The compensation administration life cycle
The annual cycle of managing an organization’s expenditure on human capital is parceled into business processes that take place at annual intervals. Salary.com looks at each of these processes and the potential to provide value through automation as part of working within a pay-for-performance framework.
Although practices vary, approximately 75 percent of organizations administer performance and compensation management on a calendar-year cycle. Employers that review employee performance and compensation on a common date typically are interested in linking rewards to the performance outcomes of the organization, while those that review employees on their anniversary typically are focused on the individual’s traits. Figure 1 illustrates the pay-forperformance life cycle.
Goal setting and monitoring
The performance period, which is typically one year in duration, begins with goal setting. Employee goals may be rendered from the top-down, whereby the process begins with goals at the overall corporate level with company executives communicating performance expectations for the year to subordinate managers. Once corporate goals have been established, then each business unit, division, or department, may create its own goals from those that are cascaded downward through the organization. In some organizations, goals are cascaded to the extent of teams or individuals, who may shape these objectives in conjunction with their managers. The process may tolerate flexibility such that goals and targets are sometimes adjusted during the performance period.
Many organizations struggle with the challenge of setting reasonable goals using the appropriate performance measures. Consider that when the goal setting process is extended deep into the organization, managers’ understanding of business drivers and employees’ visibility into organizational performance are less clear.
Training and development
Professional development initiatives are composed during the goal-setting process to focus individuals on improving competencies that relate to high performance of the job, function, or leadership. An employee might be assigned development activities such as completing training programs, project management roles, and other initiatives aimed at professional growth and career paths.
Market research>
As the rewards for the previous year’s performance are delivered subsequent to the review process, the compensation team begins a new annual compensation cycle. The first order of business is to participate in surveys that provide coverage of the company’s jobs and recruiting markets. Survey participation affords a lower cost of the survey report. Three months is a typical turnaround time from participant data submission to receipt of the survey report.
Market pricing
The corporate compensation function typically participates in multiple survey products that are used to develop a consensus of competitive pay practices for a given job in a particular recruiting market. Recruiting markets may be defined by industry, company size, and geography. Recruiting markets may differ from the company’s profile. For example, an insurance company in Boston, Massachusetts that recruits claims analysts may define its recruiting market as the healthcare industry because that is the top employer in the area.
The corporate compensation function uses its survey reports to conclude the market range of pay for the majority of the company’s jobs (i.e., benchmark jobs). Non-benchmark jobs may be slotted between benchmark jobs that have comparable elements such as years of experience, education requirements, and reporting relationships. The result is a job worth hierarchy and an assessment of the extent to which the employer is realizing its pay philosophy.
Compensation analysis
This paper is primarily concerned with the administration of salary increase programs and incentive payments in a pay-for-performance context. However, it’s much easier to administer rewards if there is an articulated pay philosophy and an updated pay structure. Moreover, to hold up under scrutiny, pay practices need to stem from an articulated pay philosophy that is defensible and consistently applied. Although many organizations of various sizes administer pay programs without formal salary structures or market analysis, such employers often cite challenges with undocumented compensation practices. Those challenges include a difficulty in responding to auditors’ requests and a perception of unfairness among employees.
Figure 2 demonstrates the relationship between internal and external equity. The red curve represents the midpoint-to-midpoint progressions along the salary structure. The green curve overlays the composite market reference points for each salary grade. The boxes show the min, mid, and max of each grade; and the dots represent incumbents’ actual base salaries.
Pay structure management
Pay structures are a system for defining the relative levels and values of different roles. The compensation team evaluates jobs in terms of their relative worth to build pay structures using the market survey data plus internal data. An emerging practice is to develop total cash structures that reflect the market ranges of pay that include the cumulative value of base salary plus other annual cash payments such as a bonus or incentive. Benchmark and non-benchmark jobs are assigned to the structure based on their relative worth in the external marketplace and then adjusted to reflect the internal value that the company places on key jobs. Organizational elements within the pay structures, such as grades, are often used as the basis for eligibility requirements for other human resources programs such as incentive plan eligibility. Therefore, it is essential to keep structures current and accurate.
Pay program design
Compensation budgets are often due shortly after the market pricing initiative. Companies will examine the variance between their actual employee pay practices and the market. Analysis of the variance may be used to establish compensation adjustment budgets such as merit increase percentages and incentive plan funds. Equity adjustment programs may be budgeted separately, so that managers don’t have to use money intended to reward merit for purposes of keeping pace with the external employment markets. Merit budgets are developed by accounting for the survey respondents’ expectations about salary increase trends.
Developing a merit program
After the merit budget has been set, the compensation team develops merit programs that provide guidance to managers for allocating their budgets.
In decentralized, entrepreneurial environments, managers are often given considerable latitude in allocating the merit budget, and there may be fewer levels of approval than in organizations with more structured programs. The challenge in such organizations is to ensure that managers distribute increases fairly and without adverse impact on one or more protected groups. Strong data analysis and reporting capabilities are paramount.
A more typical approach is to develop one or a series of programs with eligibility requirements depending on location, organizational unit, level, job, FLSA status, and other factors. Someone might be required to have been hired on or before a certain date in order to be eligible for an increase, or there could be a minimum number of hours worked in the year. The budget for the executive program might be different from the budget for the broader employee population. Similarly, there might be different budgets for each country, business unit, etc. The number of merit plans also varies by industry, business strategy, and other considerations.
Unions often have their own separate salary increase plans based on criteria other than merit (cost-of-living adjustment, step increases, time in job, etc.). Equity adjustment programs often seek to keep employees at or above the salary range minimum or above some minimum market index. Many employers also create separate budgets and guidelines for promotional increases. For example, depending on the employee’s demonstrated proficiency, he or she might be brought to the minimum of the new grade’s salary range; or promotional increase guidelines might be expressed as a percentage of the incumbent’s current base salary.
The merit matrix (see Figure 3) is a tool that can help communicate program guidelines to managers. On one axis might be the overall performance review score, or a subset of the score. Some employers use guidelines based only on performance, without taking into consideration internal or external equity. Others add a second axis to the merit matrix to represent comparatio (the ratio of incumbent’s base salary to the salary range midpoint), position-in-range (the percent penetration into the salary range), or market index (the ratio of the incumbent’s base salary to a market reference point, such as the median).
Separate merit matrices are often developed for each of the merit programs, taking into account the overall matrix that was used to model the merit budget. The merit matrix, however, usually models minimum and maximum guidelines for each combination of performance and pay, while the merit budget matrix uses a middle value for modeling purposes.
In addition to determining the ranges for the different awards, it is also necessary to set guidelines for managers to use in creating their recommendations. For example, the program should address questions such as:
Pay guidelines communicated to managers
After the pay budgets have been approved, they need to be parsed out and given to managers along with guidelines about the types and amounts of increases that are permitted at different levels of performance and internal/external equity. For example, managers might be given a 4 percent merit budget, meaning they can allocate up to 4 percent of subordinates’ basic payroll. Usually there is no merit budget associated with open positions.
Organizational hierarchy confirmed
Most employers use their HRIS or ERP to track reporting relationships between employees and managers. As individuals move from one position to another, this reporting relationship must be updated. Before performance and compensation planning can begin, it is critical to confirm that the system of record accurately reflects employee reporting relationships. Reasons include the need for managers to have full and accurate budget information; and the desire to prevent people from inadvertently seeing sensitive information for which they are not authorized.
Performance review process
Throughout the performance period, managers and employees may be tracking progress toward the goals set at the beginning of the period. In addition, employees may have completed various training and development activities considered critical to enhancing competencies and preparing for more responsibility. Results of those goal programs and training and development programs might form components of the performance review. Many organizations initiate the annual review process by requesting employees to complete a performance self-assessment. Subsequently managers add their observations and ratings to the review. The completion of reviews may be facilitated by self-service technology; however, technology must not replace the dialogue that is necessary between managers and their employees regarding performance.
Relating pay and performance
The concept of pay-for-performance may begin at the executive level, and be extended to the broader employee population via inclusive incentive plans, merit plans based on performance, and other rewards programs. Many organizations have found that linking reward programs to performance enables them to achieve better differentiation between the best performers and everyone else. In such organizations it is typical to place a greater emphasis on variable compensation, often using incentives that are based on achievement of goals. Such employers typically find that there is greater alignment between organizational objectives and the efforts of employees, including individual contributors.
Different groups within HR may administer the pay and performance programs. Their work overlaps in several ways. For example, organizational development is concerned with ensuring sufficient availability of talent by determining what competencies and talents are required to support the organization’s strategy, identifying people within the organization who have or are developing those competencies, and measuring and developing those competencies as part of leadership development and succession planning.
Compensation professionals identify the relationships among jobs in the organization, group those jobs into comparable grades, and set salary ranges for those grades commensurate with the proficiency and performance levels people exhibit as they progress through the career path.
Business managers, of course, are concerned with the application of people’s talent to the achievement of business results; and with administering appropriate rewards to recognize those achievements.
The crux of effective pay-for-performance programs is in bringing these three disciplines into synchronization. Performance reviews, salary reviews, and incentive reviews are the occasions for bringing the cycle of excellence to its annual conclusion.
The performance review or performance appraisal is a snapshot in time whose purpose is to measure an employee’s level of proficiency and results achieved, typically once per year but sometimes more frequently. Performance reviews often include forward-looking development plans and goal programs that set objectives for the following year.
Salary reviews determine the level of someone’s base pay for the coming year, taking into account the employee’s current base salary in relation to others in the job, others in the grade, and the amounts comparable employees are paid to do the same job in comparable organizations.
Rewards
Rewards programs may be linked to performance review outcomes. In pay-for-performance environments, base salary increase recommendations and incentive payments may be contingent upon the overall performance review score, or the rating the employee received on certain sections of the review, or even the rating from a special program such as a training or development program. Managers allocate their budgets by reviewing the program guidelines and using their discretion. Managers’ recommendations are approved by various levels of management, set as final by the human resources team before being communicated to and acknowledged by employees, and recorded in the payroll system. The payroll effective date might be in the March timeframe. (A tax deadline of March 15 applies to certain incentive programs.)
Types of compensation awards
Not all rewards are increases to base salary. Even some base salary adjustments are delivered in the form of a bonus and not based on a dimension of performance. The following are some of the common types of rewards.
Reporting, analysis & auditing
At the conclusion of the cycle, organizations review various metrics to determine adherence to budget; average increase sizes; performance review scores; internal versus external equity; and other measures. The new compensation data then becomes the starting point for survey participation as the new cycle of excellence begins.
Other Considerations
Timing
One of the most important decisions in compensation administration is the timing of increases. We see a heavy emphasis on an annual focal review that takes place at the end of the calendar year. We see declining use of anniversary-based reviews, principally because of the difficulty in administering budgets. Proponents of anniversary-based reviews report that they enable them to focus on performance year-round; but goal programs can be even more effective at serving this purpose.
Decentralized organizations and those that have grown by acquisition often have both anniversary and focal reviews; they may also have multiple focal periods if their divisions have different fiscal years. For ease of administration, some organizations review different portions of their population at different times of year – for example, nonexempt employees at the midyear mark and exempt employees at year-end. In such organizations, different pay programs are active or inactive at different times of year.
Recent hires may receive more than one increase in their first year. A 90-day or 180-day review might include a pay increase. Similarly, employees who are at risk of leaving are sometimes given counteroffers or market adjustments to prevent undesired turnover. These increases are often called off-cycle adjustments.
Some organizations in which employees’ performance is reviewed more than once per year also permit more than one pay increase per year. This practice is more prevalent during market upswings.
Increases may be prorated for date of hire, transfers, leaves of absence, and other reasons.
International considerations
Multinational organizations face additional challenges in designing and administering pay-for-performance programs. The following are among the considerations in international pay-for-performance.
Compensation analysis
In many organizations, the most challenging phase of the annual review cycle is the reporting and analysis requirements after the salary recommendations have been submitted. Almost every role in the organization, from the employee to the compensation committee, is interested in reviewing relevant information about compensation planning. Before the introduction of automated compensation planning systems, these budget rollups and ad-hoc reports were created using spreadsheets. The process was error-prone and time-consuming.
The following are some of the analytical requirements we typically see for compensation planning.
MetricsImplementing a Pay-for-Performance plan
Compensation plan design and administration involves a careful balance of art and science. A program might be very well engineered: the model might accurately reward the desired behavior to drive organizational results. Yet if the plan is overly complex and difficult to communicate or administer, it is unlikely to succeed in motivating that behavior.
Therefore, to ensure the success of a pay-for-performance plan, it is as important to think through the required training, communication, and administration as it is to develop a sound, well-balanced plan.
Training for Managers
Within organizations that are unaccustomed to differentiating levels of performance or rewards, the introduction of pay-for-performance plans can involve a cultural shift. Managers may initially be reluctant to distinguish top performers from everyone else, or they may be concerned that there is enough of a merit budget to go around.
Yet one compensation executive recently described a measurable, statistically significant change in the distribution of review scores – and rewards – a few years into a pay-for-performance program. The average increase for the average performer actually went up, not down as some had feared, as the distribution of scores shifted toward the middle. Mathematically, the merit model could be reworked to anticipate fewer of the top scores, fewer of the next-highest scores, and many more scores in the middle. The merit guidelines in turn could be moderated for employees in the middle of the curve – while preserving or even increasing guidelines at the upper end of the performance scale.
We see companies providing more training in compensation basics. In an era in which compensation market data has become prevalent, it has become more customary to share not just salary structure control points, but also market reference points, with line managers. More managers (and employees, for that matter) now understand compensation market pricing – selecting data sources; selecting a benchmark job; selecting the appropriate comparable industry, size, and geographic scopes; selecting a reference point that fits the pay philosophy; and then determining how an incumbent’s pay should compare to the market given his or her level of proficiency, performance, and potential.
Training in pay-for-performance should emphasize the principles and the content of the program, not the mechanics, to the extent possible. Simple, intuitive automated systems that manage pay-for-performance can separate the signal from the noise and thereby help reduce the amount of administrative training required to roll out a new program.
Employee Communication
The goal of compensation management, according to WorldatWork, is to support an organization’s efforts to attract, motivate, and retain top talent. A critical requirement for success, therefore, is to communicate the purpose and the intent of rewards programs to employees. Employees should understand when and how their performance is being measured, what it’s being measured against, and how their base pay and incentives are linked to that performance. They should understand what types of rewards they’re eligible for, as well as the criteria for achieving awards of different sizes.
Without adequate communication, employees might have lingering questions about their increases. For example, one employee recently asked an online networking group for help in putting his 3 percent raise into a context. To him, the award seemed small, and he wondered whether he should be looking for another job.
At the other extreme, an employee who receives a 10 percent raise this year might expect another 10 percent raise next year. However, an employee who receives a 3.5 percent merit increase and a 6.5 percent market adjustment this year might have a more modest expectation about the size of next year’s increase.
We’re seeing more widespread use of employee compensation statements, also called total cash compensation statements or total rewards statements (see Figure 6). The contents of these statements vary. The example includes some employee statistics such as date of hire and reporting relationships; current and proposed award amounts; and a comparison of the employee’s pay to the salary range and to the market. Sometimes these statements include a covering letter or memorandum from an executive; a total rewards statement including the value of employee benefits; and a more extensive pay history.
Administration
The administrative burden of a pay-for-performance program can be mitigated to a great extent by the use of automated compensation planning and performance management systems. The following are among the administrative considerations involved in supporting a total rewards program.
Systems
One of the most important considerations in rolling out a new compensation plan is the means of administration. Many organizations report that they intend to link pay and performance, but find administrative challenges in creating that link because of the limits of word processing and spreadsheet software. Automated systems can dramatically improve the ability to link performance and pay – practically and conceptually. Our experience has been that before automating compensation planning, clients expect the most dramatic return on investment to come from business process automation; but after the implementation, they report that better reinforcement of pay-for-performance objectives is the most valuable benefit of automation.
Some organizations introduce the new plans first, and the automation project follows in the second year. Others introduce the plan and the system during the same cycle. The following are some of the considerations in determining what type of system to use.
Homegrown systems built in more advanced programs such as database packages often meet or exceed business requirements in their initial years. But without a strong program to maintain and upgrade these tools, they become obsolete more rapidly than systems offered by vendors who have a commercial incentive to remain best-of-breed.
ERP and HRIS vendors have a vested interest in automating as many business processes as possible, often with the support of internal information technology departments. Such systems are often so complex that the vendor’s name has found its way into clients’ job descriptions or even job titles. The expertise of enterprise software vendors is often broad, but not deep. Implementations can be drawn out over years with much customization of the application. As a result, the pricing model often does not provide a compelling total cost of ownership to small and midsized firms.
Best-of-breed vendors in talent management provide both compensation planning and performance management modules. Their services are typically offered on demand, that is, over the Internet; although a few vendors provide on-premises models. State-of-the-art security protocols comparable to those offered by online banks and retailers, combined with immediate upgrades and short implementations (typically less than three months) are among the reasons software-as-a-service (SaaS) has become the preferred means of delivering talent management systems. Technology analysts including Jim Holincheck of Gartner endorse and recommend the SaaS model for human capital management.
Conclusion
Adopting a pay-for-performance approach to compensation planning and administration can dramatically improve organizational results and attract, motivate, and retain top talent. The most effective pay-for-performance programs are complete systems, where the interrelated objectives of organizational development, compensation, business units are brought into synch. Automated solutions enable organizations to reduce the margin for error in delivering rewards as well as improve the productivity of rewards programs by enhancing the link between performance and pay.
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