A Quick Breakdown of Strategic Pay

While there are no set rules or procedures to follow to ensure the effectiveness of a company’s total compensation system, there are certain fundamentals all worthwhile pay strategies have in common.

An effective total compensation system is comprised of a combination of fundamental elements—including both cash and non-cash rewards—designed to support the company’s compensation philosophy, motivate and reward performance aligned with critical business objectives, and provide a positive rate of return on the significant dollars invested in compensation.

First, a company must establish its compensation philosophy. This philosophy identifies desired market position by articulating where the company wants to position pay levels with respect to competitive market practice, e.g., median market levels, 75th percentile pay levels, etc.

In addition, the compensation philosophy sends a message to employees about the organization’s commitment to motivating, recognizing and rewarding employee contribution and performance.

Once the compensation philosophy is established, an organization must decide what elements of a total pay program are most appropriate given the business objectives, operating environment and culture of the company. In this process they should consider the following:

Base-Pay Management
The foundation for any effective compensation system is a competitive base-pay program. Base pay is the fixed rate of compensation an employee receives for performing the standard duties and tasks of a job.

Base-pay programs should be designed to reflect competitive market practices within the company’s identified competitor group. Several steps are required to develop an effective base-pay program:

First, the appropriate competitive market must be identified. Companies must consider various scope factors including their industry, geographic location, total employment, and annual revenue when identifying their competitive market. In addition, it’s important to consider not only business competitors, but people competitors as well—those organizations you get talent from or lose talent to, regardless of their size, industry or location.

The second step is to conduct an assessment of market pay practices for similar jobs within the identified competitor group. Accurate job documentation and defining the duties, skills and impact levels of each job analyzed is critical to the quality of the data. In a market assessment, the organization compares its current pay levels to competitor pay levels for jobs of similar size, scope and impact level.

As the third step in this process, using the results of the market assessment as the basis, a company can develop a framework—typically referred to as a salary structure—for managing competitive base pay levels for all jobs across the organization.

A salary range usually consists of a salary minimum, maximum and a midpoint or control point.

The minimum represents the lowest competitive rate for jobs within that range and is typically used as a starting point for less experienced employees.

The maximum represents the highest competitive rate for jobs in the range. This is typically a premium market rate where top performers and those with extensive experience may be paid.

The midpoint or control point represents the competitive market rate for fully performing employees in jobs assigned to that range. The midpoint provides a guideline for slotting various jobs and individuals in appropriate salary ranges.

A typical salary structure is comprised of a series of pay ranges or bands that reflect competitive rates of pay for specific jobs in the marketplace and provide an opportunity for salary growth. Jobs of similar value from both a market and internal perspective are grouped together. Then a competitive salary range is developed around the market rates for those specific jobs.

Merit Increases
Once the salary structure is in place, an organization must determine the most effective way for employee salaries to progress through the salary ranges over time.

The most common practice in place today is the use of merit pay. Merit pay is intended to provide a system to reward employee performance through increases to base pay. In its most basic form, a merit increase is the amount of additional compensation added to current base salaries following a review of employee performance. In most organizations, two critical factors typically impact the amount of merit increase awards:

• The amount of money a company sets aside in its “merit” budget for performance-based increases—usually based on competitive market practice.
• Employee performance as determined through a performance review process conducted by managers of the company for their subordinate employees.

At some organizations, a third factor also is considered—”position in range,” i.e., where individual pay falls with respect to the range midpoint. For instance, at companies that are interested in tightly managing to their midpoint, an employee at the low end of the competitive range may be eligible to receive a higher percentage increase than his or her counterpart currently being paid above the midpoint.

While merit increases are still an active component of most compensation systems, they are increasingly ineffective in achieving their original intent—recognizing employee performance and outstanding contributions to the company’s success.

Due to their limited size and inability to truly distinguish levels of performance, merit increases are often perceived as an entitlement or merely a cost of living adjustment. Rarely are they effective in motivating and rewarding exceptional performance.

Performance-based Variable Pay
The use of performance-based variable pay across all levels of an organization continues to gain momentum as a more effective way to recognize and reward employee performance. No longer restricted to senior management levels, incentive or bonus compensation programs, as they are commonly called, are being designed to reward achievement of specific company and/or individual performance objectives.

In variable pay plans, the size of the award “varies” between individuals and from performance period to performance period based on levels of achievement against pre-established company and individual performance targets.

There are a variety of variable pay plan designs in place today. Plan designs range from sales-commission plans to individual incentive or bonus plans to team awards and gainsharing or results-sharing plans.

An organization must determine the overall objective it wants to achieve with variable pay and consider their specific operating characteristics when determining the pay-design approach that will be most effective. As with base-pay levels, an assessment of market practice can be helpful in understanding the kinds of systems in place within the target competitive market.

Variable pay awards are commonly paid in cash on an annual, semi-annual, or quarterly basis depending on the plan design. Awards are typically determined based on a combination of company and individual performance against pre-established goals or targets.

Individual award size is typically based on competitive practice and the company’s ability to pay. Amounts are often calculated as a percent of base pay depending on job category and position.

It seems to be a fact of today’s competitive landscape that variable pay programs are increasing in importance and in value when it comes to attracting, rewarding and retaining talent. The design, value and clarity of an incentive program can be the deciding factor in an employee’s choosing to accept or decline a job offer when all other factors such as base pay and benefits are the same.

If implementing a variable pay plan seems somewhat overwhelming, just remember how valuable a tool it can ultimately be. At their best, incentive pay plans reward employee contributions to company success and encourage a shared sense of ownership for business results across an organization.

Long-Term Incentive Compensation
We’re all certainly aware of the power and impact of stock-option plans in today’s market. Millionaires are made overnight for being in the right place at the right time and for having been awarded the right amount of stock options in the right company.

However, from a compensation fundamental perspective, stock-option plans and other long-term incentive compensation vehicles are still far less frequently used to reward performance than base pay increases or annual incentives. In addition, they still tend to be used more commonly at senior levels in an organization or for key talent or critical hires.

Stock-option and other deferred-compensation plans reward employees based on company performance over the long term—typically three to five years. Stock-option plans are a prevalent form of long-term compensation at public organizations. At private companies, plans that mirror stock plans but are based on internal values or deferred-compensation plans are often used for key employees.

From an overall perspective, long-term compensation plans can be very effective retention tools. At their most effective, they focus key employees on driving and improving the financial performance of the company over the longer term.

Non-cash Reward and Recognition Practices
While each organization approaches non-cash rewards differently, consideration should be given to each of the following practices when developing a total pay strategy:

• Benefits: A comprehensive, competitive benefits package typically includes medical insurance, life insurance, vacation and leave policies and some form of company-sponsored retirement or savings plan. Plans are typically designed to address the health and welfare needs of the employee population. Benefits can send strong messages to employees about company culture and values. To help offset the significant expense associated with comprehensive benefit plans, costs are often shared with employees.

• Perks and Non-cash Rewards: Perks and non-cash rewards are used by many companies to recognize significant individual or team contributions to special projects, or for exhibiting a strong commitment to the values and culture of the company. A variety of awards are used including special dinners, event tickets, trips, additional time off, etc.

• Intrinsic Rewards: Intrinsic rewards are expressed through an organization’s commitment to openly communicate with employees about things that matter most. The value and effectiveness of performance feedback, career-development opportunities and the belief that their voices are heard are very important elements of employee recognition. Fundamentally, we all want to feel like we’re in a place that values us—effectively managed communication and feedback processes can go a long way in promoting this feeling among employees and in retaining critical talent.