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Solving the Compensation Puzzle
Putting Together a Complete Pay and Performance System
By Sharon K. Koss
Society For Human Resource Management Copyright © 2008 Society for Human Resource Management
All rights reserved.
A Historical Look at Pay for Performance
Job evaluation, compensation administration and pay for performance are not new concepts. From the beginning of time, there have been systems that reward different levels of performance. Historical evidence suggests the word "salary" is derived from the Latin word "salarium," which means "salt money." In Roman times, soldiers and workers were paid in part with salt, considered a precious commodity many centuries ago. The expression "worth his/her salt" comes from this Roman pay system where workers could earn approximately 10 times the salt for superior efforts.
As the American workforce moved from the family farm economy into the factory setting, many employers were paid a piece rate for production. The union movement was built out of the piece-rate system, where employees were treated like machines and received no pay for retirement, illness and injury. Unions became active in the early 1900s as a way to force employers to treat employees more fairly. From the 1980s to present, pay for chief executive officers rose substantially over 200 percent, while the average factory worker's pay increased about 50 percent.
In today's economy, the manufacturing sector is moving overseas, with knowledge-based services being the fastest-growing sector. In this sector, an organization's employees are its competitive advantage and its largest expense. In fact, more than 80 percent of Fortune 1000 firms use some type of performance-based compensation plan.
Major Labor Market Trends
The fastest-growing sector is small businesses. Even larger organizations realize that they need to be nimble and think, move and act like a small business to remain competitive. Conversely, small businesses must be able to manage compensation issues successfully on their own, without heading to a large corporate headquarters for assistance.
The nature of work has experienced many changes during the past decade, resulting in the largest changes in American history which uniquely support a compensation system that differentiates pay-for-performance levels. There have been noteworthy changes in the employment relationship; for example, employees no longer expect to be with one employer for life. In fact, an employee's average tenure with an organization is less than three years, and the average 34-year-old has worked for nine organizations in his short career. This fact supports the case for employers receiving maximum performance from employees, and employees receiving maximum rewards from employers.
Organizations must be open to changing their business strategy to maintain a competitive edge. Successful organizations have clear goal-setting processes and strict budgets, while employees must be inspired to change focus and efforts quickly to support the organization's mission.
There also have been changes in organizational structure. Organizations will continue to use employees, but will have a mix of employees — core full-timer workers, part-time, job share, temporaries/contractors and consultants. Some organizations will even take this a step further and contract with vendors' entire departments of employees. Both the state of Florida and the state of Texas, for example, contract many HR functions, such as benefit administration, to an outside vendor.
Job design and content continue to change rapidly. An employee's job description can change overnight. The skills and talents employees bring to the table enable an organization to seize opportunities and go in directions they had not anticipated.
Changes in organizational management, style, ownership structure and location may change significantly. It is not unusual for an employee to have several different bosses or change job locations. In addition, the company name on the front door may change if the business is bought, sold or merged with a new firm.
Workforce Trends: Generations Working Side by Side
For the first time in history, the American workforce consists of four, and soon to be five, very distinct generations working together. This wide range of working generations creates a real challenge for an organization's attempt to use compensation and benefits wisely. One of the first steps is to understand the motivations, values and goals of each generation so a compensation system can be tailored to fit each generation. The traditional family model consisting of a father working outside the home and a stay-at-home mother taking care of two children now comprises less than 7 percent of family units.
First Generation: Depression Era and World War II
This generation, born before 1946, is characterized by frugality, experience, emotional experience and employer loyalty. Employees in this generation generally do not question authority and will remain with an organization for life. This segment controls the majority of the nation's wealth, but believes there will be little or no money for the next generation to inherit. This generation will continue to work for some extra money, flexibility and social interaction.
Second Generation: Baby Boomers
This generation, born between 1946 and 1964, comprises the most sophisticated and educated employees with the highest level of discretionary income in history. They are experienced, loyal and flexible employees with a strong work ethic and serve as great mentors for younger employees. This generation represents a huge segment of employees who, in general, have postponed planning for retirement. In addition, many organizations have done very little planning to close the gap with the retirement of millions of baby boomers.
Baby boomers have worked long hours for many years, without long-term loyalty to one company. They can be enticed to stay with one employer, however, in exchange for work/life balance, interesting work and flexible schedules. Baby boomers also are exhibiting a strong pattern in retiring and coming back to work for the same employer or starting a new career in their 50s and 60s.
Third Generation: Generation X
Generation X employees, born between 1964 and 1978, can be loyal if they believe they are getting their money's worth in terms of salary, promotional and educational opportunities. They want control over their careers and are willing to change their work situation when new opportunities arise. Generation Xers like to be treated as individuals, not as part of a group. They are high-tech savvy, motivated to achieve career goals and bring enthusiasm and creativity to the workplace.
These individuals will question authority and push back if they perceive a policy as unfair. Their mantra could be a radio station, WIIFM ("What's in it for me?").
The key to managing Generation Xers is to be up front, communicate often and see the work relationship as an equal deal for the employee and the employer. The most effective way to keep these employees happy is to assist them in developing career security. Ironically, if their demands are met, these employees will remain with one employer and not seek greener pastures.
Fourth Generation: Generation Y
This group, born between 1978 and 1994, is almost as large as the baby boomers and is referred to as the baby boomer echo. Generation Yers are extremely comfortable with technology because their baby boomer parents have spoiled them with computers, I-Pods, cars, cell phones, designer clothes and an expensive lifestyle, including luxury vacations. Because of these childhood privileges, many Generation Y employees expect their employers to spoil them in the same manner their parents did. They have been the center of their parents' world and this carries over into the work environment. Many Generation Yers move home after graduating college because an entry-level job does not support their accustomed standard of living. If a job does not meet their requirements, they do not worry about rent. Mom and dad usually are willing to let them move back home and will absorb their living costs.
This group is weighed down with debt, graduating with large student loans and credit card debt. With a high level of student loans due after graduation coupled with high real estate prices, owning a home is more a dream than a reality for Generation Y.
Generation Yers want jobs that conform to their interests and will question the way things have been done in the past. As employees, they are loyal to managers they perceive as caring and trustworthy. They are willing to work hard as long as they are convinced that this will enhance their life and work experience. This group is more social and willing to be part of a team. It is fairly common for Generation Yers to spend time with their co-workers after hours.
Fifth Generation: The New I Generation
Bill Gates coined this generation's name, which encompasses individuals born after 1994. The "I" stands for the Internet because these individuals grew up with the Internet, instant messaging and the global workplace. This group will become the fifth generation of workers in the American workplace.
Organizations are going global to reach new customers. At the same time, their employee groups are becoming more diverse, requiring more employee communications, career paths, benefits and pay. Alaska Airlines, for example, pays an hourly bonus to English-speaking employees who are bilingual in Spanish.
It is almost impossible for organizations to hire employees who meets all their skill sets and competency requirements. To close the skills gap, employers can partner with schools and educational institutions. Organizations also can provide more basic on-site literacy training.
No Middle Class — The Haves vs. The Have Nots
According to Robert Reich, former U.S. Secretary of Labor, the American middle class is disappearing. In an "escalator up, escalator down analogy," he described two classes. Members in "escalator up" receive private education, private lessons, attend a four-year university and often continue on to graduate school in a professional area such as science, math or business. After college, these individuals network professionally and receive financial support from their families.
In contrast, the "escalator down" class is marked by large gaps in literacy. Many members of this group are high school dropouts, accept any job that pays well and have no career goals or aspirations. They live paycheck to paycheck and have no financial security.
Armed with knowledge about the five generations of workers, language and skill set considerations, and an explanation about the two classes in the American workforce, HR professionals should now be ready to take the next step in designing a pay-for-performance plan. In many organizations, senior managers may have no experience — or a bad experience — with pay for performance. By leading senior management through the process, rather than dragging them through it, organizations will be more willing to make a long-term commitment to the program.CHAPTER 2
Is Pay for Performance Worth the Trouble?
The phrase "Pay employees right!" is a good guide for assisting organizations in hiring employees at the right rate and promoting and rewarding employees fairly. Paying an employee too low can be just as devastating as paying too high. In today's world, it is easy for employees to find out if they have been "low balled." Two well-known websites provide this information in a matter of seconds. An employee who is poorly compensated will either leave — often at an inopportune time for the employer — or resent the fact that he is paid too low. It is not uncommon to see larger organizations struggle through the budget process to find extra money to help a great employee catch up to market.
When payroll is one of the largest organizational expenses, overpaying can have disastrous consequences because many benefit and incentive plans are based on an employee's compensation. This often makes overpayment even more significant.
A well-defined pay policy focused on contemporary outside research and developed from an internal point of view allows an organization to administer their pay system accurately and fairly, thereby avoiding employee lawsuits. Employees will be less likely to sue their employer when the pay system is well communicated and consistently administered.
Only 20 percent of an organization's employees are fully engaged. Poor performers can seriously damage an organization's reputation, alienate customers, decrease productivity, and thwart its ability to move forward. These things will never be recovered — time is one thing an organization cannot get back. Every day an employee is not fully engaged in his or her work, lost productivity will never be recovered. "Since World War II, the economy has grown eight-fold while the labor force has only grown two to two-and-a-half times. This means that the average worker is about four times as productive now as they were in 1946."
A pay-for-performance plan reduces employee turnover. The average employee remains at a job for just under three years. Employees cite pay, benefits, lack of appreciation, and no feedback or career path as reasons for leaving an organization.
Components of a Successful Pay-for-Performance System
* Top management support
* Trust in management by employees
* Job descriptions
* Regular external market compensation survey using at least three surveys
* Process for internal equity review
* Performance appraisal system that is specific and measurable
* Merit increase structure that rewards star employees and gives employees who do not perform a zero increase
* Review of the system to make sure it is fair and equitable
* Regular updating process for market rates and market pay
Get Top Management Support
Obtaining management support is absolutely necessary for a pay-for-performance system. HR professionals cannot take on a project of this magnitude without management buy-in. Even a basic plan for the smallest employee group will take at least three to six months. For most organizations, a year is required before all the tasks are complete. Some senior managers and many business owners do not like to be put into a box, so they may balk at the idea of more structure. It is important to make senior management realize that this is a flexible plan that has no hard and fast rules.
The best compensation plans with a pay-for-performance component are flexible. Emphasize that this is an important tool that will take the guesswork out of hiring, promoting and paying the organization's most important asset — its employees. Employee issues often keep HR professionals awake at night, so think of pay for performance as a sleeping aid that prevents the organization from getting sued.
Organizational Metrics to Gauge Readiness for a Pay-for-Performance Plan
Organizations with at least 25 employees will reap many benefits by instituting a pay-for-performance compensation system. Typically, unionized organizations and family businesses will wait until the company has more than 50 employees. Organizations that are heavily invested in intellectual capital and sell their employees' talents often put in a pay-for-performance plan while the company is still small. Others that should consider a pay-for-performance plan include:
* Organizations that are required to have an affirmative action plan.
* Organizations that are billing employees' time out.
* Organizations that hire more than one employee per month.
* Organizations whose competitive advantage is their people, such as government, non-profit, high-technology and biotechnology and service firms.
* Organizations that must have the talents of hard-to-find, sophisticated employees, such as IT, engineering, computer, health care and other technology-based jobs.
Organizations that have been around for more than five years. Over time, one annual raise after another will put employees' base pay considerably over the market rate.
Myths and Facts About Merit Pay
Myth: Organizations have been eliminating their merit pay systems.
Fact: Merit pay is the most popular compensation system with more than 80 percent of organizations using this method.
Myth: Merit pay is more expensive than other methods and does not work.
Excerpted from Solving the Compensation Puzzle by Sharon K. Koss. Copyright © 2008 Society for Human Resource Management. Excerpted by permission of Society For Human Resource Management.
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