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September/October 2014

Talent and Tournaments: Alternative Models of Pay for Performance


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Pay for performance has been troubling employers and employees, it seems, for as long as anyone can remember. But are they troubled enough? The conventional thinking is that pay for performance essentially means various forms of variable pay. But Mercer research and client work show that it’s a much more nuanced concept than most organizations realize, with short shrift given to alternative models of pay for performance that may yield better results.

Fortunately, the profile of pay for performance has never been higher than it is now, with every realm from academia to mass media weighing in on it. That’s no accident, for in the wake of the recent financial crisis, many companies have found themselves facing cutbacks in compensation expenses. With fewer dollars to spread around, there has been a greater emphasis on differentiation of performance ratings and pay, and even more emphasis on variable compensation.

All the while, experts debate whether financial incentives are effective drivers of business success, boards wrestle with the populist notion of giving all stakeholders some say on pay for executive compensation, and blogs and newsfeeds are never short of opinions and statistics that argue how counterproductive and disliked performance reviews tend to be.

In his 2009 book, Drive: The Surprising Truth About What Motivates Us, Daniel Pink argues against old models of employee motivation driven by rewards and fear and focused on money, as opposed to intrinsic motivation, such as mastery of work and a sense of purpose.

“The problem with making an extrinsic reward the only destination that matters is that some people will choose the quickest route there, even if it means taking the low road,” Pink wrote. “Indeed, most of the scandals and misbehavior that have seemed endemic to modern life involve shortcuts. … Goals may cause systematic problems for organizations due to narrowed focus, unethical behavior, increased risk taking, decreased cooperation, and decreased intrinsic motivation. Use care when applying goals in your organization.”

As if to underscore just how hot the issue of employee motivation has become, a recent PowerPoint presentation by top management of Netflix went viral, with more than 5 million views on the internet, according to a Harvard Business Review story. The deck detailed the company’s unconventional talent management and performance strategies, which include top-of-market pay, a resounding emphasis on employee freedom, and the abolition of formal vacation and performance review policies.

CONTINUING STRUGGLE

The simple fact is that organizations continue to struggle with pay for performance, and it’s not getting any easier. If anything, it’s more complicated, given an uncertain global economy that has prompted everything from reduced pay-increase budgets and incentive pools to increased shareholder activism, along with emerging government regulations. That so many of the performance measures used in typical variable pay plans are driven by systematic market and industry fluctuations over which employees have little control, rather than by actual worker performance, further complicates the design of effective incentive compensation.

Although human resources and total rewards leaders have always sought best practices in pay for performance, the most prevalent approach has been and continues to be the variable pay model, relying on increasingly differentiated combinations of year-to-year base pay increases and incentive payouts, all strictly aligned to individual performance for variable pay — in addition to other measures.

But most organizations are not satisfied with their pay-for-performance programs, and there’s a general sense of dysfunction. Results of the Mercer 2013 Pay for Performance Survey show evidence of that. The survey queried 570 US and Canadian organizations.

The prevailing variable pay model — reported by more than 85% of participating organizations as the reward model most closely linked to performance — reflects an overused and unnecessarily narrow view of pay for performance, especially because there are multiple models that can vary the mechanism through which higher financial rewards are made to better performers. The key to success is aligning the right model to each organizational circumstance.

Clearly, organizations are looking for better alignment. The 2013 survey results showed that 55% of participants focus “to a great extent” on pay for performance for executive, managerial, and sales employees, while all but 5% are focusing on it “to some extent.” But, more tellingly, 63% of them are working to increase differentiation of pay based on performance — mainly through guidelines for ratings distribution and next-level manager review — while only 2% are working to reduce that differentiation.

Yet nearly half of the organizations surveyed believe that pay-for-performance programs “need work.” Survey respondents embrace the concept of pay for performance, but not many said the concept is working well in their organizations.

Organizations’ dissatisfaction with their pay-for-performance programs suggests that traditional financial incentives — the most common approaches — may be overused in situations or contexts in which they are not the optimal choice. (See Figure 1.) Yet, understandably, companies are linking pay to employee performance as part of their strategy for growing their business in an uncertain economy. Because talent costs are a large portion of a company’s spending, emphasis on pay that varies by employee and company performance helps control costs, focus on spending for results, and retain top employees.

According to Mercer’s survey, attracting and retaining the right employees ranks highest among expected outcomes of pay-for-performance programs, reported by 86% of participating organizations. This outcome is followed closely by motivating employees to focus on the right things and perform at higher levels. Additional priorities, cited by more than one-third of organizations, are encouraging specific behaviors and promoting employee engagement.

Clearly, workforce capability and motivation are two areas that companies can focus on to drive performance. But by investing more time in assessing employee needs, determining where critical talent lies, and identifying factors that influence employee behaviors, companies can improve their pay-for-performance programs and enhance their overall success. And improving pay for performance can be a matter of settling on the right model.

EXPLORING ALTERNATIVE MODELS

As noted, attracting and retaining the right talent tops the list of priority outcomes expected of pay-for-performance programs. To do so, organizations must optimize their rewards programs — and seriously consider whether the prevalent variable pay model, with its emphasis on pay differentiation and linking payouts to contemporaneous performance, is the right one for them.

Too many organizations have lost sight of the fact that there is more than one way to pay for performance. Following are three other pay-for-performance models that organizations should consider deploying as alternatives to or in combination with traditional variable pay models (for the enterprise or for different employee segments):

  • In a promotion-focused or “tournament” model, pay varies significantly from one career level to the next, with less emphasis on differentiation based on performance between employees at the same level. In this model, competition for advancement, rather than the size of the base pay increase or annual incentive, is what motivates employees to perform well. The best performers earn more via promotions based on relative performance evaluation. About 14% of those in the 2013 survey reported using this type of model.
  • In a membership or “efficiency wage” model, overall pay (and benefit) levels are targeted above the market median, and employees must perform to high standards to stay with the organization. In this model, the desire to keep a high-value position is what delivers incentives to perform well. Around 14% of respondents in the 2013 survey said they use this model to attract and retain high-performing talent and motivate performance.
  • In a service or “bonding” model, a trajectory of planned increases shifts pay from early to later in the career, once performance is credibly demonstrated. This model also locks in employees over the long haul, preserving firm-specific knowledge key to productivity while enforcing performance minimums to stay with the organization. Only 7% of respondents in the 2013 survey reported using this type of model.

As observed, about half of the surveyed organizations indicated that their pay-for-performance programs need improvement; one-third of them were anticipating or planning revisions to their programs.

Misalignment is a likely reason for this, because many of those relying on traditional incentive compensation are more likely to cite their performance measurements as “noisy” or influenced by other factors that make actual performance levels difficult to interpret. They may want to consider alternatives that are less dependent on theprecision of absolute performance measures and require less frequent monitoring — for example, the tournament model that relies solely on rankings or a membership model that stipulates a performance threshold.

Although conclusions are limited because of the self-reported nature of the data, the survey responses do support the assertion that using the right model in the right context can enhance the effectiveness of pay-for-performance programs. Respondents were classified as using a particular model when they said they “strongly agreed” that the approach was a primary mechanism for managing pay for performance.

Those respondents focused on the membershipmodel — high pay relative to market — report the highest levels of effectiveness. The model is most often used by employers who say they are trying to balance “build” and “buy” talent strategies — that is, to build or develop from within and to buy talent on the open market — to support the attraction and retention of high performers.

Surveyed companies using the tournament or promotion-based model judged their plans as more effective than companies relying on more traditional incentive compensation models. The tournament model is associated with build-from-within talent cultures, but given the model’s reliance on relative ranking (and, therefore, competition), it is less likely to be appropriate for employers reporting a high need for collaboration in their organizations. Although more research is needed in this area, the survey supports the point that organizations fare better in managing pay for performance when their models are aligned with their company culture and attraction/retention/engagement strategies, as well as with their measurement approaches.

MODEL SEGMENTATION

Slightly more than one-third (36%) of survey participants reported using multiple pay-for-performance models, but it’s not clear to what extent this reflects their use of a combination of models versus using different models for different employee segments, such as business units, job families, or multinational locations.

The complex question of how different models may be used optimally for different workforce segments is worthy of careful, expert exploration. And while such segmentation makes sense, it’s vital to balance any segmentation strategy against the need for consistency in complex, global organizations, especially those with high rates of mobility.

Workforce capability and motivation are two areas that companies can focus on — not only to drive performance but also to solve the pay-for-performance challenges raised by an all-too-prevalent variable pay model and a lack of clarity, or courage, when it comes to other models and segmentation strategies that may be better aligned to the organization. Big data analytics for human resources can be leveraged to track the effectiveness of these approaches and ensure that they drive retention and performance.

Ultimately, companies must invest more time in identifying talent needs and strategies, critical talent, and factors that influence employee behaviors. It’s a matter of being open to alternative models, assessing fit to context, monitoring effectiveness, and optimizingaccordingly. Despite all the noise and negativity that surround pay for performance in today’s wired world, it’s a riddle that each organization must solve in its own way.

 

Learn more about enhancing performance management programs.

 

CONTACTS

Haig Nalbantian (New York)
Senior Partner,
Talent/Workforce Sciences Institute
+1 212 345 5317
E-mail
Jeanie Adkins (Louisville, KY)
Partner, Talent
+1 502 561 8944
E-mail
Brian Levine (New York)
Partner, Talent
+1 212 345 4194
E-mail


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