Sunday, 3 April 2011

Pros and cons of variable pay and incentives

The development of reward management practices helps employers to determine what they are willing to pay to their employees. Nonetheless, employers will be able to do that only after having determined what they consider as most valuable and important for their organisation and what type of contribution their employees should yield for the attainment of organisational success. By means of reward management organizations should basically favour and encourage those behaviours and actions which expect would help them to effectively and consistently achieve their aims and objectives or, more specifically, their strategy.

Contingent or variable pay, which can be provided for individuals, teams and organisational performance as well, linking financial rewards to those factors which most likely should be valued the most by employers, namely performance, competence, contribution and skills, is intended to help businesses to both determine what they value the most and what they are prepared to pay for it (Armstrong, 2006).

Performance and contribution-related pay represent the contingent pay methods most extensively used by employers to reward their staff, whilst service-related pay, which albeit being linked to the length of service can be extensively considered as a form of contingent pay too, is still mainly used in some public and voluntary sector organisations.

When a contingent pay scheme is used salary is habitually formed by two components: a fixed element, usually known as base pay, and an additional, variable component which is usually provided in the form of one or more lump sums.

Sometimes contingent pay is consolidated into base pay becoming, as such, a normal component of salary and losing its typical feature of “pay at risk” or performance-based reward which needs to be re-earned each year. This feature is, by contrast, maintained when this variable component of pay is provided in the form of a lump sum. In this case in fact whether the individual’s performance should deteriorate in the following year(s) his/her salary will decrease accordingly.

As a general rule, the practice of consolidating variable pay into base pay should preferably be avoided in that this method risks making it even more difficult for employers achieving their business objectives. Once this approach is used, individuals might lose sight of the link existing between this component of pay and their performance, would take thus this payment for granted and no longer as an addition which needs to be re-earned every year.

Putting aside any consideration about the motivating effectiveness of variable pay, it is absolutely normal that individuals may behave differently according to the circumstance that a component of their financial reward is variable or otherwise. Whether this originally flexible component of pay would be converted into a firm part of salary, there would not in fact be any particular apparent need for individuals to go the extra mile. In such a circumstance, employees should possibly find the reasons for performing at their best everywhere but in the variable component of pay.

The actual payment of the variable component of pay should rather be invariably, directly linked to the achievement of a particular personal or group objective agreed at the beginning of each year between employees and their Line Managers. Albeit directly linking the attainment of a pre-set objective to the payment of a variable component of pay might produce no effects at all in terms of motivation, this should if anything help managers to have specifically important works properly done.

A relatively recent survey, carried out amongst more than 500 employers in the US by Aon Hewitt, revealed that three-quarters of businesses expect to reach, or even exceed, business performance expectations, which accounts for pay and variable pay budgets to remain stable in 2011. Just a few companies anticipated the implementation of drastic pay freeze policies in order to reduce the personnel budget. The research also shows that nearly two-thirds of employers did not change their original base salary increase budgets, confirming that base salary increases, stabilising at sub-3 percent, will not return to pre-recession levels anytime soon.

Variable pay, accounting for 11.6 percent (and just a measly -0.02 percent compared to 2010) of salaried exempt workers’ payroll (that is, workers for whom overtime rules do not apply) seems to be, by contrast, destined to firmly holding on in 2011.

Ken Abosch, development leader in Aon Hewitt's Broad-Based Compensation Consulting Practice, said that the findings of the investigation suggests that, downturn notwithstanding, employers have invested in variable pay during the last three years as they have never done before. With the aim of rewarding staff in order to encourage strong individual and business performance, organizations are also likely to continue having recourse to reward management approaches based on variable pay also in the future. The main objective of such a choice seems to be fairly clear; employers want their employees to know that they are willing to provide them extra cash, provided that these effectively contribute to the organisation’s achievement of strong results.

In order to effectively implement contingent pay schemes, employers should first and foremost identify which factors they intend to link to the payment of the variable component of salary: performance, contribution, skills, results, competence or whatever else. Once these factors have been clearly identified, employers should determine the method to measure and assess these KPIs, safe in the knowledge that the more objective the method selected is, the fairer the rewarding approach will be perceived to be by individuals.

The measurement and assessment of the factors identified can hence be expressed by ratings, which by means of a formula enable employers to calculate the amount that has to be paid to the employees. Employers could also decide to determine the payments on the basis of a broader assessment method, rather than by mathematics formulae, but in this case the method could be prone to be deemed subject to bias and subjective, rather than objective, appreciation.

According to Brown (2011), there are basically two main reasons for variability being considered so important by employers in the current economic landscape. One of them is essentially represented by the flexibility it allows businesses in terms of rewarding policies. Reducing in fact the base pay component of reward, employers will be in the position to control the personnel budget when the organisational performance drops without any need to resort to jobs cut. In contrast, employees will be able to cash in on financial gains during prosperity periods.

The second reason for employers preferring having recourse to variable pay programmes is linked to their concern for retaining and motivating high fliers, especially when they are experiencing difficult times. By means of variable pay schemes they can redirect more of their pay and bonus budget in order to ensure these individuals are constantly properly remunerated.

The fact that variable pay and incentives might be considered an effective long-term motivator can be indeed considered questionable at best. Although it cannot be excluded that variable pay can have some positive motivating effects in the short run, it is nowadays rather widely recognised that extrinsic motivators cannot produce valuable effects to this extent. It is just for this reason in fact that organisations are shifting their approach towards total reward models which, by means of the intrinsic/non-financial motivator component these entail, are likely to produce more effectual long-lasting motivational effects (Total reward – What should be considered before addressing the issue).

Considering the motivational effects of contingent pay, as warned by Armstrong (2006), a distinction needs to be made between financial incentives and financial rewards.
Financial incentives - aiming at making aware individuals of the money they will receive in the future whether they perform well, are considered as direct motivators. These are essentially granted on the basis of the hypothetical promise “Do this and you will get that”. Sales incentives are a typical example of financial incentives.
Financial rewards – in contrast, representing a tangible recognition of specific achievements, are considered indirect motivators. As showed by the expectancy theory, individuals feel motivated whether they expect that what they attain in the future produces valuable results which are as such appreciated and valued by the others.
Financial rewards can both be prospective and retrospective. Prospective reward is to some extent based on gambling, the employer feels that since an employee has already reached an appreciable level of competencies and skills this will surely perform well in the future. Although the money the employer invests (or bets) on an individual is, in this case, partly justified by the level of competencies this has gained, it is nonetheless impossible to predict today how the individual will actually perform in determined situations in the future, especially whether the employer has never had the opportunity to practically test how the individual typically behaves in those circumstances or in that particular role. The move could even result counterproductive in the event, against all expectations, things should not work as planned, rewards would not be repeated, that is to say paid again, and this will clearly produce detrimental effects on the employee motivation.
People are usually prone to quickly forget the rewards they have received at earlier stages and are, in any case, expected to receive something more immediately after having yielded a good result. This is another reason for the prospective approach to financial reward being likely to fail producing the desired results in the short term too.
Retrospective reward is actually the most widely used method to provide staff financial recognition. It is based on the real situation “You have attained this result; hence we pay you this sum of money.”
Considering the benefits of the short term momentum that financial reward can provide, a mix of prospective and retrospective reward could reveal to be particularly appropriate and effective when appointing individuals for some complex projects or assignments, especially for those requiring some extra efforts during the pre-implementation phase. Providing individuals a lump sum at the start of the project or assignment and one soon after the successful conclusion of it is likely to be particularly appreciated by the individuals concerned.

Organisations whose culture, values and shared beliefs are inspired by productivity, performance, contribution and the recognition of the actual achievement of these, will find this method particularly useful to inspire integrity and effectively and consistently foster and consolidate their values and beliefs.

Supporters of individual contingent pay programmes resort to the existence of a supposed link between performance and reward to emphasise its motivating power, adding that contingent pay is preferable to just paying employees “for being there”, as it occurs in service-related reward systems (Armstrong, 2006).

According to the findings of the e-reward survey of contingent pay (2004), organisations habitually have recourse to contingent pay approaches for a wide range of reasons, namely to: improve organisational performance, attract and retain valuable individuals, motivate staff, influence individual behaviour, support cultural change, focus attention on key results and values and, obviously, to recognise and reward those levels of performance considered particularly valuable by the employer. All of these reasons, aiming at fostering performance and contributing to help organisations achieving competitive advantage, can actually be considered arguments to make the case in favour of individual contingent pay.

Amongst the reasons provided to support the introduction of variable pay schemes, many reward professionals have also suggested the “sorting effect” which these are likely to produce (Torrington, 2008). The sorting effect, differently from the “incentive effect” supposed to impact performance, is generated by the employer attracting (and subsequently retaining) valued individuals from the exogenous environment and offering to these generous financial reward packages. The circumstance newcomers receive such a higher level of pay should in turn prompt employees whom receive less generous reward packages, by reason of their unsatisfactory level of performance, to leave the business.

The provision of more generous financial reward packages to best performers only should indeed contribute to stimulate worst performers to improve their contribution level or prompt these to leave the business. In the mid-term, this apparently unforced process should by extension enable firms to count on a staff formed by good performers only and, more in general, by individuals effectively contributing to the attainment of the organizational objectives.

The idea underpinning this approach, however, should give employers food for thoughts; whether employees performing well are not financially recognised these may decide to leave the organisation (attracted, for instance, by the sorting effect generated by other organizations’ offers), businesses would thus risk losing their best performers (Torrington et al, 2008).

If the worst comes to the worst, the introduction of variable pay schemes based on real contribution and performance can produce somewhat of a natural process by means of which organisations can achieve a better labour distribution and allocation amongst their staff. Individuals who are able and willing to perform at higher standard levels are stimulated to move ahead in higher level jobs where they take growing degrees of responsibility on and provide superior contribution whilst being better rewarded. Vice versa, those employees whose level of performance is poor continue to fill lower profile, low-paid roles. In order to prevent this circumstance to clearly emerge, these individuals may very likely decide opting for alternative jobs and hence leaving the organization. All of that should consequently lead to improve the final quality of the overall output produced by the different organizational divisions.

Supporters of the expectancy theory are amongst those who consider incentives schemes useful to increase organisational performance and productivity. They believe that inasmuch as individuals are keen to produce more and better whether they are aware that other people value their achievements, individuals are also expected to receive in turn something they value. This position, nevertheless, is questionable at best in that it takes for granted that all the individuals invariably and equally value and appreciate extrinsic rewards, which as we will see later, is not actually true and cannot hence be taken as axiomatic.

In reality, the introduction of incentive payment systems in any organisations is not widely recognised as useful and as having positive impact on the organisation’s productivity and performance. According to Sisson and Storey (2000), for instance, many organisations have developed incentive schemes just for “ideological reasons”, that is, to impress stock markets analysts, reinforcing the role played by the organisation’s management and to void the role played by trade unions in the salary determination process. Albeit, they conclude, more often than not these reasons reveal to be completely ineffective in the long run.

Contingent pay programmes, especially individual incentive schemes, are not really immune from criticism. Contingent pay has attracted widespread criticism over time; one of the most relevant is certainly represented by the considerably limited impact individual contingent pay is expected to make on employee motivation. In general, financial rewards are in fact deemed to only produce a partial influence on employee motivation. These can help to avoid that things could go any worse, rather than prompting individuals to go the extra mile or induce discretionary behaviour (Herzberg, 1957). Whether managed inappropriately, pay can even act as a demotivating factor. Kohn (1993) suggests that money seldom enable employers to effectively influence their staff behaviour. Another criticism to incentives schemes is raised by Thompson (2000) who warns against the employee perception of incentive schemes as a further management control tool used to the detriment of individual autonomy and causing as such resentment and industrial conflicts.

Moreover, since individuals are different one another and differently react to the diverse ways they can be motivated, it cannot be taken as axiomatic that all individuals will be equally motivated by tangible rewards and let alone by the same type of reward. This is actually one of the main reasons for Total Reward approaches being considered of remarkable importance.

Individuals who are just motivated by financial rewards and who are thus expected to receive money in exchange for their performance will surely react positively to financial incentives. Fully complying with these extrinsic staff expectations, nonetheless, employers risk undermining the significance of intrinsic motivation; with the passing of time individuals motivated just by money could find it unpleasant to deal with their daily tasks and activities (Armstrong, 2006) and could therefore be destined to underperform. Additionally, employers supporting this employees’ attitude may to some degree contribute to abet these in this approach. Whether staff is used to receive money for everything they do, considering they work in an organisation to actually do something valuable and receive an annual pay for this, the result could be that in order to motivate staff employers should rise the worthiness of the incentives they offer at an increasing frequency, widening rather than bridging the reward gap with other employees with different attitudes but equal (or even superior) performance. In the mid-run, the risk is that everybody in the organisation may develop the same attitude towards financial incentives, which could ultimately undermine the stability of the whole organisation even in periods dominated by favourable economic conditions, not to mention the catastrophic effects such practice may lead to during downturn or grim financial periods.

Such schemes definitely “cause considerable additional costs” (Torrington, 2008) and as suggested by Cox (2006) are very likely to generate “costly side-effects.”

It is also extremely important to become aware of the likely effects an incentive scheme can produce according to the different areas and situations; as suggested by Torrington (2008), “there is a world of difference” between a system rewarding an additional 3 percent and one rewarding an additional 25 percent. An investigation carried out in the United States by Bartol and Durham (2000), for instance, revealed that the minimum salary increase capable to elicit positive long-term response has to be set between 5 percent and 7 percent of the current salary. A similar study carried out in Finland (Piekkola, 2005) revealed that beneficial effects on staff productivity can be generated by a 3.6 percent salary increase. The obvious conclusion of these investigations is that employers’ efforts will not produce any effect at all whether individual expectations are not adequately met.

These investigations could also partially explain the difficulties faced by public sector employers in motivating their staff, since they usually recognise incentives between 2 percent and 3 percent of current salary (Hendry et al., 2000).

Clearly these indications also need to be considered in respect of the times, in period of downturn or in a post-recession period where employees could consider themselves somewhat of blessed for having being able to keep their jobs, salary increases could be appreciated differently than it would be during periods in which the sun is shining.

Whether variable financial rewards can contribute to foster competition and enhance productivity and performance, the backlashes these may produce could reveal at times to be particularly detrimental for organisations. Financial incentives may possibly motivate some individuals, but could produce counterproductive demotivating effects on those individuals who do not expect further sum of money to perform well. In the latter case, financial incentives are even likely to cause counterproductive reactions, weakening and distracting individuals’ attention from the intrinsic benefits these receive whilst performing their tasks (Armstrong, 2006). In number the latter are likely to be more numerous than the former so that the negative impact on the overall organisation climate and performance could be particularly considerable.

In order to properly work, it is also mandatory that contingent pay schemes are based on accurate and reliable methods effectively and consistently enabling organisations to assess and measure performance and staff contribution to organisational success; methods which not always exist or are operated effectively.

The introduction of individual contingent pay schemes seriously risks jeopardising the efforts of modern organisations to implement organisational structures and working methods the more and more based on team and group working. Individuals who want to appear particularly brilliant, also to show their employer that they deserve the extra money they receive, could be tempted to work in isolation if not to be unfair or disloyal with the other team members, to the detriment of the final overall results that the organisation is expected to attain by the work produced by the whole team. This is possibly why team-based incentives are seen by some practitioners much better than the individual ones (Pfeffer, 1998 and Torrington, 2008).

Contingent pay schemes are all too often destined to fail because of the difficulties related to their effective and consistent management and implementation processes. Investigations carried out by Bowey (1982), Kessler and Purcell (1992), Marsden and Richardson (1994) and Thompson (1992) have all revealed that the reasons for failure are usually due to bad and ineffective implementation and to the lack of line managers’ preparation and capacity.

Line managers are of paramount importance for the implementation of every organisation’s strategy and policy and clearly contingent pay and incentives schemes, especially when implemented by means of performance management systems, make no exception.

In order to effectively work contingent pay schemes need the total support of LMs, who need to genuinely believe in the contribution of contingent pay to their organisation success. Line managers “can make or break contingent pay schemes” (Armstrong, 2006), so that they need to effectively contribute to their direct reports target determination and to the consistent and fair measurement and assessment of their staff performance.

LMs should also find the time, usually reported as one of the more recurrent reasons for managers actually not doing it, to communicate and provide feedback to their direct reports on the way the organisation’s performance management process works and on the influence it eventually has on their pay.

Finally, it can be said that as typical of many HR- and management-related issues, contingent pay programmes cannot be effectively managed resorting to the one-size-fits-all approach, their success or failure is in fact sorely depending on the different situations and contexts in which these are developed and implemented. This is also what actually emerged from the findings of a thorough investigation carried out by Brown and Armstrong (1999), which come to two conclusions: contingent pay cannot “be endorsed or rejected universally as a principle” and “no type of contingent pay is universally successful or unsuccessful.”

The study also confirmed that many organisations have experienced a lot of problems and difficulties, from the practical point of view, when implementing contingent pay systems.

Some studies (Huselid 1995; Lazear 2000; Piekkola 2005 and Gielen et al. 2006) let it transpire a correlation between incentives systems and performance, whereas others (Pearce et al 1985 and Thompson 1992) have revealed no objective evidence of any interrelation. Corby et al (2005) claim that although several investigations show the existence of a correlation between organisational performance and incentives schemes, there is indeed no evidence of a causal relationship between the two. Basically, also these studies and investigations come to the same conclusion as that cited above: the success or failure of the schemes essentially depend on the circumstances.

It can therefore be concluded with Torrington et al (2008) that failure is inevitable when the wrong scheme is applied to the wrong people, in the wrong circumstances or for the wrong reasons.
Longo, R., (2011), Pros and cons of variable pay and incentives, HR Professionals, [online].

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