What Makes a Compensation Plan Progressive & Competitive?

This article was originally published for the Strategy Human Resources Planning course for the University of Fredericton Executive MBA program

???Does art reflect society or does society reflect art? The same question could be asked of corporate compensation plans; do they reflect or dictate societal norms of work? Our (fictitious) company contends that both statements can be true.?The best compensation plans do indeed reflect societal needs and, in the best cases, shape the expectations of society.?

In most cases, modern-day businesses have evolved and benchmarked best practices to ensure they incorporate modern-day compensation plans. While some are more progressive than others, many organizations offer some form of strategic compensation to employees.?This means that many, if not all, well-designed compensation plans are built to motivate employees and align their efforts with the company’s chosen goals, objectives and culture (Belcourt et al., 2020). Compensation plans attempt to achieve these results through three distinct elements (Gibbs, 1990) which include the level of compensation, the composition of the package and the relationship between pay and performance.?

Level of Compensation?

The level of compensation is most commonly set by benchmarking the paygrade of one role to comparable positions at other organizations (Groysberg et al., 2021). Entry to mid-level positions are commonly compared to others in the local market. Employees in similar positions will receive comparable compensation packages no matter their background. In more senior, executive roles the organization is likely to compare compensation against a broader base of industry or national equivalents. The company benefits from this approach by ensuring that its compensation plans are in-line with the market. In addition, benchmarking versus competitors should limit the number of resignations from staff who want to walk across the road for seemingly greener pastures.?The theory behind this common approach is sound but does face several challenges.??

There are at least three challenges with benchmarking compensation plans. First, is the difficulty of finding comparable companies and roles to use in the benchmark process. Second, in the war for talent, the business may want to win by offering bigger and better packages only to find out that they’ve raised the bar on the industry benchmarks resulting in a race to the top. Third, because of COVID, remote work has made it possible to access global talent pools. This third point is having a significant impact on the cluster of companies to benchmark against and the financial and intangible expectations that come with acquiring or keeping people from global pools of talent.?Furthermore, new opportunities to acquire and keep global talent are often paired with new global best practices about compensation.?

Take minimum wage as an example. In 1914, Henry Ford radically altered society by more than doubling the wage of factory workers from $2.34 / day to $5.00 / day. Rather than pay employees only what they had to, Ford believed a living wage would provide greater benefit and, profit for all. As if that weren’t enough, Ford also shortened the workday to 8 hours, gave employees weekends off and established profit sharing. The bet paid off.?Ford had the pick of the litter from hordes of potential candidates and over the next year and increased productivity and profits by 40% and 20% respectively (Anderson, 2014).??

Fast forward 100 years and the idea of a living wage is still progressive and transformative. In 2015 Dan Price, the CEO of Gravity payments placed a Ford-like bet of his own. Price made headlines around the world when reduced his own paycheck to fund a living wage for employees and made $70,000 the minimum salary for all (Barnea, 2020). Price also capped the highest salary at $275,000 which, at 4:1 the executive to employee salary ratio is almost laughable compared to the 351:1 ratio for the average CEO of a public company in the US (Mishel & Kandra, 2021). The results of this ‘experiment’ are remarkably like Ford’s. Gravity’s customer base doubled as did their employee retention, cash turnover tripled and more importantly to Price, 70% of staff were able to pay debts while 10% of employees were able to purchase a home (Barnea, 2020).

In short, the process a company chooses to determine the level of employee compensation is a significant factor in defining how progressive the company is. In turn, this has an impact on the corporate culture which influences how engaged and motivated employees will be.?

The Composition of the Pay Package

Now that the company has determined the level of compensation, executives have several choices to determine how compensation is applied within the total plan. Typically, the composition of the total pay package includes three main categories: direct, indirect and non-financial (Cox, 2021). Direct financial rewards include things like salary, wage bonuses for individual and company performance, spot bonus for milestones, commission packages for sales, profit sharing, stock options and RRSP matching programs. Indirect financial rewards include employer-paid benefits such as medical, health and wellness benefits, charitable donation matching, subsidized meals, on-site fitness facilities, paid vacation, corporate team-building events and reimbursement for training, development, and professional fees. Finally, non-financial compensation elements help improve employee satisfaction and include things such as the philosophy of equal pay for equal value, employee recognition programs, rewarding work, physically and psychologically safe work environments, employer-sponsored volunteering programs, flexible work hours, ability to bank vacation, sick days, mentorship programs, corporate transparency through town halls and employee feedback through evaluations. None of these individual elements make a progressive company by themselves. Rather, progressive organizations use the individual elements of direct, indirect and non-financial rewards as like a composer writing a symphony.?

Progressive companies understand that it’s not the notes, but the open-mindedness about how the notes are arranged and prioritized that keep the organization relevant to modern audiences of employees.?For example with 45% of U.S. employees still working from home, a company’s indirect and non-financial rewards may need to expand and shift from the in-office work environment they were designed for to the modern reality of remote, hybrid and asynchronous work. Despite reporting record profits, companies like Facebook have responded to this new remote work environment by cutting financial compensation (Gilchrist, 2020) and creating pay inequality by punishing employees who remain remote. Their approach of unequal pay for equal value creates a negative perception about the organization and paints it as a company in cultural regression. Conversely, organizations like Tetranex Solutions Inc, an engineering service company in Calgary, respond to new challenges of remote work, zoom fatigue and mental health by rearranging the notes in their compensation composition with modern solutions such as employee assistance programs and access to virtual healthcare.?????

Figure 1: The pandemic continues to have an impact on where, and how, people work?

Source: (Saad & Wigert, 2021)?

Relationship Between Pay and Performance

Merit increases, promotions and incentive plans are the most common levers to manage the relationship between pay and performance. Given that the average merit increase of 2-5% is typically in line with inflation (Canadian employers expecting to increase salaries by 3% in 2022: Survey 2021), this lever is a weak force to influence employee performance.?However, the absence of a merit increase can demotivate any employee, especially high performers. Therefore, promotions and incentives are the two best levers to positively stimulate, engage and motivate employee performance.?

In most organizations, climbing the corporate ladder through promotions is the most common way to link pay with performance (Gibbs, 1990). This idea exists because of the historical orthodox structure of command-and-control hierarchies. By design, hierarchies are broad at the bottom and narrow at the top which means they are built to pay many more people low wages and very people higher wages. The trouble is that the pyramid-shaped design limits the number of positions with higher pay and thus increases competition for promotions.?

Figure 2: Most organization compensation plans are still built on a traditional pyramid despite matrix or flat reporting lines??

Source: Marc Binkley

Progressive companies like Morning Star consider how the structure of their organization influences compensation. For context, Morning Star is a successful, private organization that processes approximately 30% of tomatoes in the US each year. This company has designed their organization without a pyramid so that they create a culture where employees are paid, and incentivized, to deliver an impact to the business instead of receiving salary increases only when they get a promotion (Hamel, 2017). “Moving Up” in this organization means taking on more responsibility and rewarding people for skill and competency instead of coupling pay with increasingly senior titles.?

Incentive plans are the final, and perhaps most complicated lever linking pay with performance. On the surface, paying people to deliver more seems like a simple concept, except that it’s not. In the years leading up to the global financial crisis of 2008, pay-for-performance incentives enabled brokers and lenders to develop and sell a mortgage loan for people with no income, no job and no assets (NINJA). These NINJA loans were part of the fuel that drove incredible results and financial performance in the short term. However, over the long term, these same incentives contributed to the subprime mortgage crisis and ultimately the global financial collapse (Kagan, 2021).?In other words, incentives motivate behaviour, not performance.?

Take CEO pay as another example. CEOs are understandably rewarded for creating a long-term vision for an organization and maximizing shareholder return through that vision. Nearly 75% of CEO pay is linked to stock performance and they’re incentivized through options and awards to meet or beat market expectations. Between 1978 and 2020, CEO compensation grew by a remarkable 1322%. In comparison over the same period of time, the average wages for a typical worker only grew by 18%. Pay inequality aside, one might expect the performance of public companies to follow the remarkable growth of CEO pay. Strangely, the CEO pay outpaced actual S&P growth (817%) by 62% (Mishel & Kandra, 2021).?Results like these have led many of the worlds leading business strategists to conclude that incentive programs are often gamed for personal short-term benefits instead of actual performance in productivity and effectiveness over the long run (Martin, 2011).

Figure 3: CEO pay has increased to 351 times the average employee

Source: (Mishel & Kandra, 2021)

In addition to influencing behaviour for short-term benefits, incentive plans can actually have a negative impact on the real performance of knowledge workers.?A common belief is that higher rewards incentivize higher performance. A landmark study funded by the US Federal Reserve Bank and created by economists from leading business schools like MIT and Carnegie Mellon investigated this very belief. Researchers reported that while increasing incentives improved performance for mechanical, physical type tasks, the opposite is true for tasks that demanded more than rudimentary cognitive function (Ariely et al, 2009). This shocking result was replicated in the US and India, both vastly different cultures, and concluded that the higher the reward, the poorer the performance.?

There is good guidance for companies that care to address problems related to inequity, inappropriate behaviour and gamification for self-interests (Groysberg et al., 2021). First, organizations should carefully assess how the incentives can be gamified. Second, they should reward people, particularly executives for the actual results of leading the business instead of the perceived performance of the stock market (Martin, 2011). Third, organizations can correct pay inequity by fixing the total annual compensation and the ratio and sharing profits between CEOs and employees as Dan Price has at Gravity Payments. Fourth, organizations can take a page from Shopify’s book and create incentives that reward a balance between short and long-term decision-making by paying out rewards over the long term (Shopify, 2020). Finally, companies can encourage the behaviours that align with their strategy by following the lead of Four Seasons hotel and Tetranex by treating employees the way they want their clients to be treated (Martin, 2021) and using education rather than punishment to upgrade underperformers.?

References

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