The Pay Off in Merit Pay (Not)

If you’ve been reading this blog for a while, you know how I feel about compensation systems that claim to motivate better performance with differential pay.

For example,

A Compensation Story in 2006,

It’s What We Know That Ain’t So and

Pay for Performance and Why it Doesn’t Really Work in 2007

So of course, I was interested when I came across Where’s the Merit-Pay Payoff? by Fay Hansen on (requires free registration).

A few snippets:

The seemingly self-evident premise underlying merit pay and other individual performance-based pay plans is that they produce higher employee and organizational performance. Most companies, however, do not test the actual impact of performance-based rewards on employee behaviors and financial results. The most comprehensive empirical studies flow from the academic world, where evidence is mounting that the assumptions underlying individual performance-based pay programs are wrong.

“The evidence is overwhelming that individual pay for performance does not improve organizational performance except in very limited cases.”
—Jeffrey Pfeffer, professor, Stanford University Graduate School of Business

“Effective management is a system, not a pay plan. The mistake is that companies try to solve all their problems with pay.”
—Jeffrey Pfeffer. professor, Stanford University Graduate School of Business

Pfeffer notes the existing evidence points to group bonuses, profit sharing and gain sharing, which is a form of profit sharing, as more effective forms of performance-based pay than merit pay or individual incentives. “Group plans are more collective and recognize the interdependent nature of work today,” he says. “Most employees look at their total compensation and want to see that they share in the success of the organization.”

This is particularly germane to organizations that are asking people to work collaboratively in teams. Yes, we do pay individuals. There are rational ways to do that without so-called merit raises. I’m glad to see that group bonuses and profit sharing are starting to come up in the conversation.

I will address the top concerns that come up when I write/talk about this topic preemptively.

1. I am not suggesting that everyone be paid the same salary. Skills, experience, domain knowledge and the current market are all considerations in setting salary. The key is to pay people equitably (which is very different from “pay equally”).

2. I am not suggesting that everyone’s skills and performance are equal. Of course people have different skill levels and perform differently. Most companies recognize this with salary bands.

3. I am not saying that teams should have a team salary. Salaries are paid to individuals… though I suppose an independent team could contract jointly, and then decide how to allocate pay within their group. But that’s a different topic.

4. I am not saying people don’t need feedback on their performance at work. People need feedback–which is information about performance, not evaluation–on a frequent basis. The more we can design systems where the feedback comes from the work, the better (e.g., build lights, green bar/red bar test frames). Peer feedback and feedback from managers are crucial for improving performance.

5. I am not saying that people who aren’t actually working should continue on the payroll. But any manager who needs a pay-for-performance system with ratings and rankings to figure this out is in big trouble.

I think these are some of the things people fear when they think about removing merit pay. There are other rational pay systems… but they aren’t as wide spread, so few people know about them. More on those, later, perhaps.