Think Twice Before Substituting Incentives for Competitive Base Pay

I have been involved in several conversations recently where the topic at hand is a less-than-competitive base salary structure and one of the solutions tossed out is to add in an incentive plan to make up the difference.

I'd like to urge a bit of caution and present some thoughts to ponder for anyone considering this route.

Incentives - variable pay in one form or another - are potentially powerful reward mechanisms that can (when well conceived and implemented) accomplish a number of things, including (but not limited to):

• Focusing attention on critical objectives or business imperatives
• Rewarding extraordinary effort and/or outcomes, individual or group
• Providing a means by which to share the value of collective success

What incentives are not - I believe - is a simple substitute for a competitive wage or salary.

I don't mean to discount the concept of a total reward portfolio and a relative mix of reward elements (like salary, incentive, benefits, development opportunities, etc.), nor will I deny that there are situations where a particular strength in one area can and should "compensate" for a shortfall in another.  Many of us recall the dominant start-up model of the dot com boom of the late 90's:  very little cash, heavy on the stock options.  It's simply that we have to approach these trade-offs with care, especially in a competitive labor market.

For most organizations, an employee's base salary is the foundation of the reward package, and of the employee-employer economic exchange.  It is the purchase price associated with bringing a particular set of skills and capabilities to the table, and delivering them consistent with a set of performance expectations.  And it represents, in most cases, a fixed cost.

Incentive compensation, on the other hand, assuming it hasn't denigrated into an entitlement, is a variable cost.

The problem with the idea of substituting incentives for base pay is that you are trading variable dollars for fixed dollars.  They don't have equal value, for the obvious reason that one is contingent - on performance achievements or the largesse of management or whatever - and the other is not.  That is why the general rule of thumb says that it takes two or even three variable dollars to equal the value of one fixed dollar. 

So, to begin with, you would need to figure out what it will take to address the base salary shortfall, which will undoubtedly be more than you had in mind.  And then, as one of the conversations I recently overheard detailed, you have to figure out what to tie the incentive dollars to.  Particularly important if we're talking about a lot of money.

Which is a completely bass-ackwards way to conceive and design an incentive plan.  Given the power of incentives to influence behavior and outcomes, sometimes in ways unanticipated and unintended, the approach of piling a big (but not well conceived) incentive opportunity on top of a less-than-competitive base salary sounds to me like a disaster in the making.

My advice:  Get your base compensation act together (whatever that act might be), and then pursue incentives, with a clear set of business objectives in mind.   

Compensation Force Ranked #1!

Permit me a moment of shameless self-congratulations - Compensation Force has been ranked #1 in the first installation of the HR Power Blog Rankings sponsored by the HR Capitalist.  Click over and check out the list and rankings - what a thrill to be recognized with some of my favorite HR blogs!

Time is Right to Rethink Executive Severance and Change-In-Control Agreements

In an article in the latest Watson Wyatt Insider newsletter, consultants Ira Kay, Ph.D. and Steven Seelig, J.D., LL.M., urge companies to rethink their severance and change-in-control provisions and, as necessary, adjust them to better reflect their original purpose and intent as well as shareholder interests.

Today's climate of heightened sensitivity around and attention to executive compensation is bringing new scrutiny of severance and change-in-control packages.  Further, recent surveys by Watson Wyatt indicate that most institutional investors (64% for executive change-in-control agreements and 74% for executive severance plans) view these arrangements as "shareholder unfriendly".

With all of this in mind, Kay and Seelig provide a detailed history and overview of these agreements, and offer recommendations for rethinking and adjusting them.  The authors summarize their position in the following thoughts:

To get the most value from change-in-control and severance provisions, compensation committees must carefully balance the cost of providing specific incentives with their likely results.  Used properly, change-in-control and severance provisions can elicit behaviors that benefit executives, companies and shareholders, without forgoing fiscal restraint.  Boards and compensation committees must think carefully about how and when to implement these provisions.  Those that decide to modify existing compensation programs may need to get some complicated legal issues out of the way first.  For new hires, however, the slate is clean, and we hope that compensation committees will seriously consider these recommendations for their future executive compensation structures.  Shareholders need only to look at their company's proxy to see whether they have.

I could not do justice to Kay's and Seelig's advice with a summary of their thoughts and recommendations, so I urge any readers with interest in or a need to learn more about these arrangements to go directly to the article to read more.

Study Confirms That Salary Increase Budgets Outpaced Inflation in 2007

A finding worth noting in WorldatWork's recently released 2007/08 Salary Budget Survey:  The growth in salary increase budgets (which averaged 3.9% in 2007) outpaced inflation (as measured by the CPI for all urban consumers reported by the U.S. Bureau of Labor Statistics, which was 2.6% for the 12 months preceding the WorldatWork study) by an average of 1.3%.  This gap translates to the highest level of purchasing power for U.S. employees for several years.

While some portion of this increased purchasing power is undoubtedly being directed toward the higher (employee) cost of healthcare coverage for many, it is still a notable piece of positive news.

Related posts:

Salary Increases to Remain Flat in 2008

WorldatWork Releases Salary Increase Projections for Major Metro Areas

WorldatWork Releases 34th Annual Salary Budget Survey

Controlling Salary Structure Chaos (or Why I am Hung Up on Consistent Midpoint Differentials)

I know what they say about consistency.

Ralph Waldo Emerson:  "A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines."

Oscar Wilde:  "Consistency is the last refuge of the unimaginative."

I agree with Emerson and Wilde that consistency for its own sake is not always the best strategy.  But in the realm of base salary administration, it is often worth a nod.  This is particularly true - I believe - when it comes to midpoint differentials.

Midpoint differentials are those jumps from salary range midpoint to midpoint as you work your way up a traditional salary range structure.  For example, if you have a salary range (let's call it Grade 5) that looks like this ...

Minimum: $40,000

Midpoint: $50,000

Maximum: $60,000

... and the next salary range moving up the structure (let's call it Grade 6) looks like this ...

Minimum: $44,000

Midpoint:  $55,000

Maximum:  $66,000

... you have a midpoint differential (or a jump from the midpoint to midpoint) between the two grades of 10%.

In my work with a wide range of organizations over time, I often run into salary structures where the midpoint differentials look as though they came from a random number generator, so that differentials from grade to grade moving up a structure might be 6%, 15%, 11%, 3%, 8%, 22%, 5%, etc.  In some cases, the salary range structures are purposefully created this way, following some (goofy) sense of the organic nature of job value growth; in other cases, the chaos happens over time as a result of somewhat haphazard management of the structure.

Does it really matter?  I find that it does.  Wildly inconsistent midpoint differentials play havoc with an organization's attempt to manage promotions and job re-evaluations or upgrades in an equitable and - yes - consistent manner.   If a one-grade promotion means a 3% increase in job value in some cases, and a 22% increase in job value in other cases, it is difficult to conceive and manage salary treatment guidelines that address each case in a fair manner.  The same holds true for job re-evaluations or upgrades.  It might be easier to defend a job upgrade in a situation where we are only talking about a 3% difference than in a situation where a grade change entails a 22% leap, making it difficult to handle these decisions in an equitable way.

If things are relatively static in your organization, that is to say that there is not a lot of job change or a lot of promotional movement, then inconsistent midpoint differentials may not present you with too many headaches.  If, however, your organization is a more dynamic one, where this sort of movement is a given, a structure with inconsistent midpoint differentials will make the job of equitable salary management more difficult than it needs to be.   

Incentive Plan Design Rule #1: Stop, Think and Start Asking Good Questions

I recently met with the management of a local company to discuss their interest in designing and implementing an incentive plan for a particular group of jobs and employees where a significant shift in attitude and behavior was deemed necessary.

And in the next breath, they described for me some of the key characteristics of this particular set of people - including the fact that they tended not to be motivated by money.

I share this brief scenario because it sets the stage for what I believe is the first rule of incentive plan design, one that I will call "Stop, Think and Start Asking Good Questions."  Many of you who read this blog - I'd be willing to bet - have been approached on more than one occasion with an urgent request for immediate implementation of an incentive plan to address some performance issue.  My best advice to you:  Put the breaks on and take a moment (or perhaps a few weeks) to figure out exactly what is going on.

Incentive plans, while a powerful tool for the positive, also have to potential to inflict damage when carelessly or short-sightedly thrown at ill-defined problems.  So, your first task when asked to design an incentive plan is to start asking questions.  Here are a few of my favorites to get you started:

What, specifically, do you want to achieve by putting in an incentive plan?

What specific improvements - behaviors and outcomes - would this plan be designed to drive?

What is preventing these improvements from happening now?

What kinds of challenges and obstacles might people face in trying to make these improvements - in trying to exhibit these behaviors and/or produce these outcomes? 

How will people respond to these challenges and obstacles - what will they likely do?

You get the idea.

My advice:  Don't proceed with any incentive plan design until you get the answers to these and other good questions you come up with.  Only then will you have a true sense of the context into which this proposed incentive plan will be dropped, and whether it is likely to solve or exacerbate the performance issue.

Performance, as Deming told us, is a systems thing.  It is complex and multi-faceted.  Rewards, including incentive plans, cannot drive the performance improvement bus alone.  They succeed best as a part of an overall performance improvement effort.  Unless you identify and remove the barriers to performance, and create the setting in which performance improvement is possible and even likely, throwing incentive money at the problem will likely have little positive impact and may produce some very real negative consequences.

Stop.  Think.  Start asking some good questions.

The Carnival of HR (#14) is Up!

Check out the great array of posts featured in the 14th Carnival of HR, hosted by Wally Bock at the Three Star Leadership blog!

Hewitt Study Shows Variable Pay Programs Reaching Record High

According to new research released by Hewitt Associates, which examines the reward practices of 1,007 large U.S. employers, the past year has seen a sharp increase in employer adoption of variable pay programs.  More than 90% of the organizations surveyed offer at least one type of broad-based variable pay plan, up from 80% in 2006 and just 51% in 1991.

In another interesting finding, the Hewitt study also reports that actual company spending on variable pay as a percent of payroll was 11.8% in 2007, up from 8.8% in 2003.

Merit Pay Differentiation Trends

As part of its 2007/08 U.S. Compensation Planning Survey, Mercer HR Consulting reports information on differentials in performance-based salary increases for 2007.  According to Mercer's survey, the highest performing employees are expected to receive base pay increases of 5.7% in 2007, compared to 3.5% for average performers and 1.7% for the weakest performers.

More details on merit pay differentiation from the survey are presented below:

Average pay increase percent by rating group

• Highest-rated employees (12% of workforce):  5.7%
• Next highest-rated employees (28% of workforce):  4.5%
• Middle-rated employees (52% of workforce):  3.5%
• Low-rated employees (6% of workforce):  2.0%
• Lowest-rated employees (3% of workforce):  1.7%

Salary Increases to Remain Flat in 2008, Mercer Says

Mercer HR Consulting has released its 2007/08 U.S. Compensation Planning Survey, which features the responses of more than 1,000 employers, projects average pay increases of 3.8% in 2008, the same as the 2007 average.

A summary of 2007/08 salary increase data from the survey:

• Executives
  • Average budgeted 2007 - 4.1%
  • Average projected 2008 - 3.9%
• Management
  • Average budgeted 2007 - 3.8%
  • Average projected 2008 - 3.8%
• Professional
  • Average budgeted 2007 - 3.8%
  • Average projected 2008 - 3.7%
• Office/Clerical/Technician
  • Average budgeted 2007 - 3.7%
  • Average projected 2008 - 3.7%
• Trades/Production/Service
  • Average budgeted 2007 - 3.6%
  • Average projected 2008 - 3.6%