Quickie Primer on Lump Sum Merit Increases for "Over Max" Employees

A recent client question reminded me that not every HR professional is familiar with the use of lump sum merit increases as an approach for rewarding employees who have "topped out" by reaching (or passing) their salary range maximums.  With this in mind, here is a quick post on the basics.

(I suspect that a number of readers may already be well versed in this topic.  For those who are, please feel free to weigh in with your thoughts, experiences and any tips.)

Ahem.  To start with, let's define what we are talking about when we use the term lump sum merit increase. 

A lump sum merit increase is not really an increase at all, but rather something provided in lieu of a salary increase.  Rather than being added to the fixed base salary, the lump sum is delivered in the form of a single cash payment, separate from base salary.  For this reason, it is also (and probably more accurately) referred to as a lump sum bonus.

While there are other applications, the most common use for the lump sum merit increase - to the best of my knowledge - is as a substitute for a salary increase for those employees whose salaries have already reached - or surpassed - the maximum of their assigned salary range. The rationale is typically and simply this:  the employer wishes to recognize and reward employees who are performing well in their job, but whose salaries have reached a point where no further increases are allowed.  So the employer does so with a lump sum award, which does not exacerbate the "at or above max" problem by increasing the fixed base wage, but does provide the employee with a cash reward for their performance.

In most of the situations that I have encountered, the amount of the lump sum merit award is identical (as a % of base salary) to what the employee would have earned via the guidelines if they were still within the confines of their salary range.  In other words, if the merit increase guidelines suggest a 3% increase, the employee receives a lump sum award equal to 3% of their current salary.  I have seen a couple of situations where the lump sum award is reduced from that level suggested by increase guidelines (i.e. 50% of the amount suggested by guidelines).

(Note also that, in the interest of compliance with the Fair Labor Standards Act (FLSA), in situations where a non-exempt employee is involved, the organization must include this lump sum payment when determining the employee's regular rate of pay for the purposes of calculating overtime.)

That's my take.  Other perspectives and experiences?

Comments

[Julien Dionne]

Hi Ann,

If you tell me about a "lump sum merit increase", I will think it is in lieu of a salary increase as you said, even if it is not technically an increase.

However if you tell me about a "lump sum bonus", my mind drifts more towards a year-end bonus or some ad-hoc bonus, which have nothing to do with compensating "over max" employees, and which are much more frequent.

I guess the only solution to avoid any confusion is to call this kind of increase a "lump sum bonus for over max employees".

Julien

[Ann Bares]

Julien:

Thanks for checking in and leaving the comment. You make a good point - the terminology is confusing. And I have to admit that I am a bit conflicted about the best term to use (which probably came out in the post). To call it a "lump sum merit increase", as I did in the title, is helpful in that it points directly at the particular application of this type of award, but it is inaccurate in that we are really not talking about a salary increase at all. To call it a "lump sum bonus" is not really right either because, as you point out, nearly all types of cash bonus/incentives are delivered in a lump sum, and so we haven't clearly distinguished this particular approach. Perhaps your solution is the best, although is sure doesn't roll off the tongue very easily, does it? :)

Nominations for better terminology, anyone?

[Amy]

At our hospital, we call it a "lump sum wage adjustment." However, we changed our practice from what used to be a one-time payment since we noticed that a number of people were waiting until they received it to quit. We now fondly refer to them as "lumpettes," as we spread them over 26 pay periods.

The difficulty we encountered this year, was that we raised the pay ranges 3% at the same time awarding a 3% wage adjustment. The folks accustomed to their "lumpette" felt they weren't getting an increase since the total annual cash was the same. No matter how we explained it (benefit calcs are higher, bigger base for future, etc.), the move was perceived negatively.

Any advice as to how we can move the range and handle the lump sum issue in a more elegant manner? Or will we always face angst in this situation?

[Michael Haberman, SPHR]

Ann, what are the tax considerations when the "increase" is paid out as one payment. Is it taxed at a hire rate as are things like commissions?

[Ann Bares]

Amy:

Thanks for the comment. I love the term "lumpette" - I will have to add it to my comp vocabulary. I haven't yet encountered an employer who spreads it across all pay periods as you do, but there are certainly good reasons for doing so, as you point out.

I'm having a hard time following and understanding the difficulty you describe, so forgive me if I have to ask for some clarification. Did everyone receive the 3% adjustment (was it "across-the-board")? And why would the total cash of the "lumpette" crowd remain the same? Aren't they either getting a 3% salary adjustment or 3% worth of lumpettes? Help me better understand their negativity - I am missing something (and it is probably my head - not firing all synapses today...)

Anyone else getting what I am missing with Amy's scenario? What advice would you offer?

[Amy]

Sorry, it is rather obscure the way I described it. Here is how the math works. (BTW this scenario only plays out for employees who are at the top of the pay range.) In 2007, Sue Top O'Range was at $12 per hour and received a 3% lumpette equal to $748.80, making her annual gross $25,708.80.

In 2008, the top of the range moved 3% to $12.36. Sue was in a class of employees receiving 3% wage adjustments, so her hourly rate moved to $12.36 (no lumpette). Her new gross is $25,708.80.

Life, LTD, pension and overtime are all impacted by the hourly rate change, but her biweekly take home doesn't move in pay periods where there is no overtime.

[Ann Bares]

Mike:

Good question. It is a pretty common misunderstanding (in my experience, at least) that a bonus award is taxed at a higher rate. This is not true. What often happens that leads employees to this impression is that, because of the size of the payment, the payroll system "senses" that income has risen and it will withold taxes at a higher rate. Ultimately, though, this is reconciled at the end of the year when you file your tax statement - your income is taxed at the rate of your final income bracket, regardless of how much of your income is salary vs bonus vs commission.

[Ann Bares]

Amy-

More questions (sorry). Why did employees (and Sue Top'O) receive the 3% wage adjustment? Because they were up for salary/merit review, and their range(s) had moved 3% and they were now able to get the salary increase for which they were eligible? Or because all employees got an automatic 3% bump? Or other?

[Michael Moore]

For those interested in the legal compliance component of bonuses for nonexempt employees, there is a clear answer under the FLSA. Bonuses paid to nonexempt employees are included in the determination of the employees’ regular rate under section 778.208 unless the bonus falls into one of several exceptions. The bonuses are allocated to the pay period and added to other wages paid to nonexempt employees and then divided by the hours worked for the same period to determine the new regular rate under the methodology described in section 778.209. For bonuses earned over more than one work week, the bonus must be allocated to pay periods to which the bonus applies and the regular rate recalculated. If overtime was worked during this period, the overtime rate must be revised to be time and a half the recalculated regular rate that includes the bonus payment. This is a nightmare. There is an exemption. Bonuses based on a percentage of the nonexempt employee’s total earnings under section 778.210 do not result in a recalculation of the regular rate because overtime is already been accounted for in the calculation. Under this method, the bonus is described as a percentage of the nonexempt employee’s total (W-2) earnings, thereby including both regular and overtime payments and obviating the need for recalculation of the regular rate.

[Amy]

Thanks, Anne - I don't mind questions! Since we do not have a merit-based salary program, all employees (not on discipline) receive an annual wage adjustment in January. Pay ranges are also reviewed and adjusted in January.

Wage adjustments are distributed based on job family (everyone in the job family gets the same %). In Sue Top'O's job family, the wage adjustment was determined to be 3%. Since Sue was no longer at the top of the range after it moved up 3%, she received the bump in her hourly rate.

If the range had moved 2% and the wage adjustment was 3%, Sue Top'O would have gotten a 1% lumpette plus a 2% increase to her hourly rate.

[Ann Bares]

Mike:

Thanks for your comment, and for sharing the information on regulatory compliance here. Readers - I thought the information that Mike was providing here was helpful enough to warrant its own post, and so you will note that both Michael and I have dedicated a Friday post to this topic. Mine is here (and mine is primarily an intro and link to Michael's): http://compforce.typepad.com/compensation_force/2008/06/know-ye-the-reg.html

[Ann Bares]

Amy:

Thanks again for your willingness to expand and help me understand the scenario. Here are my thoughts - at the end of the day, no matter how elegantly we structure and administer the lumps or lumpettes, the (somewhat harsh) fact remains that the employee (Sue) has reached the top of her pay range and so her annual gross from this time forward will move slowly if at all. When I have these discussions with employees, I remind them that being at the top of the range (typically) means that they are being paid at a premium (typically 10% to 20%) above the going rate for their skills and responsibility, and that the employer is happy to do that in recognition of their performance and contribution. It is a real but sometimes-hard-to-swallow fact that different jobs command different pay rates in the market for talent - and that every job faces a pay limit related to its value in the market. Want to earn more? Then learn new skills, increase your capabilities, get a degree - preferably in a higher demand talent area.

Do employees stand up and applaud me when I give this speech? You can probably guess that they do not. But I think that it is important for them to understand how the market for pay works, and their role and responsibility in maximizing their income.

That's just my take. Can others add more - or a different perspective? Amy, what do you think?

[Amy]

Ann - how exquisitely cathartic to hear you validate the points I repeated over and over to these top of range workers. Thank you, because I had myself convinced it was me.

Looking at the situation from 10,000 feet, several things were stacked against us this year:
1) we are blessed with unusual longevity so a large number of folks are at the top of their ranges.
2) over the past 3 years, the previous director had an uncanny ability to set the range and wage adjustment movement so that it was slightly higher than the previous year and there was always something left over for the lumpettes (2% then 2.5%, then 3% -> you can predict what has to happen at some point!).
3) the economy has made it painfully obvious for anyone earning less than $15/hour (in our market anyway) that zero net cash improvement will mean a backwards slide in discretionary income. Yep, that hurts.

All of this adds up to some pretty vocal employees and a great opportunity for me to work on my patience and communication skills.

Thanks again for your feedback. Love the blog.

[Remy]

I am about to payout lump sum merit increases this June 2008. I know that 2 employees will not want to renew their contracts when these end on August 31. Should I give the full lump sum merit increase or pro-rate it until the end of their contracts and then give the balance when they renew for another year-contract? Thanks.

[Remy]

I am about to payout lump sum merit increases this June 2008. I know that 2 employees will not want to renew their contracts when these end on August 31. Should I give the full lump sum merit increase or pro-rate it until the end of their contracts and then give the balance when they renew for another year-contract? Thanks.

[Ann Bares]

Remy:

Apologies for the delay in responding to your comment - as you may know if you are a regular reader, I have been on vacation for a couple of weeks and am in catch-up mode now.

For starters, I may be misunderstanding your comment, but you speak of employee contracts, which makes me think that these are independent contractors - not employees - that you are describing. If so, a lump sum merit increase is probably not an appropriate vehicle or method for their compensation, particularly if it is driving the retention concern that you mention.

I would need more information and a clearer picture of the situation before I could even begin to formulate any advice. If you want, feel free to email me to discuss further.