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by PATRICIA K. ZINGHEIM and JAY R. SCHUSTER | March 31, 2009

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By PATRICIA K. ZINGHEIM and JAY R. SCHUSTER
Special to HRnext

Does merit pay work? If you ask for a show of hands from HR practitioners, few would indicate that it "works" for their organization. If you ask why "merit" pay does not fill the bill, most will say things like, "It doesn't really pay for performance," or, "All it does is call a 'cost-of-living' increase something it isn't," or, "It's just an entitlement with a different name."

Here are some ideas about how to make your merit pay a real solution. Some are hard to implement, but if you don't use them, you're really just wasting base pay increase dollars.

  1. When there's too little money. If you have 4 percent to spend on pay adjustments and decide that 3 percent of that must go for adjustments to market, another 1/2 of 1 percent must go for internal equity adjustments, and perhaps 1/2 of 1 percent to deal with promotions and transfers, this leaves only 1 percent of the adjustment for performance increases. This is usually not enough to make any significant differences in pay adjustments for individual performance. If you tell an employee that they are getting most of the adjustment because of changes in competitive practice, most employees will not believe that performance counts. If your organization has only 1 percent left for performance, use this for the top-performing people. If you don't have enough to make excellent performance worth more than just average performance, most of the 1 percent needs to be used only for the excellent performers. This means you must be able to measure this superior performance.

  2. Decide what you're paying for: Most organizations deploy some sort of market measurement and affordability test for pay adjustments, especially during increasingly pressing business and economic times. Subsequently, a budget is allocated for "merit" increases, and adjustments to individual base pay are made. The problem is that what is called "merit" often needs to cover a lot of things other than how people perform. For example this "merit" budget is used to address changes in competitive market pressures, internal equity and fairness between how people and jobs are paid, promotions to higher level jobs, transfers from one part of the country or world to another, and individual performance. During days of budgets of 4 percent or less, there is not enough money to "go around." So, your organization must decide what it will pay for. Do you have enough "merit" money to really pay for performance?


  3. Develop measures for merit pay. If you are going to pay anything for performance, your organization must be able to measure it honestly, reliable, credibly, and in a valid fashion. This is not an easy task because many performance measurement tools are not strong enough to capably measure performance. It means identifying the objective and measurable factors that comprise differences in performance, training people around these performance elements, providing coaching so people are given the chance to grow in the measured areas, and having a tool to objectively measure these factors when they exist or don't. This is much more than just designing a form to measure performance-it involves an entire way to manage and judge people. Not an easy task but reasonable and doable.


  4. Put money where merit message is. Once you have a real system for measuring performance, your organization must pay for this performance. Whatever money is dedicated to performance should clearly be communicated as for performance. And it should be granted for performance. The people who are judged to be the best need to be getting the most rapid pay progression. They need to be catching up with higher paid people who are paid much more. And, yes, they must even be catching up to longer service people to prove that performance is more important than is length of service with the organization. When you display all the raises and all the people together, better performers should be getting raises for performance so they are catching up and passing poorer performers with the same or more service and experience. If you don't do this, you are not paying for performance.


  5. Use variable pay for performance. Ultimately, granting "merit" increases for performance fails. That's because individual performance varies from performance period to performance period but base pay is a "gift that keeps on giving." So, you give an employee a large pay adjustment for performance within one year and this adjustment remains with the employee as long as they are with the organization. Variable pay is a lump-sum award that does not become a permanent part of base salary. So as performance varies, it can be rewarded with a larger "dose" of pay when performance is very good-making top performance financially worth while. And when performance is less-than-satisfactory, the incentive can reflect this performance and also encourage top-performance in future years. It gives flexibility and avoids the necessity of considering reducing base pay in the event the employee that is not meeting performance standards is viewed as "overpaid." Variable pay is the future and much better for performance than is merit pay-but it takes patience and communications to make it work well.


  6. Emphasize market realities and differences. If you have a specific percentage for performance in the form of merit, most organizations spread it around like cream on a bagel. This means that when your organization has limited dollars for recognizing performance, spend them on the skills and competencies that are most valuable and scarce in the labor market. It is just most important to reward the performance of people who have skills the organization urgently needs. It is great to reward everyone's performance-but when the economy and organization are financially challenged, the organization needs to emphasize the scarcest skills with the highest market value. Keeping the top performers with the scarce skills is most essential during tough times.


  7. Dump "internal equity" from pay concerns. Paying for internal equity costs pay dollars. While it is a worthy objective to make sure jobs of equal value and the people in them are paid "fairly"; it is nearly impossible to reach an agreement about what constitutes the word "fair." The concept of internal equity is very subjective and everyone has an opinion about what it is. On the other hand, the external market is a more understandable basis for determining the value of jobs and the basis for paying the people in these jobs. While organizations may need to discuss how to define the market for jobs in which they compete, internal equity creates unresolvable definition problems.


  8. Communicate what you will pay for. What will "merit" pay for and what will it not pay for? Whatever the rules of the road are, everyone should understand them. The important thing about pay is being honest about what you will pay for and then following up by actually paying consistent with your promises. People hate surprises and rapid changes in direction. Sometimes this is very difficult, but wherever possible, communicate, communicate, and communicate. And then follow up by doing what you have said you planned to do.


  9. Hire people who want your pay solution. Organizations must hire people to match how they plan to pay for "merit." This means that if you really plan to distribute pay based on individual performance; you should not hire employees who do not what their performance judged for pay purposes. Often organizations are trying to change how they pay their workforce from what it is a present. The most common reason to change is to try to base pay on performance. If the organization has a workforce that gets pay based primarily on service and experience, moving to real pay-for-performance will be very difficult.

Can this "fix" your "merit" pay solution? If it can't it can move you dramatically in the right direction. The "merit" approach to pay management is pretty long in the tooth and needs to be evaluated and updated more often than you might expect.


Editor's note: Patricia K. Zingheim and Jay R. Schuster are partners in Schuster-Zingheim and Associates, Inc., a pay-and-rewards consulting firm founded in Los Angeles in 1985. Their writing credits include the books "Pay People Right! Breakthrough Reward Strategies to Create Great Companies" (Jossey-Bass, 2000) and "The New Pay: Linking Employee and Organizational Performance" (Jossey-Bass Publishers, 1996). They've also appeared on CNBC, CNNfn, NBC, and CBS programs. Their web site is www.paypeopleright.com

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