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August 2007

The Strategy of Adapting to Variable Pay

by Pat Zingheim & Jay Schuster

Although statistics vary, it is safe to say that 50% of organizations now use variable pay and incentives for non-management jobs (and, of course, a larger portion use incentives for managers and executives). Yet many organizations still seem hesitant to move to broad-based variable pay plans and remain focused on the “merit increase” as their primary monetary tool for rewarding performance. Without doubt the principal verification of having established a “performance culture” in most organizations is the existence of a merit plan—a program that intends to grant annual pay adjustments based on employee performance.

But the reality of merit pay is that organizations use the annual pay adjustment budget to do many things in addition to rewarding performance. Annual budget money is allocated to address competitive practice, equity adjustments, promotional adjustments, and relocation along with other demands placed on the available base pay increase dollars. So the pay-for-performance application of merit pay is diluted substantially. Little difference in merit treatment exists between top performers and those who are just adequate. Base pay is traditionally better correlated with length of service than differences in performance, making base pay fall short as the primary way to recognize performance in organizations.

Also, base pay adjustments are an “annuity” that remains with employees during their entire term of service with the organization. If performance varies from year to year, they are not agile enough to focus on top performance or, if performance excellence is not sustained, to return to a more accurate representation of employee performance in the next performance period. Base pay is a “gift that keeps on giving” and is not flexible enough to respond to the changing needs of organizations and workforces. And that is one reason many organizations use variable pay to reward short-term performance.

Moving to Variable Pay

One of the major strategic moves organizations have made since 1996 is a migration to variable pay. While there have been some design, communications, and acceptance challenges along the way, testimonies verify that the decisions these organizations made were the right ones at the right time. Satisfaction with variable pay is high, and research reports that when variable pay is used, the organization is more likely to achieve goals and metrics associated with variable pay than they are when variable pay does not exist. The business case is powerful, and the results are in. Variable pay is clearly the most important performance enhancement tool an organization can add to its pay-for-performance toolkit.

What are the essentials of a reward strategy that involves implementation of a variable pay plan below the management level? And we are not talking about the oversimplified generalities about “recruitment, attraction, engagement, and retention” of talent as a strategy. Here we mean building a business case for variable pay and how to implement it. Of all the many aspects of the most successful strategic moves to variable pay, there are two that must be addressed in the business case:

1. For what do you use base pay in your total reward strategy if not short-term performance?

2. What features of variable pay are most correlated with lasting success and value-added to the business?

These are issues of business strategy, direction, and communication. The business case for total rewards is not unlike that for any element of the business proposition. It is building a best-use case for the reward alternative and then developing a tactical plan to implement and manage the decision effectively.

What Base Pay Does Best

Because base pay is the largest element of total pay and leverages most other benefits, it must be strategically focused on rewarding growth in value to the organization over time. Base pay does best when it rewards the continuing improvement in skill and competency needed to make the employee’s role a successful one. As people receive higher base salaries, they should become more valuable by acquiring and applying skill and competence to their roles and translating this into results. If this is not the case, base pay often outgrows value from obsolete skills and puts the employee's future in the organization at risk.

So rather than trying to acknowledge short-term results with base pay, value added over time is the best function for base pay. The higher paid the employee, the more contemporary and applicable skills and competencies the individual should possess and apply to their work. In this instance, any annual base pay adjustment funds are allocated to rewarding skill and competence growth and usage and the employee’s track record of performance, not short-term performance. If an employee fails to grow in skills and competencies, base pay can remain at a specific level until that growth begins again. If the employee’s overall value to the business based on their track record and trend in longer-term performance doesn’t match the pay level—either higher or lower—this should be a consideration in determining any base pay adjustment. This encourages employees to increase their value added to the business and makes it worthwhile for them to continue to grow and contribute throughout their careers.

What Variable Pay Does Best

Variable pay and incentives are the best way to reward short-term performance and among the best to reward longer-term performance of up to three years. Variable pay can be focused on one set of metrics for one performance period and another for the next to communicate a change in strategic or tactical direction for the organization. Measures related to the customer, financial and operational performance, future of the organization, new developments, and the like can be used to extend the line of sight of the workforce to measures and goals that accelerate the achievement of business objectives. Variable pay does not become an annuity, and if designed properly, avoids falling into the entitlement trap that often captures less flexible reward solutions.

From a strategic perspective, base pay and base pay adjustments can focus on growth and usage of skills and competencies over time and an employee’s sustained value added based on his/her track record of longer-term performance. Variable pay can reward the ability of the employee to convert what they know and can do into results. It makes for a strategic “one-two performance punch” that is essential to creating a high-performance organization. Variable pay can also be used to cascade measures and goals from the top of the organization throughout the enterprise to gain alignment and commitment to the overall business strategy of the business. Variable pay is a powerful communicator of values and directions and changing business needs.

The Bottom Line for Variable Pay

Strategically it makes sense to move first to variable pay to show that paying for performance increases the likelihood that goals will be met and exceeded. The importance of this as a lead strategic move is that it can provide proof positive that organizations that visibly recognize performance outperform those that don’t. So it is a wise strategic step for organizations seeking to become or remain high-performance.

The fact is that variable pay does a much better job of rewarding short-term performance than do merit pay adjustments. And organizations that want employees to help them achieve key goals and metrics will consider a move to variable pay as a lead item in their change effort.