Paying Your Staff - Some Choices
In terms of remuneration, employers pay out cash to employees under two broad categories:
Basic Pay
Variable Pay
In most organisations, 95 per cent of their payroll is spent on basic pay. It refers to the core wages and salaries paid to employees. An important characteristic of basic pay is that it is almost always driven by the job the organisation wishes to be done. In setting the value of a post, an employer may wish to take account of some or all of the following.
The value of this post in the marketplace. This market may be local, regional, national or international, or it may be occupational.
The value of this post relative to other posts in the organisation.
The extent to which the organisation has a system or hierarchy of posts within which post holders may move or progress.
The extent to which the organisation wishes (or is required) to review basic pay in relation to the cost of living.
This typically makes up around five per cent of the payroll. It is an umbrella term that encompasses a range of approaches to distributing pay that reflects the contribution of an individual or team. Unlike basic pay, variable pay is allocated to individuals or teams and is usually intended to incentivise or reward contribution over and above the core requirements of the post. In many organisations, this has come to mean that a proportion of the payroll is allocated on a discretionary basis, often with line manager involvement. Variable pay can take the form of performance, merit or discretionary bonuses (usually not pensionable or consolidated into basic pay) or other awards such as increments, which move the employee through a grading structure by increasing their basic pay.
In this paper, we discuss some current practice in the distribution of variable pay, and the extent to which it can contribute significantly to performance improvement among employees.
Paying for Performance
Paying individuals or teams for their performance has become a central pillar of reward strategy in many UK businesses. Surveys have shown that between a half and two-thirds of organisations (in private and public sectors) have some form of performance-related pay for their staff. Individual-based performance-related pay (IPRP) linked to an appraisal scheme is an increasingly popular approach and tends to be focused on mostly managerial and white-collar employees. However, there are growing signs that it is permeating through to other groups and in some instances it has been introduced for manual workers.
Employers appear to be attracted to PRP for several reasons. First, it is seen as a means of helping to influence or change the culture of the organisation, for example by modifying behaviour through the appraisal system and making it more explicit that achieving objectives and targets is valued. Organisational objectives such as the improvement of customer service, better quality and productivity can be pursued by this approach. PRP is being increasingly used, therefore, as a lever to promote organisational change and generate a new performance-focused company culture. Certainly in the public sector, this pursuit has been an explicit goal (e.g. the original Citizen's Charter talked of rewarding good performance and 'punishing’ bad).
Second, PRP is thought to introduce an element of payroll flexibility that provides employers with another lever to control pay costs. In service-based organisations where labour costs can be between 60 and 70 per cent of total operating costs, such flexibility is desirable in circumstances where many companies are striving to be cost-leaders in highly competitive markets. Furthermore, in the search for solutions to the white-collar productivity crisis, PRP is seen to play an important role in helping to ensure that increases in the wage bill are funded by increases in productivity.
Third, this form of PRP emphasises the individual's contribution to business performance. This is appealing to many employers because it is seen to reinforce the relationship between the individual and the organisation rather than have this mediated by collective representative structures such as staff associations and trade unions. In this context, trade unions are often resistant to the introduction of PRP because it is seen as a threat to the values that underpin their workplace role. The emphasis on the individual is also prompted by a desire to ensure that those contributing most are rewarded more than those contributing least. Indeed, for some employers, the use of PRP to manage poor performers has been a significant factor.
There are, of course, a host of other reasons put forward by employers, such as the need to offer PRP to recruit and retain good-performers, but those outlined above tend to underpin the more recent interest in PRP and may help explain why many employers have been seduced by its appeal.
Forms of Performance Pay
There are three main kinds of performance pay. The first focuses on individual performance. The second on the contribution of work teams and the third links reward to the performance of the whole organisation.
Individual PRP
This form of reward has received the most attention in recent years. This is primarily because of the debates that have raged about its philosophical and practical merits. Several approaches to delivering individual performance awards are commonly in use:
1. Performance-related pay increases may be consolidated into basic pay until the maximum rate of pay for the grade is reached. If pay increases are consolidated, the rate and limits of progression through pay bands are usually determined by performance ratings that are often made at the same time as performance appraisal. The increases may be made through incremental progression (e.g. up pay spines) or by a defined percentage.
2. A pay matrix may be used to deliver performance increases in a conventional grading structure. Here, increases are based on an individual’s appraisal rating and their position in the salary range, with smaller awards going to individuals higher up the pay range. This approach is based on the principle that the mid-point salary equates to the market rate, or rate for the job. This assumes that pay increases, at any given level of performance, should be lower for those whose salary is above the mid-point, since they are already receiving more than the market rate for their job.
3. Performance increases may be paid as cash bonuses (often on a discretionary basis) for exceptional effort, special attainment, sustained levels of high performance or because the individual is at the maximum of their salary band. Usually these are paid as non-consolidated increases. They are rarely pensionable.
These approaches frequently use annual line manager appraisals as the driver for assessment. They are often based on performance measures that are enshrined in objective setting and based on measurable results. Increasingly, organisations are seeking to build into these assessments recognition of the 'competencies' displayed by an individual, though these schemes may be vulnerable to challenge on equal opportunity grounds.
As well as PRP, bonuses and incentives can be another element of variable pay. They are discretionary, formula-driven bonuses that are held out as a carrot to motivate people to desired performance and made to individual employees, teams or whole workforces.
These payments are most often over and above the basic salary and are frequently non-consolidated and non-pensionable. The basis for paying them can vary. Some are contractual and relate to core working conditions (such as unsocial hours). Others, and more commonly in recent years, are attached to some kind of performance measure. These can include piece rates, productivity bonuses, performance-related bonuses, profit-related bonuses and incentive bonuses driven by formulae. An increasing number of organisations use non-consolidated bonus payments to reward employees who have reached the maximum of their pay range.
If basic pay is intended to reflect the market rate that an employer attaches to a post, bonuses and incentives today represent extra payments made to individual post-holders based on their efforts or results over-and-above the core requirements of the job. Linking individual performance with bonuses or incentives is frequently based on a number of assumptions about individual motivation and managerial capability. Chief among these assumptions are that:
Employees will increase their effort or output in order to attain the reward on offer.
Employees feel that the rewards on offer are of sufficient value to them to incentivise extra effort.
Employees are confident that the reward will still be on offer at the end of the period during which their individual performance is being measured.
Organisations are able to establish and use clear and transparent measures of performance for all relevant employees, and apply these measures consistently.
Individual, rather than collective contribution is the primary driver of organisational performance (even in organisations where there is a strong emphasis on team working).
Line managers have the time, commitment and competence to explain and administer bonuses and incentives effectively, transparently and consistently (and see the importance of doing so).
Any performance improvement brought about by bonuses and incentives is sustainable over time.
Bonuses and incentives will deliver sufficiently large pay increases to motivate and incentivise employees, even during periods of low inflation.
There is considerable debate about whether these conditions have been sufficiently satisfied in many of the organisations that have embraced bonuses and incentives over the last decade. The debate has been particularly energetic in the public sector, where individual PRP has been widespread. There can be no doubt that PRP during times of low inflation has not been as effective as was originally hoped. The evidence suggests that most individuals find PRP at least a neutral influence on motivation, and most often a negative influence. Recent studies have shown that some PRP schemes are discriminatory. Some schemes combine the PRP or merit pay approach with individual incentives. This allows high flyers to reap superior reward, but ensures that team contribution is also kept in focus.
Team Bonuses and Incentives
Incentive bonuses also allow organisations to link the payment of a non-consolidated bonus payment to a group of employees if they collectively meet or exceed a pre-determined performance target or goal. This approach has a number of advantages:
It allows the business to focus effort on high added-value performance (i.e. high margin activities).
It provides the facility to give high earnings increases to high performing teams.
It allows within-year control of payroll costs by avoiding consolidation of bonuses into base pay.
It encourages employees to see a direct link between their collective efforts, tangible business outcomes and reward.
Quite often team bonuses are based on the meeting (or exceeding) of collective performance targets (sales, profits etc.). The operation of such schemes may not be without problems. For example, employees are often concerned that managers will move the performance 'goalposts' part way through the year. For some employees the performance measures they are chasing may seem over complicated, remote from their influence or unattainable. In some cases line managers may not be in agreement with the principles of team bonuses - leading to under-performance. In general, team bonuses and incentives schemes should seek to comply with the following six design principles:
1. Define the team. A pre-existing team is clearly better than a team artificially constructed for the purpose of a bonus.
2. Agree the performance measures (to set baseline & track progress).
3. Decide reward formula and type of payout. Will the payout be a flat rate sum or proportional to salary?
4. Decide eligibility rules (joiners, ‘freeloaders’ etc). Decide what to do with people who join or leave a team mid-year. How about those on long-term sickness or those who are underperforming?
5. Set up data and communication infrastructure. It is important to provide regular and detailed data on performance against the targets.
6. Agree evaluation process. Know how success will be judged, and collect data which will help such a judgement to be made.
Emerging evidence suggests, however, that carefully constructed and simple team bonuses can significantly increased commitment and productivity. They can improve employee identification with the goals of the business and can incentivise improved collective effort and achievement.
Organisation-wide Incentives
Another mechanism for linking performance and reward can operate at the level of the whole organisation. These approaches are based on the principle that employees will exert effort if they feel they have a share of the spoils of organisational success. 'Financial participation' of this kind, therefore, concerns the involvement of employees in the financial success of the enterprise in which they work. It can take a whole host of forms, but most commonly it refers to one of three types of basic scheme:
firstly, profit sharing, in which a proportion of remuneration is tied to the profits of the organisation for the year;
secondly, employee share ownership, in which employees are rewarded with a number of shares in the employing company;
thirdly, share options, in which the employee is given the possibility of purchasing at a future date a set number of shares at a price agreed initially. Depending upon growth in the market value of the shares over the initial value, the option to purchase the shares may be exercised or not.
These schemes may be seen discretely or combined with each other – e.g. profit bonuses may be invested in company shares. Some schemes are applicable to all employees; others are restricted to particular groups, such as senior executives or directors. Government aims in promoting financial participation are various. One driver relates to economic performance. The advantage of employee financial participation is that it is a form of financial flexibility. In other words, it allows employers to see their wage bill rise and fall in line with business activity. This means that the payroll adjusts to suit the exigencies of the business situation. Wages can be contained during lean times, but rise on the back of profits, but in a controlled way. Labour costs thus become more flexible, just as they do if the numbers employed varies with work demand.
As organisations search for approaches to remuneration which both reward performance and help keep the lid on payroll growth, more are turning to forms of incentive bonuses as a solution. A variety of bonus schemes have been in use for many years, but only recently have businesses and, more latterly, the public sector, begun to re-assess the value of these schemes in their reward strategies.
Cash bonuses and incentives in the UK: the state of play
Until relatively recently, bonuses and incentive schemes were confined to sales jobs and manufacturing environments. Now they are being used more extensively in the service and public sectors, reflecting growing interest in the use of bonuses and incentives among a wider group of employers. Key developments here include the following:
Approximately two-thirds of employers in the UK pay some form of bonus to at least a proportion of their workforce.
In 2001, just over three per cent of gross weekly earnings were made up by some form of bonus or incentive payment.
While interest in team bonuses is growing, recent surveys show that between eight and 22 per cent of employers are using them with a proportion of their employees. Interest is particularly high in the Civil Service, where HM Treasury are keen to extend its use to incentivise delivery of targets.
Traditional forms of bonus plan such as piecework and productivity-based schemes have been phased out in recent years in the UK as multi-factor bonuses have become increasingly prevalent. These schemes reward a variety of dimensions of performance e.g. both sales volume and customer retention, in an attempt to ensure employees do not maximise performance on one measure to the detriment of others.
Although still a minority pursuit, ‘gain-sharing’ schemes (in which employees share the benefits of costs and efficiency savings through formula-driven bonuses) remain a feature of reward in manufacturing organisations.
Many unions, while initially sceptical of bonus and incentive schemes, have accepted their introduction as they have been used as a way of boosting earnings in a time of low inflation-related settlements. However, unions remain wary of these schemes becoming too embedded for two main reasons. First, they still prefer to see payroll increases being focused on basic pay rather than non-consolidated payments. Second, such bonuses are only rarely pensionable.
What works best?
The Work Foundation has been involved in the design, implementation and evaluation of reward and incentive schemes in both private and public sector organisations. In our experience, the ten keys to success include:
1. Clarity about the place of bonuses and incentives alongside other components of remuneration (base pay uplifts, individual PRP, share ownership etc).
2. Visible senior management commitment to the principle and practice of bonuses and incentives.
3. Clarity over the definition of a ‘team’ for the purposes of team incentives.
4. Clear eligibility rules: especially rules governing poor performers in team bonus schemes. It is important to avoid concern over freeloaders.
5. Consultation during design.
6. Simple, objective and achievable (but stretching) performance measures.
7. Clear line of sight for employees: high level of awareness of how they can directly affect the measures that will determine their bonus.
8. Regular and reliable communication about progress on rewards.
9. Training for line managers in the operation of the scheme.
10. Monitoring and evaluation of the scheme against ‘success’ criteria (cost; impact on performance, and on morale/motivation; perceived fairness, etc.).
The operation of such schemes may not be without problems. For example, employees are often concerned that managers will move the performance goalposts part way through the year. For some employees the performance measures they are chasing may seem over complicated, remote from their influence or unattainable. In some cases line managers may not be in agreement with the principles of bonuses and incentives and undermine their effectiveness, which leads to under-performance.
Emerging evidence suggests that carefully constructed and simple bonuses and incentives can significantly increase commitment and productivity. They can improve employee identification with the goals of the business and can incentivise improved individual or collective effort and achievement.