24 May 2007

Performance-based compensation

By Jim Pinto

Most of today’s employee compensation systems originally came from the old factory environment, stemming from how hourly workers were paid and advanced in the labor-orientated hierarchy. A job meant fixed pay, with annual pay increases based on performance and the expectation of lifetime employment.

In a new knowledge-based business environment, many companies still cling to archaic systems, lax reviews, and automatic pay increases. This simply results in increasing jeopardy for employees whose pay has escalated over the years to a level that simply cannot compete in the modern global environment.

With legacy systems, the expectation is pay will continue to escalate based on years of service. Indeed, resentment develops when compensation does not increase, at the very least to keep up with the cost of living. Further, employees who have had many years of service tend to get comfortable and overpaid for what they are doing. With regular increases, mediocre people may get paid too highly when compared to new hires or outsourcing alternatives. When the company has to cutback, long-term workers are often the first to go.

There are two ways to motivate people—the carrot and the stick. Competitions with prizes (carrots) for the winners tend not to work. This is because only the top few who see the awards within reach tend to try harder. Most of the others, recognizing winning is not within reach, simply ignore the competition and continue to plod.

Jack Welch of General Electric came up with a solution to this paradox. When he took over, GE was profitable, but it had become relatively stodgy and too comfortable for people who had been there a long time. To affect change, Welch instituted a pay-for-performance matrix for all GE’s professional employees: 10-15% of the employees were considered outstanding and received good pay increases; 70% were categorized as satisfactory and got lesser increases; the remaining 10-15% were unacceptable, and depending on budgetary considerations, they could be eliminated.

As hard as it seemed, Welch issued an edict to all managers to systematically eliminate the bottom 10-15 % of the workforce during annual reviews. He insisted there are always bottom performers that need to be trimmed. Indeed, if managers did not trim, that unwillingness became part of their own review, and they themselves could be subjected the same rule. Welch became known as “neutron Jack” for his drive to eliminate poor performers. There were many that agreed GE needed a driving force like him to generate much needed change.

In today’s knowledge-worker business environment, the best form of compensation is performance-based, with measurable objectives. Reasonable, measurable goals and performance incentives should be the basis of compensation for everyone, no matter what their job. Objectives should be achievable and quantifiable to provide the proper incentives for good performance.

The question then arises: Should the performance measurement and reward system be for individuals, or should it include teams, or extended to the entire organization? In my view, it can and should be all of the above—parts of an individual’s incentive should include broader results to encourage everyone’s involvement in the success of every part of the enterprise, demonstrating the clear linkages that occur.

Related links:

• Performance-based compensation increasingly popular
  http://albany.bizjournals.com/albany/stories/2002/12/16/focus4.html
• Pay-for-Performance Doesn’t Always Pay Off:
  http://hbswk.hbs.edu/item/3424.html
• Compensation planning solutions align rewards with performance
  http://www.hrmreport.com/pastissue/article.asp?art=26467&issue=160

Behind the byline

Jim Pinto is an industry analyst and founder of Action Instruments. You can e-mail him at jim@jimpinto.com or view his writings at www.JimPinto.com. Read the Table of Contents of his book, Pinto’s Points at www.jimpinto.com/writings/points.html.