Do Merit Pay Systems Work? NO, Says Expert

In fact, he says, it is his goal to eliminate such programs. Why?

A merit increase program is a zero sum game; that is, the more you give one employee, the less you can give another. This is especially problematic when you want to reward teamwork and your primary reward vehicle is merit pay. You can’t get more individualistic than merit-based pay, says Rubino.

Challenges of Merit Systems

Say you have an excellent manager, but you have10 employees, and all 10 exceeded their performance goals. If you were to give all what they deserve, you would bust the budget—so the manager goes to HR, who asks, Were these objectives correctly set? The manager answers, Yes, so I need more money. And the answer from HR is HA HA.

You in HR say, You have to decide which of your employees are more excellent—you must rank their excellence. Does that manager leave your office a motivated manager who has been helped by HR?

And how about old Joe who has been there 25 years, excellent all the time, and doesn’t want a higher job (and there’s no one for him to go to anyway)?

Now comes time for Joe’s performance appraisal—“Joe, what can I say, another banner year. You are an excellent employee. However, this year, bad news—no increase; you are at the maximum of your range.”

What Really Works?

A comprehensive variable pay system in concert with a step-based system, says Rubino.
Move all performance pay out of base pay and into the lump sum, he says.

Lump sum lets you control your costs and gives employees good line of sight, he says. The main caveat is that you do need to keep moving up to stay with the market.

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Success Criteria for Variable Plus Step-Based Pay

Rubino offers the following tips for setting up your system:

• Organizational culture and values must support a performance/reward framework: instilling a “sales mentality.”
• Compensation policies and programs must be aligned with the organization’s strategic objectives.
• Senior management must allow the variable pay program to work.
• Should have “pay by example” at the top of the organization.
• Your solution must be internally equitable and externally competitive
• A variable pay program must deliver what is promised on time and fairly.
• Plan design should guard against “windfall” payments.
• Performance criteria must be discernible, valid, and understandable (i.e., if performance appraisal system is not good, do not proceed).
• Variable payouts must be aligned with performance criteria achievement.
• Variable opportunities must be perceived as “valuable enough” to motivate performance.
• Timing of payout allocations should be as close as possible to the qualifying event—usually start once a year, and then consider doing it more frequently if the job lends itself.
• If designed and implemented properly, variable payouts to employees will yield “slices from an expanding financial pie”—based on the growth—as employees accomplish goals.
• Middle managers will make or break the variable pay program. Communicate directly—mechanism, strategy, how it fits culturally, mechanics of how it works.
• Should involve managers in variable pay program design and performance criteria identification.
• Must build trust and get buy-in from managers and employees through effective training and communication.
• A well-designed and executed variable pay program can improve the organization’s bottom line.
• Measurable benefits can include improved morale, productivity, quality, customer service, on-time performance, work methods, etc., etc., etc.

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Consider adding more pay at risk, says Rubino:

• Remove performance considerations from base salary increase decisions—pay for performance within the variable pay framework.
• Redefine base salary increases as across-the-board market adjustments only (step-based), determined by competitive position analyses.
• The difference between the base salary “merit” budget and the market adjustment factor can be used to partially fund the incentive program. (It will not be fully-funded the first year; it requires an “investment” on the part of the organization—3 to 5 years to reach the breakeven point.)
• On-going “fixed” expenses can be considerably reduced due to the compounding effect of base salary increases.
• Variable compensation is paid in lump sum only when performance warrants: “pay at risk.”

In tomorrow’s Advisor, details of how Rubino’s system works, plus an introduction to BLR’s Wage & Hour Compliance: Practical Solutions for HR.