Pay-for-performance should drive results

By David Neilly and Claudine Kapel
|Canadian HR Reporter|Last Updated: 09/04/2003

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lthough many organizations have long emphasized the importance of a high-performance culture, the current challenging economic environment and lacklustre financial results are fuelling more earnest discussions on the subject.

During tough times, getting people to focus on top business priorities is especially critical. It’s not just about achieving best practice — it’s an economic necessity.


Designing, executing pay for performance

Getting a return on investment from a performance-based pay system depends on a sound program design and a solid execution.

The quality of design is largely a function of:

•the goals being measurable;

•the program being simple to understand;

•employees seeing that they can influence the outcome; and

•the reward being meaningful to the employee.

The quality of implementation is determined by:

•a willingness to differentiate rewards based on performance;

•a sound performance management system;

•management team with the appropriate training and competence; and

•a strong communication process.

There is a growing body of research that shows important links between employee behaviour, customer satisfaction and financial results. Recognizing this, organizations are looking for better ways to align employees with the business strategy and to inspire them to deliver their very best.

Strategies include a number of mechanisms, such as:

•stronger links between performance levels and salary increases;

•the use of broad-based incentive plans; and

•the use of cash and non-cash recognition programs.

First, and perhaps most importantly, the goal is to optimize individual performance, which in turn improves the likelihood of a business achieving its operational and financial objectives. In addition, highly engaged employees are less likely to be in the market for another job.

Incentive plans can reinforce links between pay and performance in a number of ways. They can reward strong performance at the individual, team, unit and corporate levels.

Furthermore, a well-designed incentive plan ensures there is a strong connection between the level of incentive awards delivered and the organization’s ability to pay. Poor corporate performance will typically limit or eliminate incentive award payments, thereby reinforcing the importance of achieving key business objectives.

Finally, performance-based pay can be used to send powerful signals into the organization about business priorities, the outputs that will be measured, and the value that the organization places on individual, team and organizational performance. Performance-based pay can help align large numbers of employees around the most critical goals.

So, the business case for implementing performance-based pay is compelling. It does not matter if your organization is private or public sector, profit-oriented or not-for-profit. If performance is important to an enterprise, you should link it to pay.

What reward elements do you want to tie to performance?

Once you’ve decided to pay for performance, you need to establish what reward elements you want to link to performance.

One common approach is a bonus that gets paid independently of base salary increases, usually at the end of a performance cycle (end of quarter or fiscal year).

Base salary adjustments are also commonly linked to performance, although many employers think of base salary adjustments as being linked to competency development rather than recent performance.

Bonus programs are the most popular method of performance-based rewards, and the possibilities are almost endless, limited only by imagination, the willingness to be different from the competition and an organization’s administrative systems.

Here are some examples:

•stock-option grants tied to individual performance;

•stock options with a vesting timetable that varies with company performance;

•recognition systems in which employees accumulate points for various achievements, and use these points to purchase items from a catalogue;

•flexible benefits credits or pension plan contributions that vary according to company performance;

•employee share purchase plans where the company match varies depending on organizational performance.

You need to define “performance”

Once you’ve decided to link part of the pay package to performance, you have to decide what you mean by “performance.” Performance can be defined at the individual, team or company level.

You can choose “output” measures such as customer satisfaction and profitability, or “process” measures such as cost per hire, revenue per employee or regional sales volume. You can choose “hard” measures such as the number of widgets produced per day, or “soft” measures such as an employee’s leadership contribution to a project.

There are two key variables that determine the success of a performance-based reward program — the degree of measurability and the “line of sight.” Line of sight is the ability of the employee to influence the result, relative to the target performance expectation that has been established.

The more measurable, more objective the means of calculating the bonus or reward, the more credible the process becomes for employees. The greater the line of sight, the more control employees will have over the business result that will determine the reward, and, typically, the more motivated employees will be to meet the goal.

If the business result sought is either vague and open to interpretation, or difficult for employees to directly influence, then employees will be more likely to feel less empowered, and therefore less motivated, to help pursue the goal.

In general, the more quantitative the goal, the more measurable it is. The closer you can bring the goal to the individual employee’s job, the higher the line of sight.

Compromises are inevitable, but as long as you’re striving to maximize both measurability and line of sight, you should be successful in engaging employees with the program.

The role of front-line managers

Underpinning pay-for-performance strategies is a growing focus on management development. It is generally well understood that even the best designed pay programs will yield less than desired results if people managers are not effectively engaged in driving and rewarding superior performance.

Effective manager involvement is critical for organizations seeking to better differentiate salary increases based on performance. Managers need to understand the criteria for differentiating rewards based on performance. That means they also need to be equipped to have tough conversations with low performers, while also being able to identify and recognize top performers.

Like most employee programs, the design of performance-based pay programs is usually much easier than the execution. It’s worth remembering however that in this case a badly designed program is worse than none at all. Here are some tips:

Keep the program as simple as possible:

Some organizations go overboard with complexity when designing a bonus program, using multiple (and sometimes conflicting) measures, complicated pay-out formulas and a highly time-intensive management process. The more “moving parts” there are in a program, the more difficult it is to communicate and administer, and the greater the risk that employees will get lost trying to figure out what the program is trying to accomplish.

Differentiate performance and rewards:

Sometimes incentive plans will yield pay-outs that do not vary significantly with business or individual performance.

In these cases, incentive payments become an entitlement, and the company wastes significant resources administering a portion of pay that might just as well be delivered as base salary. The motivating power and the credibility of a performance-based pay program hinges on the ability and willingness of the organization to differentiate rewards based on performance.

Train front-line managers:

The most important person in the successful implementation of a performance-based pay system is the front-line manager. Managers must be trained to set objectives, assess performance, differentiate performance and allocate rewards with a limited reward budget. This training should be done every year to keep the skills fresh and to reinforce the message to managers that the process is important.

Communicate openly and relentlessly:

Successful performance-based pay programs have a high profile in the organization, indicative of the importance placed on the program by senior management. The rules of the program, the pay-out formula, performance updates and changes to the plan are given a high profile in both face-to-face discussions with employees and in the organization’s communications.

Get your performance management system right:

When a performance-based pay program is based on, or includes a component based on, individual performance, the performance management system is a critical success driver. Goal setting, regular feedback, timely communication on changes in priorities, multi-source performance measurement and performance ratings all take on increased importance when rewards are at stake. The components of a performance management system need to be consistently managed and well integrated, to ensure the system itself supports the success of pay-for-performance strategies.

David Neilly and Claudine Kapel are consultants in Towers Perrin’s Rewards and Performance Management practice in Toronto. For more information contact Dave Neilly at (416) 960-4468.

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