Is there any corporate activity that takes up as much management time as the annual merit increase process? So much is expected of it, yet companies and employees consistently tell us it’s not working and no longer fit for purpose. Given that base pay has for many years been the most important driver of attraction and retention, this situation is unsustainable and suggests companies need to radically rethink their approach.
Nearly 2,000 companies around the world recently participated in Willis Towers Watson’s Getting Compensation Right Survey, the latest installment of the Talent and Rewards Breakthroughs Survey series. One of the most startling findings, which didn’t surprise me given my experience as a manager, was the average company takes up to six factors into account when determining individual base pay increases. In low-inflation Western economies where budgets have been running at 2%-3% a year for several years, this is simply asking too much of too little.
Here are just a few of the factors companies are taking into account when determining merit increases, based on findings from our survey:
Individual performance. Much has been written in recent years about problems with the traditional approach to performance management. Many companies have been looking to simplify their approach and make the connection with pay less formulaic, but there’s really no right answer. Simply put, pay-for-performance is complicated.
However you define performance, it’s clear that high performers are getting a raw deal. Our survey shows that the highest performers receive merit increases double those of average performers. When base pay increases are running at 5%-10% a year, as we see in higher growth economies in Asia, it’s a meaningful degree of differentiation. However, in the West it equates to around 2% of salary, which doesn’t provide significant differentiation, even when compounded over many years. This certainly doesn’t encourage discretionary effort.
Market competitiveness. In reality, the market rewards skills and knowledge, and with budgets trying to achieve so many competing objectives, they’re unable to keep pace with individuals’ development. It’s no surprise that moving jobs is the best way to remain competitive. Market competitiveness isn’t new, but that doesn’t mean it’s easy for managers and HR to get right.
Future potential. An increasing number of companies tell us they’re looking at base pay to reward future potential, in addition to past year’s performance, for certain critical-skill employee groups. This especially applies to those early career professionals or those considered future leaders where pay needs to keep pace with expected future career development. This is an emerging trend, adding an additional layer of complexity.
Critical skills. As the world of work adapts to advances in technology, we’re seeing speedier changes to the relevance and value of different skills, yet homogenous pay budgets are unable to adapt. Our survey respondents identified the ability to reward strategically critical skills as the top factor growing in importance when making base pay decisions over the next three years. Another factor to consider.
Fairness. Legislation in markets such as the U.S. and U.K. have significantly raised the profile of pay fairness, particularly when it comes to gender. Respondents in those markets – 41% and 58%, respectively – and 28% of companies globally indicate that ensuring gender pay fairness will increasingly be a critical factor in merit increases over the next three years. And once again, another factor on the list.
Overwhelmed? It’s time to simplify.
Clearly, there are too many competing demands on a limited pot of money, making it extremely difficult for even the most competent managers to get right. It’s time to make some difficult choices to simplify base pay administration. So where can you begin?
Consider these four steps:
- Use analytics to segment the workforce and base merit increases on the elements that matter for each talent group. For some, it may be critical skills, for others it may be future potential.
- Be clear and disciplined on the different roles of reward elements. Aim to do fewer things with base pay for any given employee, but more effectively. Perhaps annual bonus is the right place to reward last year’s performance, rather than merit. Make bonus genuinely differentiated to accomplish that objective. Don’t use two overlapping pay elements, trying to do the same thing, which ultimately waters down your intent.
- Be more transparent about the pay process with employees. Communicate the choices and trade-offs you’ve made, explain the role of each pay element and set the agenda. Much of employees’ current dissatisfaction arises from the lack of clarity of purpose.
- Move away from an annual cycle – if base pay tracks an individual’s progression why should that be annual? The frequency of pay increases might decline over a career as progression slows. More substantial increases may be justified as career or capability milestones are achieved. Don’t be afraid to consider off-cycle awards and merit increases that keep pace with your employees’ actual career progression.
The bottom line:
Base pay is the single biggest expense on most companies’ profit and loss sheets, and we haven’t seen real innovation in this area for two or three decades. However, over the last year, I’ve increasingly seen even the most traditional companies start to fundamentally rethink their approach to base pay. Can you afford to be left behind?
Mark Reid is global practice leader of Executive Compensation at Willis Towers Watson and executive sponsor of the Getting Compensation Right Survey.