and water, suggesting that compensation provides the
necessities in life. In the recent past the state owned all Chinese enterprises, and
compensation was treated as an entitlement. In today’s China, compensation takes on a
more subtle meaning. A new word, dai yu, is used. It refers to how you are being treated
—your wages, benefits, training opportunities, and so on. When people talk about
compensation, they ask each other about the dai yu in their companies. Rather than
assuming that everyone is entitled to the same treatment, the meaning of compensation
now includes a broader sense of returns as well as entitlement.
“Compensation” in Japanese is kyuyo, which is made up of two separate
characters (kyu and yo), both meaning “giving something.” Kyu is an honorific used to
indicate that the person doing the giving is someone of high rank, such as a feudal lord,
an emperor, or a samurai leader. Traditionally, compensation is thought of as something
given by one’s superior. Today, business consultants in Japan try to substitute the word
housyu, which means “reward” and has no associations with notions of superiors. The
many allowances that are part of Japanese compensation systems translate as teate, which
means “taking care of something.” Teate is regarded as compensation that takes care of
employees’ financial needs. This concept is consistent with the family, housing, and
commuting allowances that are still used in many Japanese companies.
C. Forms of Pay
Total returns are categorized as total compensation and relational returns. The
relational returns (learning opportunities, status, challenging work, and so on) are
psychological.41 Total compensation returns are more transactional. They include pay
received directly as cash (e.g., base, merit, incentives, cost-of-living adjustments) and
indirectly as benefits (e.g., pensions, medical insurance, programs to help balance work
and life demands, brightly colored uniforms).42 So pay comes in different forms, and
programs to pay people can be designed in a wide variety of ways. WorldatWork has a
Total Rewards Model that is similar and includes compensation, benefits, work-life,
performance/recognition, and development/career opportunities.
The importance of monetary rewards as a motivator relative to other rewards
(e.g., intrinsic rewards such as how interesting the work is) has long been a topic of
interest, as have the conditions under which money is more or less important to people
(and even whether money is sometimes too important to people).44 Although scholars
and pundits have sometimes debated which is more important (and have sometimes
argued that money does not motivate or even that it demotivates), our reading of the
research indicates that both types of rewards are important and that it is usually not
terribly productive to debate which is more important.45 It will no doubt come as little
surprise that we will focus on monetary rewards (total compensation) in a book called
Compensation. Whatever other rewards employees value, it is our experience that they
expect to be paid for their work, that how and how much they are paid affects their
attitudes, performance, and job choice, as well as their standard of living. These effects of
compensation on employees (as well as the cost of employee compensation) have major
implications for how successfully organizations can execute their strategies and achieve
their goals.
Base wage is the cash compensation that an employer pays for the work
performed. Base wage tends to reflect the value of the work or skills and generally
ignores differences attributable to individual employees. For example, the base wage for
machine operators may be $20 an hour. However, some individual operators may receive
more because of their experience and/or performance. Some pay systems set base wage
as a function of the skill or education an employee possesses; this is common for
engineers and schoolteachers.
A distinction is often made in the United States between wage and salary, with
salary referring to pay for employees who are exempt from regulations of the Fair Labor
Standards Act (FLSA) and hence do not receive overtime pay. 47 Managers and
professionals usually fit this category. Their pay is calculated at an annual or monthly
rate rather than hourly, because hours worked do not need to be recorded. In contrast,
workers who are covered by overtime and reporting provisions of the Fair Labor
Standards Act—nonexempts—have their pay calculated as an hourly wage. Some
organizations, such as IBM, Eaton, and Walmart, label all base pay as “salary.” Rather
than dividing employees into separate categories of salaried and wage earners, they
believe that an “all-salaried” workforce reinforces an organizational culture in which all
employees are part of the same team. However, merely changing the terminology does
not negate the need to comply with the FLSA.
A cost of living adjustment (COLA) to base wages may be made on the basis of
changes in what other employers are paying for the same work, changes in living costs,
or changes in experience or skill. Such provisions are less common than in the past as
employers continually try to control fixed costs and link pay increases to individual
and/or company performance. Merit increases are given as increments to base pay and are
based on performance. According to a WorldatWork survey, 94 percent of U.S. firms use
merit pay increases.49 Given that 22 percent of respondents to the survey were in the
nonprofit, not-for-profit, or public sectors where we know that the use of merit pay is
less,50 it may be that nearly 100 percent of U.S. private sector organizations use merit
pay. Merit payments are based on an assessment (or rating) of recent past performance
made (with or without a formal performance evaluation). In recent years, merit increase
budgets (or average merit increases) have been around 3 percent.51 Survey data indicate
that, on average, an outstanding performer receives a 4.8 percent increase, an average
performer a 2.9 percent increase, and a poor performer a 0.2 percent increase.52 Finally,
companies increasingly use merit bonuses.53 As with merit increases, merit bonuses are
based on a performance rating but, unlike merit increases, are paid in the form of a lump
sum rather than becoming (a permanent) part of the base salary. 54 Merit bonuses (also
referred to as short-term incentives) may now be more important than traditional merit
increases. “Indeed, merit bonuses now appear to account for more of the pay-
performance relationship than do the traditional and most often discussed form of pay for
individual performance, merit pay.”
Incentives also tie pay increases to performance.57 However, incentives differ
from merit adjustments. First, incentives are tied to objective performance measures (e.g.,
sales) usually in a formula-based way, whereas a merit increase program typically relies
on a subjective performance rating. There is also some subjectivity in the size of the pay
increase awarded for a particular rating. Second, incentives do not increase the base wage
and so must be re-earned each pay period. Third, the potential size of the incentive
payment will generally be known (given the use of a formula) beforehand. Whereas merit
pay programs evaluate past performance of an individual and then decide on the size of
the increase, what must happen in order to receive the incentive payment is called out
very specifically ahead of time. For example, a Toyota salesperson knows the
commission on a Land Cruiser versus a Prius prior to making the sale. The larger
commission he or she will earn by selling the Land Cruiser is the incentive to sell a
customer that car rather than the Prius. Fourth, while both merit pay and incentives try to
influence performance, incentives explicitly try to influence future behavior whereas
merit recognizes (rewards) past behavior, which is hoped to influence future behavior.
The incentive-reward distinction is a matter of timing.
Incentives may be short-or long-term. Long-term incentives are intended to focus
employee efforts on multiyear results. Typically they are in the form of stock ownership
or else options to buy stock at a fixed price (thus leading to a monetary gain to the degree
the stock price later goes up). The belief underlying stock ownership is that employees
with a financial stake in the organization will focus on long-term financial objectives:
return on investment, market share, return on net assets, and the like. Bristol-Myers
Squibb grants stock to selected “Key Contributors” who make outstanding contributions
to the firm’s success. Stock options are often the largest component in an executive pay
package. Some companies extend stock ownership beyond the ranks of executives and/or
other high salary employees. Examples of companies that provide both broad-based
equity awards and employee stock purchase plans include Cisco, Intuit, Adobe Systems,
and Goldman Sachs.
Some income protection programs are legally required in the United States;
employers must pay into a fund that provides income replacement for workers who
become disabled or unemployed. Employers are also required to pay one-half the payroll
tax for each employee to fund Social Security coverage. (Employees pay the other half.)
Different countries have different lists of mandatory benefits. Medical insurance,
retirement programs, life insurance, and savings plans are common benefits. They help
protect employees from the financial risks inherent in daily life. Often companies can
provide these protections to employees more cheaply than employees can obtain them for
themselves. In the United States, employers spend roughly $725 billion per year just on
health care costs, or 19 percent of all U.S. health care expenditures.62 Among employers
that provide health insurance, the cost to provide family coverage is $21,342 per year per
employee. The average employer pays $15,574 (74 percent) of that and the average
employee pays the remaining $5,588 (26 percent).63 Given the magnitude of such costs,
it is no surprise that employers have sought to rein in or reduce benefits costs. One
approach has been to shift costs to employees (e.g., having employees pay a larger share
of health insurance premiums).64 Some companies have allowed their benefits costs to
get so far out of control that more drastic action has been taken. For example, as noted,
companies like Chrysler, GM, and American Airlines have recently gone through
bankruptcy, which has been used to reduce benefits costs and labor costs more generally.
GM benefits costs had gotten so high that GM was sometimes described as a pension and
health care provider that also makes cars.
Programs that help employees better integrate their work and life responsibilities
include time away from work (vacations, jury duty), access to services to meet specific
needs (drug counseling, financial planning, referrals for child and elder care), and flexible
work arrangements (e.g., remote work, nontraditional schedules, nonpaid time off).
Responding to the changing demographics of the workforce (two-income families or
single parents who need work-schedule flexibility to meet their family obligations), many
U.S. employers are giving a higher priority to these benefit forms. (This trend was
reinforced by the pandemic.) Medtronic, for example, touts its Total Well-Being Program
that seeks to provide “resources for growth—mind, body, heart, and spirit” for each
employee. Health and wellness, financial rewards and security, individual and family
well-being, and a fulfilling work environment are part of this “total wellbeing.”65
Medtronic believes that this program permits employees to be “fully present” at work and
less distracted by conflicts between their work and nonwork responsibilities.
Allowances often grow out of whatever is in short supply. In Vietnam and China,
housing (dormitories and apartments) and transportation allowances are frequently part of
the pay package. Many decades after the end of World War II-induced food shortages,
some Japanese companies still continue to offer a “rice allowance” based on the number
of an employee’s dependents. Almost all foreign companies in China discover that
housing, transportation, and other allowances are expected.66 Companies that resist these
allowances must come up with other ways to attract and retain employees. In many
European countries, managers assume that a car will be provided—only the make and
model are negotiable.
Up to this point we have treated compensation as something received at a moment
in time. But a firm’s compensation decisions have a temporal effect. Say you have a job
offer at $50,000 a year. If you stay with the firm for five years and receive an annual
increase of 4 percent, in five years you will be earning $60,833 a year. For your
employer, the five-year cost commitment of the decision to hire you turns out to be
$331,649 in cash. If you add in an additional 30 percent for benefits, the decision to hire
you implies a commitment of over $430,000 from your employer.
Sometimes it is useful to think of an organization as a network of returns created
by all these different forms of pay, including total compensation and relational returns.
The challenge is to design this network so that it helps the organization to succeed.71 As
in the case of crew rowers pulling on their oars, success is more likely if all are pulling in
unison rather than working against one another. In the same way, the network of returns
is more likely to be useful if bonuses, development opportunities, and promotions all
work together. So the next time you walk through an employer’s door, look beyond the
cash and health care offered to search for all the returns that create the network. Even
though this book focuses on compensation, let’s not forget that compensation is only one
of many factors affecting people’s decisions about work. (You might enjoy listening to
Roger Miller’s song “Kansas City Star,” or Chely Wright’s “It’s the Song” for some
other reasons people choose their work.)
D. A Pay Mode
Pay systems are designed to achieve certain objectives. The basic objectives,
shown at the right side of the model, include efficiency, fairness, ethics, and compliance
with laws and regulations. Efficiency can be stated more specifically: (1) improving
performance, increasing quality, delighting customers and stockholders, and (2)
controlling labor costs. Whole Foods is the nation’s largest organic-and natural-foods
grocer. Its markets are a “celebration of food”: bright, well stocked, and well staffed.72
The company describes its commitment to offering the highest quality and least
processed foods as a shared responsibility. Its first compensation objective is “Increase
long-term shareholder value.” Fairness (sometimes called equity) is a fundamental
objective of pay systems.73 In Medtronic’s objectives, fairness means to “ensure fair
treatment” and “recognize personal and family well-being.” Whole Foods’s pay
objectives discuss a “shared fate.” In their egalitarian work culture, pay beyond base
wages is linked to team performance, and employees have some say about who is on their
team.
Asian philosophy gives us the concept of yin and yang—complementary
opposites rather than substitutes or trade-offs. It is not yin or yang; part of yin is in yang,
and part of yang is in yin. So it is with objectives in the pay model. It is not efficiency
versus fairness versus compliance. Rather, the aim is to achieve all three simultaneously.
The tension of working toward all objectives at once creates fertile grounds for ethical
dilemmas. Ethics means the organization cares about how its results are achieved.75 Scan
the websites or lobby walls of corporate headquarters and you will inevitably find
statements of “Key Behaviors,” “Our Values,” and “Codes of Conduct.”
Because it is so important, it is inevitable that managing pay sometimes creates
ethical dilemmas. Manipulating results to ensure executive bonus payouts, misusing (or
failing to understand) statistics used to measure competitors’ pay rates, repricing or
backdating stock options to manipulate (increase) their value, encouraging employees to
invest a portion of their wages in company stock while executives are bailing out,
offering just enough pay to get a new hire in the door while ignoring the relationship to
co-workers’ pay, and shaving the hours recorded in employees’ time card— these are all-
too-common examples of ethical lapses.
There are probably as many statements of pay objectives as there are employers.
In fact, highly diversified firms such as General Electric and Eaton, which operate in
multiple lines of businesses, may have different pay objectives for different business
units. At General Electric, each unit’s objectives must meet GE overall objectives. In
summary, objectives guide the design of pay systems. They also serve as the standards
for judging the success of the pay system. If the objective is to attract and retain the best
and the brightest skilled employees, but they are leaving for higher-paying jobs
elsewhere, the system may not be performing effectively. Although there may be many
nonpay reasons for such turnover, objectives provide standards for evaluating the
effectiveness of a pay system.
E. Four Policy Choices
Every employer must address the policy decisions shown on the left side of the
pay model: (1) internal alignment, (2) external competitiveness, (3) employee
contributions, and (4) management of the pay system. These policies are the foundation
on which pay systems are built. They also serve as guidelines for managing pay in ways
that accomplish the system’s objectives. Internal alignment refers to comparisons among
jobs or skill levels inside a single organization. Jobs and people’s skills are compared in
terms of their relative contributions to the organization’s business objectives. How, for
example, does the work of the programmer compare with the work of the systems
analyst, the software engineer, and the software architect? Does one contribute to
solutions for customers and satisfied stockholders more than another? What about two
marketing managers working in different business units of the same organization?
Internal alignment pertains to the pay rates both for employees doing equal work and for
those doing dissimilar work. In fact, determining what is an appropriate difference in pay
for people performing different work is one of the key challenges facing managers.
Whole Foods tries to manage differences with a salary cap that limits the total cash
compensation (wages plus bonuses) of any executive to 19 times the average cash
compensation of all full-time employees. The cap originally started at eight times the
average. However, attraction and retention problems were cited as a need for raising the
cap several times since. (Note that the cap does not include stock options.)
External competitiveness refers to pay comparisons with competitors. How much
do we wish to pay in comparison to what other employers pay? Many organizations claim
their pay systems are market-driven—that is, based almost exclusively on what
competitors pay. “Market-driven” gets translated into practice in different ways.78 Some
employers may set their pay levels higher than their competition, hoping to attract the
best applicants. Of course, this assumes that someone is able to identify and hire the
“best” from the pool of applicants. And what is the appropriate market? When, for
example, should international pay rates be considered? Should the pay of software
engineers in New Delhi or Minsk influence pay for engineers in Silicon Valley or
Boston?
How much emphasis should there be on paying for performance? Should one
programmer be paid differently from another if one has better performance and/or greater
seniority? Or should there be a flat rate for programmers? Should the company share any
profits with employees? Should it share with all employees, parttime as well as full-time?
The emphasis to place on employee contributions (or nature of pay mix) is an important
policy decision because it directly affects employees’ attitudes and work behaviors. Eaton
and Motorola use pay to support other “high-performance” practices in their
workplaces.79 Both use team-based pay and corporate profit-sharing plans. Starbucks
emphasizes stock options and sharing the success of corporate performance with the
employees. General Electric uses different performance-based pay programs at the
individual, division, and company-wide levels. Performance-based pay affects fairness, in
that employees need to understand the basis for judging performance in order to believe
that their pay is fair.
A policy regarding management of the pay system is the last building block in our
model. Management means ensuring that the right people get the right pay for achieving
the right objectives in the right way. The greatest system design in the world is useless
without competent management. Managing compensation means answering the “So
What?” question. So what is the impact of this policy, this technique, this decision?
Although it is possible to design a system that is based on internal alignment, external
competitiveness, and employee contributions, what difference does it make? Does the
decision help the organization achieve its objectives?
F. Caveat Emptor
Most managers do not read research. They do not subscribe to research journals;
they find them too full of jargon and esoterica, and they see them as impractical and
irrelevant.84 However, a study of 5,000 HR managers compared their beliefs to the
research evidence in several areas and identified seven common and important
misconceptions held by managers.85 The study authors concluded that being unaware of
key research findings may prove costly to organizations. For example, when it comes to
motivating workers, organization efforts may be somewhat misguided if they do not
know that “money is the crucial incentive … no other incentive or motivational technique
comes even close to money with respect to its instrumental value.”
How useful are the variables in the study? How well are they measured? For
example, many studies purport to measure organization performance. However,
performance may be accounting measures such as return on assets or cash flow, financial
measures such as earnings per share, operational measures such as scrap rates or defect
indicators, or qualitative measures such as customer satisfaction. It may even be the
opinions of compensation managers, as in, “How effective is your gain-sharing plan?”
(Answer choices are “highly effective,” “effective,” “somewhat,” “disappointing,” “not
very effective.” “Disastrous” is not usually one of the choices.) The informed consumer
must ask, Does this research measure anything useful?
Consider a hypothetical study that attempts to assess the impact of a performance-
based pay program. The researchers measure performance by assessing quality,
productivity, customer satisfaction, employee satisfaction, and the facility’s performance.
The final step is to see whether future periods’ performance improves compared to this
period’s. If it does, can we safely assume that it was the incentive pay that caused
performance? Or is it equally likely that the improved performance has alternative
explanations, such as the fluctuation in the value of currency, changes in competition, or
perhaps a change in leadership or other human resource practices in the facility?
G. Similarities and Differences in Strategies
Google is a popular Internet search engine company. Nucor is a pioneer in
recycling steel scrap and other metallics into steel products, including rebar, angles,
rounds, channels, flats, sheet, beams, plate, and other products. Merrill Lynch, now part
of Bank of America, is a financial services organization that had an eventful several years
(following the 2008 Great Financial Crisis) and advises companies and clients
worldwide. We will focus primarily on financial advisors (“brokers”) at Merrill Lynch.
All three have been innovators in their industries. Their decisions on the five dimensions
of compensation strategy are both similar and different. All three formulate their pay
strategies to support their business strategies. All three emphasize outstanding employee
performance and commitment. However, there are major differences.
Google (now called Alphabet), while in fact one of the largest companies in the
world with a market value of over $1.8 trillion, positions itself as still being, at heart, the
feisty start-up populated by nerds and math whizzes. It offers employees such generous
stock programs that many of them have become millionaires. Its benefits are “way
beyond the basics” compared to its competitors. (Yes, there is a free lunch, a gym, a
grand piano, bocce courts, a bowling alley, and roller hockey in the parking lot. There is
also food: 25 cafés in the company, all free.) Not surprisingly, Google was named the
best company to work for by Fortune six years in a row, and #1 on the 2020 Forbes
World’s Best Employers list. Google has traditionally not emphasized cash compensation
(base plus bonus) in its communications, but the reality is different. For example, Google
was ranked #1 on Glassdoor’s list of Top Companies for Compensation & Benefits.1
According to Glassdoor, the mean salary for a senior software engineer at Google is
$183,413 plus an average $33,000 in additional variable pay (e.g., bonuses) for a total of
$209,838, compared to the national average of $124,784 plus $11,000, a total of
$134,784. A few years ago, Google implemented an across-the-board 10 percent increase
in base pay, reportedly based on employee survey results indicating that Google
employees “consider salary more important than bonuses or equity.”2 Google also
believes strongly in pay for performance. Laszlo Bock, its former Head of People
Operations, in his book, Work Rules!, recommends that organizations “Pay unfairly (it’s
more fair!).” Bock explains that a small percentage of employees create a large
percentage of the value and that their pay must recognize their disproportionate
contributions.
Merrill Lynch went through a turbulent period, having been acquired by Bank of
America in a deal brokered by the U.S. Treasury Department. However, unlike its former
key competitors like Lehman Brothers, which entered bankruptcy, and Bear Stearns,
which appears to have lost its identity within J.P. Morgan after being acquired, Merrill
Lynch has retained its separate identity and is structured as a wholly owned subsidiary of
Bank of America. Its compensation approach for brokers, its key employee group,
remains essentially unchanged.
The aggressive pay-for-performance approach at Merrill Lynch was traditionally
seen as a key factor in generating substantial wealth both for shareholders and for many
of its employees over the years. However, that same aggressive pay-for-performance
approach at Merrill Lynch (and at its competitors), most notably in the Global Markets
and Investment Banking segment, is now seen as having been a key factor in the
“meltdown” in the financial industry. A widely held view is that this aggressive approach
led to too much risk-taking (e.g., in areas of the business like subprime lending and
currency trading) and consequently the downfall of firms in the financial industry. So, the
same aggressive approach that was seen as the core of a culture that generated substantial
wealth for Merrill Lynch shareholders, and many employees, subsequently was identified
as the culprit in the downfall of Merrill Lynch and its peers. What about going forward?
Merrill, like the rest of the industry, has adjusted and to date, has not had similar
problems. Further, it has in a number of years produced a disproportionately high (for its
size) share of Bank of America overall net income.
Google, Microsoft, and SAS all compete for software engineers and marketing
skills. In its earlier years Microsoft adopted a strategy very similar to Google’s, except its
employees “put some skin in the game”; that is, they accepted less base pay to join a
company whose stock value was increasing exponentially. 14 But when its stock quit
performing so spectacularly, Microsoft shifted its strategy to increase base and bonus
from the 45th percentile of competitors’ pay to the 65th percentile. It still retained its
strong emphasis on (still nonperforming) stock-related compensation, but eliminated its
long-standing, broad-based stock option plan in favor of stock grants. Its benefits
continue to lead the market. More recently, Microsoft, as CNET put it, “took another step
toward middle age” by “significantly scaling back its stock awards for employees,
replacing that with cash.” CNET describes this shift as “implicitly acknowledging that its
stock performance isn’t enough [any more] to retain top talent.” Microsoft has gone from
being #8 on the first (1998) list of 100 Best Companies to Work For to being #86 on the
2014 list. More recently, it was #4 on the 2020 Forbes World’s Best Employers List and
#15 on the Forbes Best Large Employers 2021 List.
Sometimes different business units within the same corporation will have very
different competitive conditions, adopt different business strategies, and thus fit different
compensation strategies. The business units at United Technologies include Otis
Elevator, Pratt & Whitney aircraft engines, Sikorsky Aircraft, Climate Controls/Security,
Aerospace, and Building/Industrial Systems. These businesses face very different
competitive conditions. The Korean company SK Holdings has even more variety in its
business units. They include a gasoline retailer, a cellular phone manufacturer, and SK
Construction. SK has different compensation strategies aligned to each of its very
different businesses.
It also follows that when business strategies change, pay systems should change,
too. A classic example is IBM’s strategic and cultural transformation. For years IBM
placed a strong emphasis on internal alignment. Its well-developed job evaluation plan,
clear hierarchy for decision making, work/life balance benefits, and policy of no layoffs
served well when the company dominated the market for high-profit mainframe
computers. But it did not provide flexibility to adapt to competitive changes and changes
in what their customers wanted and who their customers were. Thus, IBM “exited
commoditizing businesses like personal computers and hard disk drives.”19 Instead, it
shifted to a focus on “high-growth, high value segments of the [information technology]
industry.” In its most recent annual report, IBM now describes its business as “We create
value for clients by providing integrated solutions and products that leverage: data,
information technology, deep expertise in industries and business processes, with trust
and security and a broad ecosystem of partners and alliances.”
Consider alignment between compensation and other aspects of HR at SAS.
Rather than being sold in a one-time transaction, SAS’s software is licensed. This is part
of a business strategy by which SAS gets ongoing and substantial feedback from
customers regarding how products can be continually improved and also regarding what
new products customers would like. To support this long-term customer relationship,
SAS seeks to have low employee turnover. Its heavy emphasis on benefits in
compensation seems to be helpful in retaining employees. SAS also gets many job
applications, which allows it to be very selective in its hiring. That no doubt helps build a
highly able workforce and allows selection of those who fit SAS’s emphasis on
teamwork and idea sharing. The deemphasis on pay for individual performance probably
reduces the risk that competition among employees will undermine this objective.
As we discuss in the next section, Whole Foods also is team-based. Unlike SAS,
however, it relies heavily on pay for performance. But it is team performance that
matters. (Contrast the deemphasis on differences in individual performance at SAS and
Whole Foods with the very different approach—strong emphasis on individual pay for
performance—that seems to fit the business and HR strategies of companies such as
General Electric, Nucor Steel, Lincoln Electric, and Merrill Lynch.) How effective can a
compensation strategy be in supporting business strategy if it is at crosspurposes with the
overall HR strategy? While reading about Whole Foods below, ask yourself how well its
reliance on teams and giving workers wide decision latitude would work with a different
compensation strategy. Such a mismatch happens surprisingly often.
H. The Pay Model Guides Strategic Pay Decisions
Let us continue our discussion of Whole Foods. The competitive advantage of
Whole Foods is apparent with the first visit to one of its grocery stores, described as “a
mouth-watering festival of colors, smells, and textures; an homage to the appetite.”30
What started out in 1978 as a small health food store in Austin, Texas, has, through
strategic decisions, grown to become the world’s leading natural and organic foods
supermarket, whose objective is to change the way Americans eat. Along the way, Whole
Foods’ managers have designed a total compensation system to support the company’s
phenomenal growth from 10,000 “team members” and $900 million in sales in 1996 to
87,000 “team members” and sales of $16 billion as of 2017. (Whole Foods was acquired
in 2017 for $13.7 billion by Amazon. Whole Foods data are not reported separately by
Amazon.) Whole Foods was on the Fortune list of Best Companies to Work for 20
consecutive years and is on the 2021 Forbes list of America’s Best Large Employers.
John Mackey has so far continued as CEO of Whole Foods, which would suggest
planned continuity.)
All organizations that pay people have a compensation strategy. Some may have
written compensation strategies for all to see and understand. Others may not even realize
they have a compensation strategy. Ask a manager at one of these latter organizations
about its compensation strategy and you may get a pragmatic response: “We do whatever
it takes.” Its compensation strategy is inferred from the pay decisions it has made.
Managers in all organizations make the five strategic decisions discussed earlier. Some
do it in a rational, deliberate way, while others do it more chaotically— as ad hoc
responses to pressures from the economic, sociopolitical, and regulatory context in which
the organization operates. But in any organization that pays people, there is a
compensation strategy at work.
I. Developing a Total Compensation Strategy
Think about any organization’s past, present, and—most vitally—future. What
factors in its business environment have contributed to the company’s success? Which of
these factors are likely to become more (or less) important as the company looks ahead?
This first step includes an understanding of the specific industry in which the
organization operates and how the organization plans to compete in that industry. What is
your company’s strategy? How do you compete to win? How should the compensation
system support that strategy? Learn to gauge the underlying dynamics in your business
(or build relationships with those who can).
As noted earlier, the pay strategy is also influenced by how it fits with other HR
systems in the organization.40 Whatever the overall HR strategy, a decision about the
prominence of pay in that HR strategy is required. Pay can be a supporting player, as in
the high-performance approach, or it can take the lead and be a catalyst for change.
Whatever the role, compensation is embedded in the total HR approach. Context refers to
a wide range of factors, including legal and regulatory requirements, cultural differences,
changing workforce demographics, expectations, and the like. These also affect
compensation choices. In the case of Whole Foods, its business is very people intensive.
Consequently, Whole Foods managers may find that an increasingly diverse workforce
and increasingly diverse forms of pay (child care, chemical dependency counseling,
educational reimbursements, employee assistance programs) may add value and be
difficult for competitors (other supermarkets) to imitate.
The simple fact that employees differ is too easily overlooked in formulating a
compensation strategy. Individual employees join the organization, make investment
decisions, interact with customers, design new products, assemble components, and so
on. Individual employees receive the pay. A major challenge in the design of next-
generation pay systems is how to better satisfy individual needs and preferences.
Offering more choice is one approach. Older, highly paid workers may wish to
defer taxes by putting their pay into retirement funds, while younger employees may have
high cash needs to buy a house, support a family, or finance an education. Dual-career
couples who have double family coverage may prefer to use more of their combined pay
for child care, automobile insurance, financial counseling, or other benefits such as
flexible schedules. Employees who have young children or dependent parents may desire
dependent care coverage.45 Whole Foods, in fact, as described in its annual report each
year, holds an employee vote every three years to determine the nature of their benefits
program.
Contemporary pay systems in the United States do offer some choices. Flexible
benefits and choices among health care plans and investment funds for retirement are
examples. As noted above, Whole Foods employees vote on the benefits they want.
Netflix employees can choose the mix of stock options and salary. General Mills
similarly allows many employees to swap several weeks’ salary for stock awards. The
company believes that allowing employees their choice adds value and is difficult for
other companies to imitate—it is a source of competitive advantage for General Mills.
Whether or not this belief is correct remains to be studied.
Pay strategies need to take into account the nature of the union– management
relationship. Even though less than 7 percent of U.S. private sector workers are now in
labor unions, union influence on pay decisions remains significant in key sectors (e.g.,
manufacturing, health care, education). Union preferences for different forms of pay
(e.g., protecting retirement and health care plans) and their concern with job security
affect pay strategy. Unions’ interests can differ.
In Denver, Colorado, a merit pay plan was developed collaboratively by the
Denver Public Schools and the Denver Classroom Teachers Association, the local union
affiliate. Teachers approved the agreement by a 59 percent to 4 percent vote, and Denver
voters approved a $25 million property tax increase to pay for it. Conversely, many
teachers in Springfield, Massachusetts, left for neighboring, higher-paying school
districts in part because the district wanted to impose a merit pay plan.
J. Source of Competitive Advantage
Developing and implementing a pay strategy that is a source of sustained
competitive advantage is easier said than done. Not all compensation decisions are
strategic or a source of competitive advantage. Three tests determine whether a pay
strategy is a source of advantage: (1) Is it aligned? (2) Does it differentiate? (3) Does it
add value? Alignment of the pay strategy includes three aspects, as we have already
discussed: (1) align with the business strategy, (2) align externally with the economic and
sociopolitical conditions, and (3) align internally within the overall HR system.
Alignment is probably the easiest test to pass.
Some believe that the only thing that really matters about a strategy is how it is
different from everyone else’s. If the pay system is relatively simple for any competitor
to copy, then how can it possibly be a source of competitive advantage? The answer,
according to the advocates of the strategic approach, is in how the pay system is
managed. This rhetoric is appealing, but the evidence to support it is slim. Are they
difficult to imitate? Probably, because each strategy is woven into the fabric of the
company’s overall HR strategy. Copying one or another dimension of a strategy means
ripping apart the overall approach and patching in a new one. So, in a sense, the
alignment test (weaving the fabric) helps ensure passing the differentiation test.
Microsoft’s use of stock awards for all employees—often worth considerably more than
people’s base pay—is difficult for its competitors to copy.
SAS’s workfamily-balance (like Medtronic’s total-presence-at-the-workplace
strategy) is difficult to copy. It may be relatively easy to copy any individual action a
competitor takes (i.e., grant stock options to more employees or offer more choice in their
health insurance). But the strategic perspective implies that it is the way programs fit
together and fit the overall organization that is hard to copy. Simply copying others by
blindly benchmarking best practices amounts to trying to get in and/or stay in the race,
not win it.56 (Of course, being in the race, or achieving competitive parity, may be a
major improvement for some organizations.)
Organizations continue to look for the return they are getting from their
incentives, benefits, and even base pay. Compensation is often a company’s largest
controllable expense. Because consultants and a few researchers treat different forms of
pay as investments, the task is to come up with ways to calculate the return on
investments (ROI). But this is a difficult proposition. As one writer put it, “It is easier to
count the bottles than describe the wine.”60 Costs are easy to fit into a spreadsheet, but
any value created as a result of those costs is difficult to specify, much less measure.
The premise of any strategic perspective is that if managers align pay decisions
with the organization’s strategy and values, are responsive to employees and union
relations, and are globally competitive, then the organization is more likely to achieve
competitive advantage.64 The challenge is to design the “fit” with the environment,
business strategy, and pay plan. The better the fit, the greater the competitive advantage.
But not everyone agrees. In contrast to the notion of strategic fit, some believe that (1) a
set of best-pay practices exists and (2) these practices can be applied universally across
situations. Rather than having a better fit between business strategy and compensation
plans that yields better performance, they say that best practices result in better
performance with almost any business strategy.
K. Virtuous and Vicious Circles
A group of studies suggests specific conditions to look at when making strategic
pay decisions. One study examined eight years of data from 180 U.S. companies.73 The
authors reported that while pay levels (external competitiveness) differed among these
companies, they were not related to the companies’ subsequent financial performance.
However, when combined with differences in the size of bonuses and the number of
people eligible for stock options, the pay levels were related to future financial success of
the organizations. This study concluded that it is not only how much you pay but also
how you pay that matters.
Additionally, there are several studies that analyzed pay strategies as part of the
“high-performance workplace” approaches discussed earlier. This research focused on
specific jobs and workplaces, such as sales and service representatives in call service
centers and jobs in factories.77 They indicate that performance-based pay that shares
success with employees does improve employee attitudes, behaviors, and performance—
especially when coupled with the other “high-performance” practices. One study even
reported that the effects of the compensation strategy equaled the impact of all the other
practices (high involvement, teams, selective hiring, and training programs) combined.78
These findings are near and dear to our hearts. So other “high-performance” HR practices
also become factors that support improved performance and the virtuous circle.
Perhaps we believe so strongly that pay matters and that studying it in the
workplace is beneficial, that this is what we see—believing is seeing. So, caution and
more evidence are required. Nevertheless, these studies do seem to indicate that
performance-based pay may be a best practice, under the right circumstances. (Could
performance-based pay sometimes be a “worst practice”? Yes, when incentive systems
don’t pay off and they alienate employees or lead to government investigation of possible
stock option manipulation.) Additionally, we do not have much information about how
people perceive various pay strategies. Do all managers “see” the total compensation
strategy at Merrill Lynch or Google the same way? Some evidence suggests that if you
ask ten managers about their company’s HR strategy, you get ten different answers. If the
link between the strategy and people’s perceptions is not clear, then maybe we are using
evidence to build on unstable ground.
