Can Pay for Performance Really Work?

by Janet Wiscombe

While pay for performance can be a solution for some organizations in search of new compensation concepts, it's not the answer far every company. Design is important, and the downside can be steep.

At a time of economic slowdowns and uncertainty, a compensation concept such as pay for performance is particularly tempting and increasingly popular. A recent survey by Hewitt Associates LLC found that nearly 8 in 10 companies have some kind of variable pay system, up from fewer than 5 in 10 in 1990. It's an understandable trend at a time when revenues slump, stock options shrivel, and across-the-board raises just aren't feasible for many organizations.

The question for HR people who wonder if they should follow suit is this: does pay for performance really work? The answer is that while pay for performance can work, it's not the solution for every organization.

The range of opinion about pay for performance is broad and deep. Its proponents say that rigorous, long-term pay-for-performance systems offer effective methods of helping companies continually improve the workforce while getting and keeping the best people. Opponents argue that incentive pay plans tend to pit employees against one another, erode trust and teamwork, and create what critics call dressed-up sweatshops.

Sometimes, it's bad even while it's good. Lisa Weber, executive vice president of human resources for MetLife, calls the shift to a pay-for-performance model "absolutely gut-wrenching. Some people hate it."

But after MetLife placed all employees on a rating scale that is subject to change based on the performance of specific goals and core behaviors, the company's return on equity jumped from 7 percent in 1998 to 10.5 percent in 2000. "It's been tough, but it's been fabulous," she says.

The concept of pay for performance isn't new. Ever since ancient Mesopotamians were paid by the basket for picking olives, there's been some form of performance-based pay. In the modern era, the term is used fairly loosely: commissions and bonuses are often thrown into the definition.

For the purposes of this story, pay for performance means a variable pay approach that is anchored to a measurement of performance, whether that's how many hours an attorney bills every month or a more subjective standard--how well a manager fosters teamwork, for instance. Often, evaluations are based on best-to-worst forced ranking systems--known to many employees as rank and yank--which are thought to provide a way of identifying and rewarding strong performers and encouraging everyone to work harder and smarter. True pay for performance is more formalized than an occasional attaboy bonus. It is variable compensation that must be re-earned each year and doesn't permanently increase base salary.

What makes it work?

When it is measurable and objective: Pay for performance is not limited to such environments as assembly lines or the piecework arena. It can translate to any business, including banks, accountants, and legal firms, says Niki Somerset, a management consultant in Virginia Beach, Virginia, who has helped many businesses move from a straight salary plan to a performance-based program. "Incentive pay has always been quietly done in boardrooms," she says. "If you've got 250 attorneys in 30 cities, you've got to set projections, people have to be productive. Billable hours are the ticket."

MetLife measures employees and managers by comparing each person to others who are on the same level. Employees are measured on a 1-to-5 scale. The company then calculates which employees are at the top, in the middle, and at the bottom. Employees who rate a 3 receive about 65 percent more in bonuses than those who earn a 2. A person rated 3 might receive a bonus of $6,900, whereas one who was rated 2 would get $4,200.

The company is concentrating a great deal of attention on the most senior 250 of the organization's 46,393 employees, says Weber. They are evaluated on their individual performance results and on questions such as: Do they show partnership? Do they demonstrate teamwork? Do they create heroes? How dedicated are they to learning and development?

Synygy, Inc., the largest provider of incentive management software and services, implemented its own plan a couple of years after the company was founded in 1991. Company spokesman Oliver Picher describes it as a bonus program that ranges in amount from 5 to 100 percent of an employee's base salary and is paid quarterly. Evaluation ratings are set by a "mentor" (supervisor), and also by coworkers who use an appraisal system called OPTIC: Ownership, Professionalism, Teamwork, (Continuous) Improvement, and Client Focus.

Employees are rated on a 1-to-5 scale. Objectives are set at the beginning of the quarter and at the end, and everyone in the company participates--whether clerical worker or top executive. As director of public relations, Picher says, he is evaluated on responsibilities that apply to his specific job, such as the number and quality of press releases and their impact, and the contacts he's made with specific people and organizations.

When it is designed for whole-company success: Pay for performance is often criticized for tilting a company toward one measure and away from another. Individual goals can pit workers against each other. A plan that focuses only on output will invariably suffer in the area of quality

At MetLife, the focus is on individual performance, but "it's not OK to step on people's toes," Weber says. "You must rate high on partnership and teamwork. If you're a great performer but a terrible team player, you won't do well."

Financial results shouldn't be the only measure for pay-for-performance success, says Margaret Bentson, principal compensation manager at Hewitt Associates, San Francisco. Customer service should also be considered, with a scoring system that might include such factors as on-time delivery, reduction in the number of returned products, and client satisfaction surveys. "The idea is to marry the fortunes of the employee to the performance of the company."

When employees have a sizable stake in the action: At Nucor Corporation, the largest steel producer in the United States, the secret to success is to give huge bonuses of 100 or even 150 to 160 percent, says James M. Goblin, vice president of human resources. "That's when employees catch fire."

The Charlotte, North Carolina, company--which employs 8,000 people at 22 plants in nine states--has the highest productivity the highest wages, and the lowest labor costs per ton in the American steel industry. The average pay in the year 2000 was $63,000 for a steel mill employee. Goblin says the program succeeds because every employee can see how the incentive arrangement affects his wages each week.

During the down times, of course, there's also sharing. The company doesn't lay people off, Goblin says. Rather, the plant shuts down its production lines for a day or two a week. Salaried executives still work; hourly employees aren't required to. About 80 percent of Nucor's employees are on this production-incentive plan. Other employees also have performance-based compensation.

When the whole organization is involved: "To make it work, the most important thing is the involvement of the whole company," Somerset says. "Even if there's only a 1 percent profit, it should be divided among everyone, including the administration. Everyone is part of the team-building." Nucor, for instance, gives non-production employees other awards--from free dinners for outstanding work to one share of stock for every year of employment.

Involvement of another kind has been a key to success in Colorado's Douglas County School District, which has one of the oldest and most extensive pay-for-performance programs in the country The program works, in part, because of the enormous effort that was invested in developing the system over a two-year period, says Douglas Hartman, the district's HR director. That built confidence among teachers long before the plan was implemented, he says.