Annual Pay Increases Becoming Obsolete

2017 Compensation Trends

Overland Park, KS (September 1, 2017) – Some employers are beginning to break away from scheduled annual base pay or merit increases.

For many employers, the continual modest labor market wage growth has led to smaller pay increase budgets, limiting the “wow” factor of these annual base pay increases. It is believed that this practice can lead to employee indifference, particularly for high performers who may see little to no differentiation in rewards for the additional value they create for the business. This is especially true when these small base pay increases either do not, or barely, keep pace with the annual increase in health care costs.

This limited “wow” factor for pay raises and differentiation of rewards can also increase employee tendency toward entitlement – “I should get a pay increase regardless of how I performed.” The challenge with a feeling of entitlement is that employees may feel less inclined to use discretionary effort to achieve goals or expectations and perform at a higher level. This is even more likely to happen when employees have little or no other emotional connection to the organization, which ultimately leads to low employee engagement and poor overall organizational performance.

Lastly, and likely as a result of the previously described dynamic, employers have been experiencing increased difficulty in achieving expected return on their people investment (ROI).

Seeking Motivation

Making annual pay increases seem more meaningful and motivating for employees has been a challenge for employers for some time. Modest pay increase budgets make it hard to distinguish awards between average and high performing employees. While it is all relative, a 3.5% annual base pay increase for a top performer is not much different than a 3% base pay increase for an average performer. Even worse, some employers still provide the average 3% increase to all employees, regardless of the level of performance or contribution, because it is easier and it avoids the discomfort of communicating a less than average increase to those who contribute less. This dynamic can create significant drag on employee morale and overall engagement, which are integral variables to driving ROI.

So, what is an employer to do? How do you create a system and environment that more closely aligns pay with performance when the market still only supports modest increases in overall employee rewards? There are several options available for consideration, but they require commitment beyond use as just a tactic – they require commitment for the long-term to foster an environment that creates value for employees and employers alike.

More Focus on Variable Pay

One approach is to shift some, or all, of annual pay increase budgets to incentive compensation payments. This strategy enhances the ability to reward top performers, and minimizes the compounding effect to the bottom line of annual base pay increases. However, shifting more focus on variable pay increases the need for sound goal setting.

For example, an employer could allocate resources for a 1% or 2% annual pay increase budget to keep base pay on par with the market, while the other 1% or 2% is shifted toward performance-driven variable bonus payments.  In this scenario, the employer should not provide any base pay increases for those employees who fail to meet or exceed performance expectations, a tactic that will allow for additional resources for those employees who do meet or exceed expectations.

This can shift the expectation more towards occasional base pay adjustments to keep pace with the labor market, and on recurring incentive compensation payouts based on performance.  In addition, this can create more of a “pay for performance” environment for the organization, which tends to appeal to valued high performers. Most importantly, this method improves the potential for ROI on employee rewards.

Keeping – But Refining – Merit Increases

Another approach is to set different expectations for merit based pay increases. In this scenario, instead of focusing on an overall average base pay increase budget for all employees, employers focus on different funding levels for different levels of performance. For example, employers can still manage to provide an overall average 3% increase budget, but manage to provide a 2% increase budget pool for average performers who make up the majority of the employee population, and a 6% increase budget pool for top performers who make up a small but important share of the employee population. Overall, the company manages to provide an average base pay increase of 3%, but noticeably differentiates the rewards for high performers while keeping pace with the overall market rate of pay for others.

Employers can also do a better job of setting performance goals and expectations for employees and make sure performance ratings accurately reflect each employee’s performance towards goals and contribution. This notion is certainly fundamental to driving any ROI, and is critical to the success of any pay for performance environment as it is the basis for differentiation and rewarding value creation. Employees should be paid for achieving expected and mutually understood outcomes, not for simply executing tasks.

Finally, refinement of the annual merit-based base pay increase can be achieved by mixing base pay increases with lump sum payments. In this scenario, the highest performers could receive all merit payments as a base pay increase, while average performers could receive part of the merit increase as a lump sum payment and part as a base pay increase. Poor performers could get a payout – if anything, but only as a lump-sum payment. This minimizes the compounding effect of the annual base pay increase while driving some differentiation of rewards based on performance.

Performance Funded Bonus Pay

A third approach is to establish a performance based bonus program that supplements the annual base pay increase program but only pays out when the company achieves predetermined performance expectations. In this scenario, the bonus program is funded when the company exceeds certain pre-determined financial goals, and the available bonus pool is linked to a percentage of the company’s performance achievement. For example, the bonus pool is funded with 3% of every dollar of Earnings Before Income Taxes and Depreciation (EBITDA) the company achieves over a specified EBITDA target.

This approach, much like a profit sharing plan, allows for the employees to share in the financial success of the company – when the company succeeds, employees succeed. Thus, a clearer linkage between pay and performance. This pay for performance alignment can be taken even further by differentiating the employee’s share of the bonus pool by their personal performance – higher performers get a greater share of the reward, etc.

Adapt or Succumb

Employers must adapt to the constraints of the market to successfully survive and grow. The considerations above, individually or in some combination, can form the basis for a long-term strategy to create a rewarding employment experience while driving incremental ROI. But plan carefully, as these considerations can have significant impact on company culture. Implemented hastily, these changes could have devastating impact on business. Careful consideration and planning will ensure employers can strategically create great results and a highly rewarding environment for years to come.

As we enter budget season, the time is now for employers to plan for high leverage tactics that will attract and retain strong talent and deliver high return on their employee compensation investment.

Jon Binder
Senior Consultant & Compensation Practice Leader
OMNI Human Resource Management