The Pay-Off of Merit Pay

The subject of merit pay can evoke strong reactions from many within higher education. Yet, as more campus leaders learn that they cannot achieve their teaching, research, and service missions with mediocre performance, they are realizing that it’s their faculty and staff who differentiate their institutions and provide their competitive advantage. As more colleges and universities adopt a broad talent-management strategy to focus on retention of top employees, leaders are moving away from across-the-board pay increases toward offering performance-based pay or bonuses to highly productive faculty and staff.

The Case for Performance-Based Pay
Any large population of faculty and staff will typically contain the following mix of employees:

• Stars: top 5 percent
• Top performers: next 20 percent
• Solid core: middle 65 percent
• Consumers of resources: bottom 10 percent

With across-the-board pay increases, stars and top performers see no incentives for high achievement, since those who are under-performing benefit equally without contributing, thus rewarding and reinforcing poor behavior. Organizational productivity may actually decrease since there is no correlation between goal achievement and pay increases. Some institutions provide a cost-of-living increase and then have a small pool of money beyond that to reward performance. The difficulty with this approach is that low performers develop an entitlement mentality; subsequently, there is little money left to reward high performers.

One argument used against merit pay is that in hard times—as most institutions are currently facing—less than 2 or 3 percent may be available for salary increases. Thus, some argue that the money should be allocated across the board, since it is not worth the trouble to differentiate among employees. However, in an institution with 1,000 employees, that pool could be well in excess of $1 million. That $1 million becomes part of base expenses and increases benefits expenses. In tough economic times, any other investment of $1 million would be highly scrutinized and leveraged to provide the best benefit to the institution. Why wouldn’t an organization respond similarly in the case of performance-based pay?

Research extending back at least a decade suggests that merit-pay systems are worth the time and effort. In their 1998 published study, “High Performance Work Systems and Firm Performance” (Research in Personnel and Human Resources Management), Brian Becker and Mark Huselid compared human resources practices and outcomes in high-performing organizations with less successful organizations. They found that in high-performing organizations with advanced HR practices, 87 percent of the workforce received pay increases that were tied to performance. In organizations that were not as successful, only 23 percent of employees received pay tied to their performance.

These data are consistent with the common-sense knowledge that people want their work efforts to be recognized; high performers believe they should be paid more than those who don't perform well; and everyone who is carrying extra workload due to a colleague who can't or won't do the job wants the inequity to be addressed. In a September 2003 Society for Human Resource Management white paper, “Effectively Managing Base Pay: Strategies and Programs for Success,” human resources consultant Robert Greene notes that more than 90 percent of Malcolm Baldrige Award winners use merit pay as a primary tool to elicit and reward top performance. He also admits that an effective program can be “devilishly difficult to get right.” Even so, says Greene: “Research has shown again and again that pay for performance can positively impact performance, but it must be seen as being tied to performance.”

The fact is, developing, articulating, and successfully implementing an effective merit-pay strategy requires good planning, time, and hard work.

Moving Toward Merit Pay
Because the performance-management cycle involves multiple loops during a year, implementation of a merit-pay system can normally be achieved over the course of a one-year cycle. Key to shifting compensation strategies is ongoing communication about performance.

Performance communication is a continuous cycle of setting clear expectations, measuring performance, giving feedback, and rewarding positive results. A key distraction in the process may be the categorization of overall performance into ratings, such as outstanding, excellent, highly satisfactory, satisfactory, marginal, and unacceptable. In many places, no standards exist that would allow for such clear differentiation of performance. Likewise, once the rating becomes the point of the discussion, it is likely that the person whose performance is being rated will no longer hear any further explanations of how that rating was determined. And, because there is a natural tendency for managers to avoid conflict, many will give the highest possible rating allowable, thereby making the ratings devoid of any real meaning.

At least three key factors should be kept in mind when transitioning to a performance-based pay strategy.

1. Define performance expectations and set clear goals aligned with institutional goals. People generally perform at a higher level when they know the expectations. Time must be spent upfront to define what represents excellence for a faculty member, staff person, or administrator within given units. That dialogue occurs between the administrators and members of the department or school. The dialogue itself should advance the understanding of the unit’s goals in relation to the vision and strategy of the institution. Standards should be clear and in writing. While they can be modified as circumstances change, it is important to have written standards and goals that are tied to the institution’s goals. Once employees understand performance expectations and how their work makes a difference, they are more likely to derive satisfaction from furthering the worthy goals of educating people, conducting research, and performing service for the community. This direct link between individual efforts and institutional success can create a tremendous sense of employee engagement, further enhancing the retention of your best talent.

2. Discuss performance regularly. Discussions about goals and performance should occur throughout the entire year, not only every six or 12 months. Discussions should allow for two-way communication and include how a supervisor can enhance an employee’s ability to succeed and what adjustments, if any, should be made to an individual’s goals. When discussing performance, an administrator should refer to the written standards and goals and be direct but constructive, distinguishing between his or her feelings about an employee’s personality from evaluation of the employee’s work.

3. Address compensation separately. Discussions about performance often take a detour once compensation is mentioned, since employees often view how they are paid as a measure not only of their performance, but also of themselves personally. Therefore, communication of salary increases should take place at a separate time. The reality is that managers do not have budgets that allow them to pay everyone at the top quartile of the salary market, so compensation decisions must also be communicated clearly to employees. Four factors must be considered when setting pay: the individual’s performance; his or her current pay as compared to others with comparable experience; the person’s potential in the organization; and the budget available for pay increases.

Focus on Top, Core Talent
An organization can never make every employee happy, so it is important to focus on those people who are the stars and top performers as well as those who comprise the solid core of the institution. Those few whose work is marginal or unsatisfactory should receive a clear message to meet standards or leave.

Throughout the cycle, continue to question whether the institution’s compensation practices support its larger talent-management strategy. For instance:

• What is the institution doing to attract, develop, reward, and retain the faculty, staff, and administrators who are critical to its success?
• Are appropriate systems in place to make clear what is expected?
• Are people held accountable for their role in achieving goals?
• Is excellent performance acknowledged and recognized?

Implementing a merit-pay system, or reforming one that has strayed from its initial course, can have a powerful impact on employee engagement, job satisfaction, goal achievement, and the success of an organization. The process serves to align employees’ behaviors with the goals of the institution, and will be well worth the time and commitment to get it right.

Kathy Hagedorn, formerly vice president of human resources at Saint Louis University, is president of The Hagedorn Institute. E-mail: KHagedorn@HagedornInstitute.com.