Despite embracing the concept of pay for performance, a surprisingly large number of employers say their programs aren’t doing what they were designed to do: drive and reward individual performance, according to findings by HR consultancy Willis Towers Watson. That’s leading organizations to adjust both their merit pay and annual bonus tactics, and even to explore ratings-less performance-management approaches.
“Traditional pay-for-performance programs, primarily annual merit pay increases and annual bonuses, are falling short in the eyes of many employers,” said Laura Sejen, the consultancy’s global practice leader for rewards in New York City.
The latest Talent Management and Rewards Pulse Survey was conducted by Willis Towers Watson in October and November 2015. Responents were primarily HR executives at 150 large and midsize U.S. and Canadian employers. Among the findings:
• Just 32 percent said their merit pay program is effective at differentiating pay based on individual performance.
• Only 20 percent found merit pay to be effective at driving higher levels of individual performance at their organization.
The survey also found that 71 percent of employers use wage increases in the local market as the basis for determining what they still call their “merit” increase budget, making it more of an annual cost-of-living adjustment or a general reflection of demand for skills, rather than a reward tied to outstanding individual contributions.
Similarly, employers give their annual bonus programs low marks:
• Just over half (51 percent) reported using organizationwide performance measures to determine the award funding pool and individual performance measures to determine award payouts.
• Only half said annual incentive programs are effective at boosting individual performance levels.
Rethinking Merit Increases
“As human resources professionals, we need to be encouraging organizations to think differently about merit pay,” Sejen said. “As radical as it may sound, maybe the best thing to do with merit pay is to bury it.”
Instead of providing nearly everyone with a raise that’s seen as an entitlement, “base pay should be representative of an employee’s ongoing and potential contributions,” Sejen said. “Maybe employees who are early in their career and performing well should receive a couple of increases during the year, while longer-service, career-level people who have reached a certain pay level shouldn’t anticipate any kind of increase, but rather an occasional adjustment to represent their role and what the market says their role should be valued at.”
She added, “There are many tools available to companies that would be far more effective at differentiating pay based on performance then this old-school approach called the annual merit increase,” such as recognition awards and spot bonuses.
Improving Short-Term Incentives
Annual short-term incentive programs, because they often have more dollars budged to them, also should be more effective at differentiating pay to top performers, Sejen noted. “You typically have bonus targets of 10 percent or 15 percent of salary, so it’s easier to differentiate these rewards than with a 2.5 percent merit increase budget,” she said. But when employers don’t measure individual performance effectively, “they won’t have a foundation for determining what the associated bonus awards ought to be.”
As with merit pay, “there is an opportunity with annual incentives as well,” Sejen said. “It starts with rethinking plan design—do we have the right metrics in place? When managers sit with their employees either individually or as a team, how robust is the objective-setting process and how aligned are those individual and team targets with higher-level objectives at the unit or business level? There also needs to be managerial discipline around accepting results received—delivering significant upside for the people who over-deliver while holding back on employees who under-deliver.”
Short-term incentive awards “should be determined one year at a time, asking ‘How well did the company do, how well did a business unit do, how well did I do against goals?’ Some years it might be under-target, some years it might be above, but every year it’s a fresh look.”
Doing Without Ratings
Some companies have moved to eliminate annual employee ratings from their performance management systems, Sejen said.
“Instead of just plugging in a rating and moving on to the next management activity, the theory is to drive managers to have more-robust discussions with employees about their performance, and then finding a way to better differentiate pay. I think the jury is out on whether that will yield fruit; it’s a very small percentage of organizations that say they’ve actually abandoned ratings altogether”—around 8 percent of midsize and large companies, Sejen said—“so we don’t have the results yet on whether or not that’s going to work. But it’s certainly an idea that’s out there.”