Performance Pay: New Trend Has Its Rewards
Three years ago, Bank of America employees who sold payroll services earned a salary just like everyone else at the San Francisco-based bank. Today, they earn no salary--only commissions.
This year, for the first time, the 8,000 managers at Pacific Gas & Electric will be able to earn cash bonuses. But they will be evaluated on individual performance--and on corporate measures such as return on equity, customer satisfaction and cost control.
Welcome to the world of “pay for performance”--the new buzz phrase in compensation circles. If some companies have their way, a smaller portion of an employee’s annual earnings will come from base pay and more will come from annual cash incentives that vary year to year. It’s all designed to shore up productivity, cut costs, reward deserving top performers and motivate lackluster workers.
B of A and PG&E; are among the increasing number of companies coming up with innovative pay programs. Many firms have already abandoned traditional reward systems of across-the-board annual wage or merit increases and cost-of-living adjustments.
They are beginning, instead, to peg pay increases to individual, group and company performance. These rewards are coming in the form of lump-sum payments, profit sharing and other one-time incentives in lieu of salary increases.
The rules of the compensation game today are flexible and variable pay. In short, companies are turning to their employees to bear a greater share of their fortunes--and misfortunes.
“This is quite a revolutionary change,” says Francis W. Miller, executive director of the American Compensation Assn. in Scottsdale, Ariz. “The traditional ways of paying people are no longer reliable and valid in terms of today’s competition.”
For employers, the change means greater control of people costs, which in some industries such as health care accounts for more than 60% of a company’s operating budget. “It’s a way to reward people but control fixed salary costs,” explains Charles Peck, a compensation specialist at the Conference Board in New York.
For U.S. workers, however, the changes could ultimately crimp their standard of living. Since the new pay plans put greater emphasis on one-time cash awards, base salaries are not expected to rise as fast as in the past. That, in turn, could mean fewer medical and pension benefits, since those are pegged to base pay.
The move away from traditional pay systems breaks an “entitlement mentality” of compensation--that “one expected or was entitled to a wage increase” no matter what, says Jerrold R. Bratkovich, senior vice president and general manager of Hay Management Consultants in Los Angeles.
Concern Over Repercussions
The changes, however, are occurring slowly and ever so cautiously because “compensation change is one the most traumatic changes for a corporation. There is a lot of concern over the repercussions,” Bratkovich explains. If a program is not implemented correctly, it can paralyze instead of motivate employees.
Until the 1980s, companies have used compensation systems that were developed after World War II, when American business was No. 1 worldwide. “The system was based on the assumption companies would always grow and have the ability to promote and pay more. Nobody had to worry about productivity. In fact, they didn’t know what it was,” says Carla O’Dell of the American Productivity Center in Houston.
So companies used cost-of-living indexes or followed other external measures such as cost and pay surveys to determine wage levels. The problem was that pay packages were mostly developed for ease of administration. They had virtually nothing to do with a company’s performance and did not take into account changing market factors, says Bernadette Steele, a vice president at Hay Management Consultants.
Even into the 1970s, through the oil embargo, recessions and rampant inflation, companies continued to followed the old systems. Many gave double-digit wage increases when they could not really afford them. Many deregulated industries such as banks and airlines continued to use the old pay systems while they wrestled with newly competitive markets.
“Starting in 1980, that was a watershed year for American business,” O’Dell says. “They woke up and discovered they don’t have the playing field to themselves. Suddenly it became critical not to base compensation on external measures of inflation, tax law, everything but productivity. Now there is a shift toward basing it on performance and competitiveness. The implications are dramatic.”
Adds Miller of the American Compensation System: “A lot of CEOs (chief executives) are calling their compensation people and saying, ‘We need to know how to get more bang for the buck and figure out how to do it.’ This is the type of pressure compensation people are under: Distribute the compensation dollar to maximize the dollar.”
Compensation experts say poll after poll reveals that U.S. workers do not correlate their pay with their performance. A Louis Harris survey in 1983 found that 73% of U.S. employees thought there was no relationship between how they were paid and how well they performed, while 68% believed that their productivity would go up if their pay were tied to performance.
Pay increases traditionally vary so little between top and lesser performers that they are deemed meaningless and provide no real incentives.
“Top performers resented those systems because they knew people sitting next to them got the same (raise) for just showing up for work,” says Robert Beck, executive vice president for corporate human resources at Bank of America.
In addition, when companies needed to cut costs in the past, they simply cut people. “You can’t afford Kleenex people--use them, throw them away,” O’Dell says. “This sort of disposable work force doesn’t work in a competitive environment. You need long-term people who are flexible and feel a real sense of common fate with their company.”
To develop that feeling requires motivational and psychological changes in corporate culture, according to compensation experts. This is especially true now that inflation has dropped under 2%. Wages have been rising faster than inflation, but the gains appear paltry to workers who once received increases of 10% to 12% when inflation was as high as 14%.
Raises Appear Smaller
“There is a psychology that has developed over the course of the 1970s into the 1980s. That psychology is that 5% is not a whole lot of money compared to 10%, even though in real dollar terms the smaller percentage increase actually yields a greater amount of a raise in real terms,” says Margaret Bentson, manager of direct compensation at the Santa Ana office of Hewitt Associates, a consulting firm.
Because routine annual cost-of-living and merit raises become part of an employee’s base salary in future years, they have a compounding effect.
“If you put less in the base, which is fixed, and more in the variable, as your business goes up and down, personnel expenses can go up and down,” said B of A’s Beck. “It really motivates employees through compensation. We want more outstanding performers than average performers.”
Since 1982, the bank has been using several different incentive pay programs, including commissions, bonuses and cash incentives tied to achieving annual goals. These incentives can range from as much as 50% of a year’s earnings for a non-management employee to 70% for managers.
The American Compensation Assn.’s annual salary and budget survey showed that in 1980, 27.1% of the companies surveyed gave their employees general increases, but in 1986, that percentage fell to 12.8%. Similarly, 7% of the firms gave cost-of-living increases to their non-management employees in 1980, compared to 2.1%. last year.
Separately, a recent study on non-traditional reward practices by the American Productivity Center and American Compensation Assn. showed a striking growth in the number of firms adopting non-traditional reward systems during the last five years. For example, 73% of existing gain-sharing programs--in which bonuses are earned and shared by all employees of a unit--have been implemented since 1980.
The survey also showed that “more gain sharing . . . small group incentives, lump-sum bonuses and two-tier plans have been adopted in the last five years than in all of the prior 20 years.”
Measurable Results
PG&E;’s new Team Award Program provides cash incentives based on measurable results both on a corporate and work-group basis. The corporate award--of up to 3% of annual pay--is based on the company’s return on equity, customer satisfaction and cost control, and it is measured quarterly and paid annually. The work-group award is based on individual goals established for a division or department and could add up to another 1.5% of base pay.
This year, the utility company also plans to award its traditional merit increases, but it eventually plans to wrap that into the Team Award Program, according to Barbara A. Coull, manager of compensation and benefits at PG&E.;
Typically, the new plans are expected to be “self-funded.” The amount of money available for bonuses depends on whether employees--and the company--meet or exceed established performance goals.
Companies using the new plans seem to be pleased with their results so far, but they acknowledge that they need time to measure long-term gains in productivity, profits and employee morale. And they admit that the programs need constant fine-tuning.
Innovation in compensation will not make up the difference between paying a Korean $1.45 an hour in a manufacturing job, compared to the average $12.62 a hour that an American earns for a similar job, according to O’Dell at the American Productivity Center. “What matters is not how much you pay, but what goes out of the door for what you pay. A very productive company can afford to pay more.”
“Compensation is one of the strongest management systems in a corporation,” says Bratkovich at Hay Management. “If you change the compensation, you will change the organization.” But he cautions that plans can backfire.
Suppose, for example, that an employee buys supplies at a big discount, which helps to increase profits but does nothing to increase productivity. Should that be shared with the employees? Compensation experts say it depends on whether the employees are also willing to accept lower pay when the price of supplies go up.
Requires More Skill
And sometimes firms underestimate their employees. “We made some mistakes,” says Beck at B of A. “We underestimated some plans and started paying out more than we planned. But this is a commitment to your people. It takes a greater level of management skill than a pure salary environment.”
Competition is healthy, but it can run counter to the goals of a company, Beck cautions. “One of the things you have to watch out for is one-on-one competition that destroys morale. You have to make sure the individual sets his own goals and achievements.” Otherwise, competition among employees can lead to “back biting” and a breakdown in cooperation.
Pressure to achieve performance goals can also lead to unethical behavior. Last year, for example, the state Public Utilities Commission found that some Pacific Bell salespeople, under pressure to reach sales quotas, had broken state regulations by charging residential customers for “custom” telephone services that they hadn’t ordered and by misleading poor families about low-priced phone services that were available to them. When Pacific Bell officials learned of the abuses, they discontinued the sales quota program and began retraining the sales staff.
The trend toward stricter pay-for-performance measures is not expected to eliminate conventional increases in base pay. Many companies that offer general increases will maintain or wrap them into new incentive pay programs. And consultants say companies will periodically need to adjust base wage rates to stay competitive with the local job market.
In fact, flexible compensation has been practiced for years by a few companies. For example, Safeco Corp., a Seattle insurance company, has a flexible pay system that goes back to the 1940s. Supervisors and managers review all salaries once a month for all employees, and recommendations for merit increases can be taken into account during any month.
“We do that because employees are hired at different times of the year,” explains Karl Papenfus, vice president of personnel. “It breaks up the pattern of an annual review for everyone.”
Profit-Sharing Bonus
Safeco’s plan works in conjunction with a lump-sum cash bonus from profit sharing. If the company makes its goal for underwriting profits, employees share in the profits. “One without the other, you’d probably lose something. Individual salaries with individual performances is one aspect. The other aspect happens when all of that individual effort is combined, and the team result is how the company does,” Papenfus says.
“So many companies have fallen into the trap of simplifying this process and saying ‘Oh, this is so difficult and complex, do it once a year and get it over with.’ ” Papenfus notes that Safeco’s process is “more equitable for the employee, who is assured that the supervisor is looking at his performance every month rather than once a year.”
