COLA and Merit Raises: Can We Stop Giving COLA Raises to Substandard Employees?

We tend to give employees two types of raises. First, everyone gets a COLA raise on July 1. It’s the same percentage for everyone. Then we also give annual merit raises on anniversary dates. My question is, can we start not giving the COLA raise to substandard employees? Is there a better way to structure our pay system so we don’t reward substandard workers? — Melissa, HR Manager in Modesto

The HR Management & Compliance Report: How To Comply with California Wage & Hour Law, explains everything you need to know to stay in compliance with the state’s complex and ever-changing rules, laws, and regulations in this area. Coverage on bonuses, meal and rest breaks, overtime, alternative workweeks, final paychecks, and more.

The short answer to your first question is yes—you are not required by law to grant pay increases at all. You also can differentiate between who receives a pay adjustment and who does not based on performance, assuming that such adjustments do not result in illegally discriminatory pay.

In fact, it is generally never a good idea to grant pay increases of any kind to poor performers. If you later want to terminate such an employee for poor performance, he or she could assert that the increase was evidence of good performance and that the termination, therefore, was unlawful. Thus, the increase itself could come back to bite you!

Now, for the longer answer to your second question. There are, indeed, significantly better ways to structure the administration of base pay. Before going into them, however, we need to step back and ask a key strategic question: “What is your company’s pay philosophy?” The philosophy statement will broadly identify which factors are intended to determine pay differences among employees. Fundamentally, there are three such factors: 1) the job, 2) the employee’s skills, and 3) the employee’s performance. Of these, measures of job value and employee performance are the most commonly used to administer annual salary increases.

The pay philosophy may also include the intention to use pay (financial incentives) as a way to motivate performance improvement (pay for performance).

Job Classifications

The first consideration is establishing and maintaining a meaningful job classification structure within which jobs—not people—are evaluated and classified with respect to 1) the external labor market and 2) relative internal job comparisons. This forms the essential framework within which the organization can make pay increase decisions that result in equitable, competitive, cost-effective, and legally compliant wages and salaries consistent with the organization’s pay philosophy.

Employee Performance

It is important to define what “performance” for pay administration purposes means in your organization. For some employers, employee skills, traits, and behaviors (means) are equated to performance. Other employers define performance strictly in terms of outcomes produced (end results). Still others measure a combination of these indicators.

If you choose to utilize measures of individual and/or team performance to determine base pay increases, you should do it consistently and with performance indicators that are as objective, well documented, and well communicated as possible. Otherwise, you risk having illegally discriminatory pay levels.

Administering Pay vs. Administering Increases

There are two basic approaches to determining wages and/or salaries: 1) administering pay, and 2) administering pay increases.

RECOMMENDED—Administering Pay. Pay administration is, in my opinion, much the better of the two options. This means that the employer is focused on using whatever financial resources are available to achieve improvements in:

  • internal pay equity and fairness
  • labor market competitiveness
  • linkage to performance
  • legal compliance

Administering base pay increases based on what salary levels should be, and not focusing on across-the-board increase percentages, is an effective way to manage payroll costs while helping to reduce undesirable turnover. It can also reduce legal liability for pay discrimination. Ultimately, it will clearly communicate the organization’s compensation philosophy and enable the organization to be a good steward of available financial resources, as well as to attract, retain, and motivate valuable employees.

The effective administration of base pay requires 1) well-defined and maintained job classifications and 2) solid measures of performance (if used). If you switch to this kind of approach, it also means that overpaid employees may not receive adjustments until the structure and job values increase over time in response to labor market inflation, while underpaid individuals may receive significant adjustments to reflect the value of their jobs and their performance.

NOT RECOMMENDED—Administering Increases. The administration of pay increases alone can lead to a broad array of undesirable consequences, including the perpetuation of existing salary inequities, potential illegal pay discrimination, reinforcement of an “entitlement” mentality, possible unintended linkage of pay to length of service (as opposed to performance), and wasting resources.

It is well-known among compensation professionals that the “peanut butter” approach—granting general or COLA increases of the same percentage to all employees, thus “spreading” the salary increase budget evenly over the entire employee population–builds an entitlement mentality and clearly indicates to all that superior performance is not valued.

Unfortunately, general COLA increases are sometimes communicated as merit increases even when there is no linkage between performance and the increase amount, and/or the resulting pay level. This has led most employees to assume that merit increases are an entitlement.

One question to ask is whether cost of living is even a relevant factor in determining pay levels. Some employers mistakenly assume that general increases assure that employees are “kept whole” in the face of inflation. Others, however, have now recognized that labor market inflation is a more pertinent indicator of competitive pay levels than is the Consumer Price Index. We do not recommend using COLA increases unless mandated by contract. If your wage and salary structure reflects the labor market and is updated regularly, it will incorporate labor market inflation, which is what you need to pay to be competitive.

Another commonly used, generally accepted, and yet ineffective way to administer pay increases involves using a chart called the “merit increase matrix.” Employers using this approach typically compute salary increases by specifying percentage-based guidelines linked both to position in range (current salary in relation to job value, or the compa-ratio) and performance rating. This is usually presented to supervisors as a chart that cross-references the two criteria and presents the prescribed percentage increases. Although this is a step in the right direction, unfortunately, unless the base pay levels are already where they should be, the focus on variable percentage increases rarely achieves the objectives of having competitive and equitable actual pay levels.

Shari Dunn is Managing Principal of CompAnalysis, a compensation and performance management consulting firm in Oakland.