Pay for Performance

What is Pay for Performance?

The term “pay for performance” refers to a pay strategy where
evaluations of individual and/or organizational performance have
significant influence on the amount of pay increases or bonuses given to
each employee.
When a pay for performance system functions properly:
• Outstanding performers will receive the greatest rewards, to
acknowledge their superior contributions and to motivate them to
continue high performance.
• Average performers will receive substantially smaller raises, which may
encourage them to work harder to achieve larger raises in the future.
• Poor performers will receive no increase, which is intended to persuade
them to improve their performance or leave.
 Assessing Organizational Readiness for Pay for Performance

Dimension Indicator
Organizational • Open, two-way communication is valued and pursued.
Culture • Trust exists between employees and supervisors/managers.
• Human resources management (HRM) systems such as selection, training, and performance
evaluation have clear and consistent objectives and support pay for performance.
Supervisors • Employee efforts support organizational goals.
• Work assignment, evaluation of performance, and distribution of awards are fair.
• Discretion and accountability go hand-in-hand.
Performance • Assessment of employees is fair and accurate.
Evaluation • Employees receive timely, accurate, and meaningful feedback.
Funding • Appropriate pay increases and bonuses are given.
• Top leadership is willing to make difficult choices when allocating funds and awards.
Fairness • Checks and balances are in place.
• Transparency is valued and ensured.
Training • Training is provided to both supervisors and employees.
• Training covers both pay system philosophy and mechanics.
System Evaluation • The organization evaluates how the pay for performance system is being administered and whether
the pay for performance system is accomplishing its goals.
• Employee attitudes are tracked.
Methods of Pay for Performance
The two most common are:
• Bonuses, which are one-time cash payments, and
• Performance-based pay, which provides a permanent increase
to base pay
Methods of Pay for Performance
Bonuses
• This represent an amount of pay that is “at risk” every year.
• In contrast to base pay, which is stable and primarily reflects an employee’s
market value, bonuses depend purely on performance and are not guaranteed.
• Employees in these types of systems frequently receive a base pay that is
considered comparable to average market rate to facilitate recruitment and
retention of a high quality workforce, but additional amount is distributed (often
annually) on the basis of performance during the rating period.
• Employees are guaranteed a certain salary, with the potential for earning more.
• The amount generally depends on a variety of factors, such as the available
funding and the evaluation of the individual’s contributions, but the
organization retains discretion over how much to spend each year
Methods of Pay for Performance
Bonuses
• This serve to raise an employee’s salary above average market rate but
only on an annual basis.
• i.e. each year an employee must earn an amount above the base rate of
pay.
• Since each year’s bonus is independent of the bonus earned in prior years,
total salary can fluctuate dramatically from year to year. When the
employee excels, he may receive a sizable bonus, but if the employee’s
performance is “average” or lower, he may not receive a bonus and his
salary drops to the base rate
Methods of Pay for Performance
Impact of Bonuses on Total Salary
Methods of Pay for Performance
Bonuses (Advantages)
• Employee performance may vary from year to year so an employee may
deserve a bonus one year, but not the next. Since the increase resulting
from bonuses does not carry over to subsequent years, agencies can
distribute a larger pool of bonus money each year rather than continue to
fund performance-based pay increases from prior years.
• Organizations may use bonuses throughout the rating period to facilitate
timeliness, thereby strengthening the connection in employees’ minds
between efforts and outcomes.
• If organizations direct funding for increases into a bonus pool, they may
provide sizable bonuses to top performers.
Methods of Pay for Performance
Bonuses (Disadvantages)
• Putting a large amount of pay “at risk” to be earned each year makes the
employee’s salary less predictable.
• If base pay levels are not fully competitive, reliance on bonuses as a
reward may increase turnover.
Methods of Pay for Performance
Performance Based Pay
• Performance based pay increases are incorporated into the employee’s
base pay and are usually only adjusted upward.
• Organizations differ in how they move employees through the
performance-based pay scales. Some pay systems include pre-determined
levels, which employees step through in an orderly manner, while others
allow the supervisors to determine salary amounts anywhere within a
broad range.
Methods of Pay for Performance
Impact of Performance Based Pay on Total Salary
Methods of Pay for Performance
Performance Based Pay (Advantages)
• Employees may perceive the continual increases (or at least a plateauing
of salary) to be more desirable than the potential for ups and downs with
individual bonuses.
• Employees may also view increases to base pay as more attractive than
bonuses because salary increases enhance the dollar value of several
benefits, such as retirement earnings, thrift savings plan, and life
insurance. Although employees often realize that much of the value of a
base pay increase is “hidden,” agencies may enhance the motivational
impact of the base pay increase by making sure employees are aware of
the total value of a salary increase.
Methods of Pay for Performance
Performance Based Pay (Disadvantages)
• Limit an organization’s flexibility to adjust pay to reflect an employee’s current level
of performance. An individual may demonstrate outstanding performance in one
year and base pay is increased accordingly. However, in the following years, the
employee may decrease performance while continuing to receive an enhanced salary
based on previous outstanding performance, resulting in overpayment. Very few pay
for performance systems incorporate a mechanism for decreasing pay based on not
performing at the same level in the years following the increase.
• Generate long-term costs. Not only do performance-based increases add to salary
and benefits costs for the current year, but they also impact budgets in future years.
• Eliminate or at least greatly reduce the incentive of offering future pay increases
based on performance for those who top out in a pay band.
• May be too small to be meaningful. Funding limits or formulas may result in small
base pay increases for many employees.
Methods of Pay for Performance
Combination Strategies
Combining bonuses and base pay increases enables organizations to realize the benefits of
both while limiting the downsides. For example, agencies may use bonuses to recognize
exceptional achievements, while pay increases may be reserved for longer term
accomplishments.
For example, an organization sets a a control point at $45,000. The employee is paid at the
average entry level pay rate of $30,000 in the first year. During the second year, he receives a
performance-based pay increase to $40,000. He does not receive an increase in the third
year. In his fourth year, his performance warrants a $50,000 salary, which would exceed the
$45,000 control point. Therefore, he receives a $5,000 increase in base pay and the additional
amount is paid as a bonus of $5,000. In the fifth year, the control point holds his salary at
$45,000 and he receives a $15,000 bonus.
Control points ensure that employees do not receive pay above a certain level unless they
sustain high performance levels. Employees at the control point may see this as a downside,
since they cannot accurately predict what their salary will be each year, but at least they can
be confident that their pay will not slip below the control point once they reach it.
Methods of Pay for Performance
Impact of Combination Strategies on Total Salary
Popular Pay for Performance Schemes
1. Merit pay – Raise salary at the end of each year if performance is strong.
Some researchers believe merit pay has little impact on performance
2. Lump-sum bonuses – A one time bonus (not part of base salary) for good
performance. E.g. end of the year bonus. Much less expensive than merit
pay because it is not permanently built into the base pay. Thus, it is more
efficient than merit pay.
3. Piece rate – Pay varies with the number of units produced. Advantage is
that it is simple to understand.
4. Tournaments – a worker or supplier is awarded a bonus or promotion
only if he outperforms another worker or supplier. Only relative
performance matters.
Designing Effective Incentive Systems:
Basic Principles
1.What objectives does the manager want her employee to pursue?
2.How will these objectives be measured and how much transparency is
there in the way performance is measured?
3.How much control does the employee have over outcome and how risk
averse is the employee?
4.Will employees work in teams or will they be assessed individually?
5.What is the duration of the relationship?