Merit looks back. Let’s look forward.

Attention rewards thinkers.

We have been “paying for performance” for decades, giving “merit” increases. This is way better than not differentiating. It is a legal basis for differentiating pay and a smart one. But merit pay is backward looking, focusing on KPI achievement and other aspects of “performance” the last 12 months. We should be paying for retention of future performers. Past performance is a consideration, but future performance is better predicted on the basis of potential, competency, mastery or other attributes of the person, and not simply last year’s results. Like value investors, we should put our money on people (like stocks) that we feel are undervalued relative to their future performance.

Let’s break it down.

My business school class on salary administration back in 1985 used a textbook called “Compensation Management: Rewarding Performance”. It featured the following diagram:

Seriously? While behavioral psychology “works” with laboratory animals, I am not sure the above model fully explains human work performance (and the textbook did not claim it fully explains performance.) Yet we have designed our pay for performance practices on the concept of positive reinforcement. Employee performs, employer rewards him. The reward stimulates more performance, and so on.

Let’s flip it around.

Let’s say you start a business and employee salaries are paid with your money. You hire two people and one of them, Richard, is far more productive than the other, so a year later, you give a big raise to the Richard. You give half as much to Carla. The following 2 years, same thing. But after three years, “rocket” Richard is out of fuel. Seems his long hours have caught up with him. He settles into an easy going pace, but makes sure new employees know he was the first employee.

Meanwhile the other original hire, Carla, has been learning, thinking, imagining a few ideas for how to serve customers, etc. One of those ideas works well and while Richard tries to take some of the credit, everyone including you knows Carla came up with the idea. Carla is now suddenly “on fire” but more importantly she is generating new ideas almost monthly, while Richard seems to be living in the past.

It’s your money, what do you do? Richard is making 15% more than Carla.

If it’s MY money, I will give Richard nothing and have a very frank discussion with him. I will give a very large increase to Carla, because I can’t afford to lose her. She’s my MVP, or to be more accurate, my MVT, most valuable talent.

Contrast that with modern corporate merit pay where it’s company money and managers don’t like having unpleasant conversations with people like Richard who were superstars in the past. Merit pay focuses almost entirely on the past 12 months, starting with a standard budget %, then bumping it up or down just a bit in relation to the performance rating. It is a looking back process. It is based on behavioral psychology, just like most of our bonuses. Except we don’t repeat bonuses forever… a raise is forever, since the new salary is the basis for next year’s raise. (Merit pay is the best residual income scheme ever invented!)

A raise is forever, since the new salary is the basis for next year’s raise.

Talent Value

Let’s look forward, like investors do. After all, are we not investing in human capital? If salaries and training dollars are an investment in a person’s future performance, why do we design our pay reviews around the past?

Investors move their money when the big investments of the past stop performing. When earnings fall and the share price is high, maybe it’s time to sell and invest in a lower-priced company stock that is likely to outperform it’s peers in the future. Investors who focus on finding low-priced future performers are called value investors. They look at price-to-earnings ratios or “P/E ratios the way we look at compa-ratios, except that compa-ratios do not consider likely future performance. Instead, we pair up compa-ratios with ratings of past performance.

Let’s apply investment logic to our pay decisions.

When “value investors” see new, disruptive companies coming along with game-changing advantages, they dump their high-priced under-performing (high “PE”) stocks and put their money into the value stocks. What do they look at? Amazingly, they can look at Trailing P/E which looks at the past 12 months, as well as Forward P/E which is the expected return in the coming 12 months. Isn’t this exactly what we need to do? Let’s learn to be more like talent value investors when making pay decisions, not that we would “dump” a person like an investor would dump a stock, but rather we must recognize when a person is paid too much for their value, relative to other people who may be paid too little relative to theirs.

We are undergoing a fundamental transformation in the area of pay for performance, toward a broader view a person’s value to the organization, or specifically the value of their talent, i.e. talent value. We must also take a broader view in our salary guidance.

Do we need to drop performance ratings? As far as pay is concerned. no. We can continue using ratings as one consideration, but no longer the main consideration. We can also use ratings of the past 12 months in differentiating bonuses or to support recognition. The rating and compa-ratio (salary divided by salary range midpoint) together tell us a person’s “trailing P/E”, i.e. how they performed the last 12 months relative to their price. Our traditional merit matrices reflect the trailing P/E concept exactly.Merit Matrix

As you can see, the traditional merit matrix, or salary increase guideline, guides managers to give bigger increases to those employees who are making less (low in the range) and/or who have a higher performance rating for the last 12 months. My personal estimate is that at least 80% of Fortune global 500 companies have been using such a matrix to guide managers in making annual salary review decisions the last 25 years.

The question now is whether we can revise a salary review matrix along the concept of “Leading P/E”, considering expected future performance, instead of past performance. The answer is yes, and we are already doing it in the form of talent review and succession planning. We just need to link it to pay.

Pay for Talent Value

I have had at least 200 conversations with HR and reward leaders the last three years about the move away from ratings (in the tech and white collar sectors, mainly) and toward more future-looking approaches that also reduce individual competition for scarce ratings. I have been designing pay for performance (P4P) systems for companies since 1991 and have guided annual reviews for hundreds of thousands of employees in over 100 countries. If there is a better way, I need to find it.

These discussions—along with my firm’s research, much thinking, reading (especially David Rock and Daniel Pink), attending conferences and other inputs—have led me to a new, simple salary review matrix design to guide managers in their annual pay review decisions, based on consideration of 1) performance, looking back and 2) retention, looking forward. I call these P-Rating and R-Rating. Together, this holistic view of the value of a person’s talent can be called Talent Value, a term some respected companies are starting to use.

The P-rating is no different from your current performance rating, looking at the past 12 months.

The R-Rating indicates how a person is paid relative to their talent value, i.e. how important it is to retain them and whether their current pay reflects it. Someone who is paid very well, yet is not critical to retain would have a low R-rating. A person who is paid low for their job yet is critical to retain would have a high R-rating. Essentially the manager must judge what the person’s target compa-ratio should be, and compare that to the actual compa-ratio.

What about compa-ratio? It is still very important. Compa-ratio is a good indication—regardless of what country or job you are in—of whether a person is at risk of leaving over salary. Critical talent—talent you cannot afford to lose—should have a high enough compa-ratio to put them out of reach of other potential employers.

R-Rating (retention) takes compa-ratio into account.

So here is the new Pay for Talent Value or “PayTV” model as I call it:

The first thing you will notice is that there is no Compa-ratio. Actually, the CR is a consideration in determining the R-Rating. The ability to retain talent has a lot to do with how well you are paying them. The Rating reflects whether you are paying someone well enough considering their talent value.

Ignore the percentages, they are only indicative here, and must be calibrated for each organization, as a reflection of the company’s pay philosophy, and of course the budget, number of ratings and degree of differentation desired.

I mentioned ratings, yes. If your organization considers past performance as an important factor, then use them, at least for bonuses, where at least you are not paying a person forever. But if you no longer use ratings, not to worry. There is a variation on this matrix, which does not look at the past. Instead you use Compa-ratio and R-rating only, where the R-rating reflects a person’s “target” compa-ratio based on their value.

Communicating a Pay Decision

Managers must communicate their pay decisions, no longer focusing on the past, but focusing on the future, with due consideration of the recent past. They should talk about the needs of customers, the needs of the business and the talent that is critical looking ahead. They should not talk about a person’s value, but rather their talent or talent value, otherwise people could take it personally. The manager can discuss (and should already be discussing) development and building job competence with each team member, so linking pay to future value—driven more by competence than by past achievement—should be a natural fit with the manager’s role as coach and grower of talent. If your managers are not able to do this, help them. Going forward, select managers who understand growth and development, and who have the courage to give little or no increase to people who insist on living in their past glory, who believe loyalty is all that matters or who refuse to learn new tricks.

Organizations in all industries are now talking about forward-looking, team based rewards. Incentives and recognition are wonderful ways to reward individuals or teams. But base salary is not, and should not, be team based, unless you have self-directed work teams where people rotate roles on a regular basis. Base salary competitiveness heavily affects talent retention. It is certainly possible to manage salaries in relation to future talent value.

Is your organization looking this type of approach? Let’s talk. I will be happy to collaborate with you to pilot test this approach, to build a success story. Please comment and let me know what you think!

3 thoughts on “Merit looks back. Let’s look forward.

  1. Hello there,

    Even 2 years passing, but fortunately for me that I found your type of pay approach when my company are in struggle with heavy labor cost and biz downing. I am looking for a framework to apply for my situation as follows:
    – In talent war if hi-tech in emerging country
    – More than 1000 headcount
    – Optimization period due to biz down ( have o profit for 2 years and no new products launching. We are in Game Industry)
    So I would like to know more about your approach and do hope to receive your sharing.

    Thank you very much for your sharing.

    Best Regards,
    Kat Tran

  2. I am glad to find out your thoughts on this topic as I have been lately thinking about the same. I have even started a discussion on linkedin to find out what other C&B professionals are doing to improve the pay increment matrix since it’s quite one dimensional and over reliant on P Ratings. Another problem with with pay for performance concept is that its generally linked with performance bonus and increment resulting in double reward for the same factor.

    You rightly said that while making a pay decision performance is only one of the many factors which should be considered simultaneously because that is how actual conversations pan out in real world. Hence, I was thinking to convert this 2D model into a 3D model with the help of a 3rd factor i.e. employee potential (which is also forward looking and represent many underlying sub-factors i.e. criticality to retain, competence and future value creation). Since I could not come up with the 3D version so I decided to use a different and simpler approach i.e. combined weighted score between performance and potential ratings and then put it against the Compa-ratio to determine the % increase. The a toned down weighted score for performance rating will also reduce double reward issue if the performance bonus is also paid on performance rating.

    There are other factors such as index pay, pay compression etc. that are not accounted for in the pay increment matrix so I think we need a more comprehensive approach to determine a salary increment that can lead towards an “Ideal Pay”.

    Let me know your thoughts on this.

    1. Muhammad, your ideas are sound and your 3-dimensional idea is a good one, if managers (or AI, perhaps—keep an eye on TalentCode) can rate them. The idea of multiple vectors came into my head back in January, but I’m not quite sure how to develop that idea. You are making a real contribution here.

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