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Merit Pay: Is It Worth It?

September 16, 2013  |   Compensation,Uncategorized   |     |   Comments Off on Merit Pay: Is It Worth It?

Most of us have been challenged over the years to find the best way to appropriately reward above-average and exceptional performers. Many believe pay is the single most important motivator of performance. Yet, when employees are surveyed, they claim they are not motivated by pay and their pay system has little influence over the way they behave on a daily basis. That’s what this blog post challenges our thinking about.

Why Do They Exist?

The concept of merit pay has been around for decades. The original merit increase matrix was designed back in the ’60s for an ACA (now WorldatWork) course on Audit and Control Statistics. This was done well before computers or other forms of electronic media.

The objectives of a merit pay system are to:
> Attract, retain and motivate.
> Develop a method to distribute pay equitably based on performance.
> Use of merit increase guidelines tied in with objective performance measures.

The majority of companies today use some form of merit increase guidelines as a manner of distributing salary adjustments throughout their companies.

The current economic outlook doesn’t provide much hope for higher merit increase budgets:
> Inching up of consumer price index that will affect inflation.
> Jobless claims are slightly down but doesn’t capture underemployment.
> Lack of job expansion.
> Lack of economic expansion.
> Consumers’ confidence is low.
> Organizations are hoarding cash but not spending.
> Employee engagement is at an all-time low.
> High potentials are at risk.

Given the current economic outlook, the news around what’s projected for merit increases is on a downward trend for most industries. A survey conducted by Towers Watson last year indicated that on a 5-point scale with 5 being the highest, top performers being rated a 5 received an average increase of 4%, next level performers received an average of 3.4%, and those who met expectations received a 2.5% increase. Not much differentiation is there. As inflation rises will those merit increases even be noticed?

Progressive organizations are seeking out alternative pay methods to both maintain cost controls and increase employee performance. We’ve even coined a new word — “incentivize” — a particular process as a way to increase employee motivation.

Current Economic Outlook

The current economic environment has produced an era of employees happy to have a job accompanied with an attitude of distrust and disenfranchisement, and an unwillingness to align their efforts with organizational goals.

So, for organizations, we are asking our employees to do more with fewer resources and not providing much of a reward from a base pay perspective. We are expecting employees to work harder and longer, both in the office and outside with virtual office hours, with no real downtime, to meet minimum work standards.

Motivating By Pay

We have Victor Vroom to thank for the Expectancy Theory and others like Lawler and Milkovich have explored these concepts further.

The idea behind merit increases is to reward those employees who have differentiated their performance above others in their work group, department, or division. The components of using pay to motivate performance lies within its Instrumentality, Valence and Expectancy from the employee’s perspective:

Instrumentality: The relative pay received is higher for high performers than low performers. Pay distribution is contingent on high performance.

Valence: The differential between low performance pay and high performance pay is significant to the individual.

Expectancy: Good performance is clearly defined and under the influence/control of the individual.

We should review our own merit increase systems to see how they’d score on these three components.

Conditions for Success

The conditions for a merit increase program being successful are based in part on the elements of the Expectancy Theory. Merit pay plans motivate individuals to perform extra role behavior when they desire increased pay. They believe that the relative size of pay raises is contingent on good performance, and believe they are capable of good performance.

Condition: Value
Impact: Individuals must value increased pay more and be willing to work harder or spend more time meeting performance goals (Valence).
Results: Higher level of  performance.

Condition: Differential
Impact: The differential in raises for high performance should be substantially higher than that awarded to average or low-performing individuals (Valence).
Results: When differential is high, increased effort is warranted.

Condition: Clear Communications
Impact: The criteria for good performance should be clear and communicated to employees (Expectancy; Role Expectations).
Results: Employees don’t need to guess what they need to do to get good performance reviews.

Condition: Trust
Impact: Employees must trust managers. There must be trust in the evaluation system so that employees do not perceive favoritism (Expectancy) and trust in the allocation system (Instrumentality).
Results: Higher level of performance equals a higher raise.

Condition: Non Zero-Sum
Impact: Everyone who meets high performance expectations receives a high increase.
Results: When systems are Zero-Sum, only the best employees receive the highest raises. So, middle and lower ranked employees lose instrumental motivation because even if they improve performance they don’t believe they’ll be rated higher than the “stars.”

Design Flaws in the Merit Increase System

The potential issues with merit pay systems are the opposite of the Conditions for Success outlined above.

A Zero-Sum system, given a 3% budget, puts a manager in a position of giving each employee a 3% raise or, if he/she wants to give a higher raise like 5%, someone else has to get 1%. If employees’ performance fits a normal distribution it might work, but if the manager takes the easy way out and gives everyone a 3% raise it turns into a COLA.

In most merit increase programs, adjustments are granted annually. The issue is timing. Many managers, even with two review cycles, don’t assess performance across the entire year; they rely on observations of performance in the few weeks or months preceding the performance review (recency effect).

Most merit increase systems call for annual performance evaluations and pay adjustments contributing to the annuity and entitlement feature of these systems.

To sum it up, the design flaws in Merit Increase Systems are:
> Zero-Sum feature.
> Timing – annual performance evaluations and pay adjustments.
> Annuity feature disconnect.
> Small differentials between average and exemplary performance.
> Inequity.
> Breakdown in group cohesiveness and cooperation.

We spend a lot of time and effort on the distribution of merit pay. It may be time to change our ways.

Written by: Barb Manny, BCR President and Consultant

BCR is a local, minority-owned firm with more than 25 years experience in serving non-profit, public, and privately held entities in the key areas of Benefits and Compensation Consulting, Performance Management, Human Resource Organization Development, and Human Resource Information Systems and Processes.

Call (847) 236-1208 or email us today for a no-cost, no-obligation consultation to discuss how we can partner to achieve rewarding results.


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