13 Jun DESCRIBE HOW TO ESTABLISH A SYSTEM THAT PAYS ONLY FOR MERIT.
Read the attached article, write an essay answering “Is pay for performance a thing of the past or of the future?’
BASED ON THE GIVEN ARTICLE BELOW.
Learning Outcomes
After reading this issue, you should be able to:
• Define merit pay as it applies to organizations.
• Gain an understanding of the challenges of adopting merit- pay systems.
• Describe how to establish a system that pays only for merit.
• Identify alternatives of merit-pay systems that HRM profes- sionals may provide.
• Understand international perspectives on the subject.
ISSUE SUMMARY
YES: Fay Hansen, contributing editor for Workforce Management, provides studies of leading professors from Stanford and MIT which suggest that merit pay has lost its meaning because employees are not being actually rewarded for performance. They assert that this compensation system is not distinguishing between success and failure and hence has lost its meaning in the workplace.
NO: S. J. Wells, a writer for HR Magazine, contends that organiza- tions should become rigorous in establishing a pay-for-performance culture. She provides examples of organizations that have estab- lished such practices successfully.
Merit pay can be defined as providing increases in an employee’s pay based on his or her job performance. A 2009 study suggests that U.S. human resource lead- ers will decide how to distribute their organizations’ $200 billion in merit increases for their employees. While the amount seems huge, the most contentious piece
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of the merit pay is that employees are rewarded merit increases regardless of their job performances. On an average, organizations usually provide employees merit increases of approximately 3.6–3.8 percent on their base salaries. Should employees receive merit increases in pay when their performance is mediocre?
Professor Pfeffer of Stanford University suggests that organizations have debated how to reward employees effectively for their performances. Many organizations, such as Hewlett-Packard and Verizon, struggle to identify the best methods to compensate and reward high performers. Organizations vacillate on whether they should provide high bonuses or merit increases for their employees. The main question that remains to be answered is which form of compensation will lead to higher organizational productivity? However, some organizations sug- gest that when they adopted pay initiatives that identified and rewarded their star performers (such as employee of the month or star of the quarter), it has resulted in dysfunctional practices. Employees have observed a reduced collaborative spirit and a sense of negativity among employees when such reward systems are intro- duced. Hence, organizations continue to use the traditional merit-pay systems that award a minimum percentage raises regardless of the performance levels. Therefore, employees receive different performance ratings of superior, average, or low yet they obtain the same merit increases. This pay practice may contribute and promote a work culture of mediocrity and consequently to reduced firm performances. Therefore, what is the meaning or value of a merit increase?
Emilio Castilla, assistant professor of MIT, in a study of technically skilled employees, identifies that the main problem of the merit-pay system is establishing a consistent procedure between performance evaluations and merit increases. Organizations should make it very clear to employees that their annual performances will be their defining criteria for their merit-pay increases. Therefore, organizations should adopt rigorous performance ratings that can justify such annual raises. This should be a transparent system so as not to create any complications that are associated with pay and rewards. Further, he adds that the profits of any business experiences should also be included as a component of the merit increases. For instance, if a business unit makes significant profits, employees in that unit should therefore get higher merit increases. A significant negative HR outcome of the traditional merit-pay method is that superior performers feel demoralized as all employees receive the same pay increases. Hence, such star performers leave organizations in hope for better remuneration systems for their work. Why should organizations lose their star performers because of a traditional pay system that does not distinguish the good, the better, and the best well?
Wells, a journalist for the HR Magazine, suggests that organizations should proactively establish a rigorous compensation system based on employee per- formance. He refers to this concept as “tough love,” implying a zero tolerance policy for rewarding low performers. Organizations should establish a reward system clearly, communicate the goals frequently, and evaluate employees’ performance regularly. Most often organizations have these practices in place but do not enforce them strictly in their organizations. Experts are confident that if the top management reiterates the theme that poor performers will not get the merit increase, a pay-for-performance culture can be instilled.
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The NO article also shares how a technology-based company has imple- mented such a “tough-love” policy and has seen positive organizational out- comes. The management has ensured that employees get the clear message that their base salary increases are completely dependent on their annual per- formances. The company has also tied the cost-of-living raises to be based on employees’ performances. The firm noticed reduced turnover and also exiting of employees who did not like the new performance culture. Another financial organization rewarded its star performers 20 percent increases and did not award any raises to its poor performers. The company noticed a doubling of its stock prices as firm performance increased substantially.
Managers should also know how to provide effective performance reviews to employees. Usually mangers do not provide realistic performance reviews in fear that they might lose their employees. Therefore, it might be imperative that organizations provide additional training so that managers actually pro- vide authentic feedback. Management should also make managers understand what a critical role performance management plays in deciding the quality of their products and services.
An alternative perspective to this issue might be to provide employ- ees another opportunity for appraising their performances. This might give employees a second chance to turn around their inferior performance levels. Experts suggest that employees who have not performed to receive the annual merit increase should be provided additional time so that they may meet job expectations. This might also make employees perceive organizations to be developmental in their approach rather than punitive. Also, it may suggest that employees are at different learning levels and some employees take a longer time to learn some skills and vice versa.
Scholars suggest alternatives to the merit-pay system could be provid- ing lump-sum bonuses. Employees who perform at superior levels should be recognized and rewarded in special ways. These bonus rewards should be pro- vided when employees achieve specific organizational goals. This could allevi- ate the main problem associated with the annual merit-pay system as superior performers do not feel distinguished from the average or the low performers. Every employee receives the same percent raise regardless of his or her per- formance. This is a fatal flaw in the merit-pay and performance system of the U.S. corporate world. Several companies are replacing merit-pay systems with pay-for-performance plans to ensure their tops performers are justly rewarded.
An international perspective suggests that merit-pay practices are fol- lowed by organizations in other countries also. In the United Kingdom, merit pay is referred to as PRP (performance-related pay). It follows a model similar to that of the U.S. corporate culture of providing annual increases of around 3 percent. In Japan, merit pay was introduced in the early 1990s to diminish the practices of seniority pay. It has been received with mixed reactions as the traditional Japanese school of thought perceives it might disturb the concept of group harmony, which is very important to their collective culture. In 2009, China announced that it would implement merit pay in its public sector serv- ices such as teaching and health care to increase productivity in these sectors.
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YES
Fay Hansen
Abstract (Summary)
Merit-Pay Payoff?
Human resources executives help manage the $4.5 trillion that US corpora- tions are spending on wages and salaries in 2008 and determine how to dis- tribute the $200 billion increase in wage and salary spending for 2009. Most of this increase will take the form of merit pay, the nearly universal method for distributing wage and salary raises across the US and, increasingly, around the world. The seemingly self-evident premise underlying merit pay and other individual performance-based pay plans is that they produce higher employee and organizational performance. Most companies, however, do not test the actual impact of performance-based rewards on employee behaviors and financial results. Survey reports show years of flat merit increase budgets that barely meet inflation rates and bear no relationship to productivity growth or profitability trends. Emilio Castilla, assistant professor at MIT’s Sloan School of Management and a visiting professor at New York University, advises HR executives to pursue collaboration with academic researchers.
It doesn’t exist, several recognized experts say. The issue for companies is not whether they should be paying more for performance compensation pro- grams, but whether they should be paying less.
When Verizon Business announced the completion of the first next- generation trans-Pacific undersea optical cable system in September, senior vice president for human resources Robert Toohey was buried in budget deci- sions. “A big struggle is deciding whether you invest more in merit pay or short-term incentives,” he says. “Am I going to get more out of higher bonuses or a 2 percent increase in fixed pay through merit increases? Which will drive employees to perform better?”
Verizon Business, based in Basking Ridge, New Jersey, is one of the three operating units of Verizon Communications. The unit generated $21.2 billion in revenue in 2007 and employs 32,000 workers worldwide. Pay decisions carry huge consequences. “You can’t walk into finance and tell them you want to spend another $50 million on merit pay without a business case,” Toohey says.
Human resources executives help manage the $4.5 trillion that U.S. cor- porations are spending on wages and salaries in 2008 and determine how to distribute the $200 billion increase in wage and salary spending for 2009. Most
From Workforce Management, November 3, 2008, pp. 33–37. Copyright © 2008 by Workforce Management. Reprinted by permission.
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206 ISSUE 13 / Has Merit Pay Lost Its Meaning in the Workplace?
of this increase will take the form of merit pay, the nearly universal method for distributing wage and salary raises across the U.S. and, increasingly, around the world.
A large part of the remainder will go to a complex array of incentive plans. Spending on variable pay plans for salaried exempt employees as a per- centage of payroll will reach 10.6 percent in 2009, with 90 percent of all orga- nizations using at least one variable plan, Hewitt Associates says.
The seemingly self-evident premise underlying merit pay and other indi- vidual performance-based pay plans is that they produce higher employee and organizational performance. Most companies, however, do not test the actual impact of performance-based rewards on employee behaviors and financial results. The most comprehensive empirical studies flow from the academic world, where evidence is mounting that the assumptions underlying individ- ual performance-based pay programs are wrong.
With the drive for evidence-based management now moving across all corporate functions, the sheer force of intuitive practices and the shortage of obvious alternatives no longer suffice as justifications for rewards programs that tear into corporate resources. The real question posed by the best research is not whether companies should be spending more for individual perfor- mance pay programs, but whether they should be spending less.
Meritless Pay
One of the most forceful advocates for evidence-based management is Jeffrey Pfeffer, the Thomas D. Dee II professor of organizational behavior at Stanford University’s Graduate School of Business. Drawing from his own work and citing three decades of empirical studies, Pfeffer testified before a 2007 con- gressional hearing on federal personnel reform that the idea that individual pay for performance will enhance organizational performance rests on a set of assumptions that do not hold in the vast majority of organizations.
Pfeffer, with the full support of other recognized experts, continues to sharpen the challenge that now sits squarely before human resources execu- tives and compensation directors.
“The evidence is overwhelming that individual pay for performance does not improve organizational performance except in very limited cases,” he says. “Why do people, when confronted with the facts, turn their backs on them?”
Given the lack of evidence that merit pay boosts employee performance and organizational results, should companies abandon it?
“We’ve already abandoned merit pay,” Pfeffer says. “Merit pay is not based on merit. Performance evaluations are biased; overwhelming studies show this. Even if merit pay was based on merit, the pay increases are not enough to motivate employees, but they are enough to irritate them.”
Survey reports show years of flat merit increase budgets that barely meet inflation rates and bear no relationship to productivity growth or profitability trends. The major salary budget surveys point to 2009 merit increases averag- ing 3.6 to 3.8 percent, with the highest performers receiving 5.6 to 6 percent. In effect, for the vast majority of employees, merit increases are unevenly
distributed cost-of-living and market-adjustment increases couched in the language of performance rewards.
Even when companies create seemingly significant pay differentiation between low and high performers, the actual cash increase is insufficient to sustain performance—or it drives the wrong behaviors, Pfeffer says. And, as many studies show, high levels of differentiation destroy engagement, breed distrust and undermine teamwork.
A series of experiments conducted by Hewlett-Packard in the 1990s veri- fied longstanding academic studies demonstrating that high incentives for top performers adversely affect organizational performance. Despite the del- uge of consultants calling for companies to boost pay differentiation, Pfeffer cites dozens of studies showing that more dispersed pay distributions generate higher turnover, lower quality and a vast array of unintended results, includ- ing serious ethical breaches and business-killing behaviors.
“Individual performance pay plans cost a lot of money and upset every- one,” Pfeffer says. Perhaps more important, when companies overestimate the power of financial rewards to affect behaviors, they neglect critical skills devel- opment and strong leadership, which Pfeffer and other experts agree play a more central role in raising organizational performance.
“Effective management is a system, not a pay plan,” Pfeffer notes. “The mistake is that companies try to solve all their problems with pay.”
At Verizon Business, Toohey takes a more holistic view. “I take it beyond pay,” he says. “When an employee leaves, does he leave for more money? Man- agers will say that the employee had a better offer. But why did the employee pick up the phone and call the headhunter in the first place? Was the employee trained and developed? Was there proper management? Are you spending the appropriate amounts on training and do employees know how much you are spending? You must have the right data to determine any of this.”
Building the Evidence
At the heart of the performance pay problem sits the assumption that correla- tion implies causation. That assumption continues to pervade decision mak- ing in human resources and pay plan design.
“There is the inferential issue,” Pfeffer says. “The CEO drank Wild Turkey; the company performed well; ergo, all CEOs should drink more Wild Turkey. The company uses individual incentives; the company performs well; ergo all companies should use more incentives.”
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