Top pay for best performance: in a sluggish economy, compensation system gets new focus by rewarding star performers more than the rest of the pack - Cover Story

HR Magazine, Jan, 2003 by Steve Bates

Like many companies, fiber optic cable manufacturer Corning Inc. is struggling financially. Sales are way down. Its stock price recently dipped to just over $1--about 1 percent of its value three years ago. Executives have slashed more than 16,000 jobs in two years and have frozen salaries for everyone who's left.

But while the Corning, N.Y. based company hasn't had a profitable quarter since early 2001, next month it will give bonuses to employees who met their goals this year.

Why reward employees for a disastrous year?

The answer, says Corning, is that rewarding good workers is the best way to increase productivity and to secure dominance in its potentially lucrative market. The bonuses will likely be very small this year. But the payments will fulfill a promise to the workforce that better employee performance results in better compensation.

Forward-thinking companies are using the sluggish economy "as a time to capture market share, to do things that aren't common" in their industry to gain competitive advantage, adds Thomas B. Wilson, president of Maynard, Mass.-based Wilson Group consultants, a firm specializing in consulting on performance-based total reward systems.

In fact, compensation experts argue that paying for performance is more important in a down economy than in boom times. The reason is that companies typically have a smaller pot of money to allocate for compensation during a slowdown. So, instead of giving everyone an equal but minimal increase to their base pay, some organizations are dishing out salary increases, bonuses or both in varying amounts, with the most going to the best performers or to the most essential employees. In some cases, poor performers get little or nothing above their base pay.

"For the first time, companies truly have to differentiate" among their workers in a visible, dramatic way, says John M. Bremen, national compensation practice leader for consulting firm Watson Wyatt Worldwide in Chicago.

Compensation experts urge companies to take this opportunity to move farther from a system that relies heavily on across-the-board merit increases to one that focuses on rewarding top performers substantially more than the rest of the field. Companies need a compensation system that catches a top performer's attention and sends a signal to a poor performing employee. To do this, the system must differentiate between the two.

"We can't think of a better time in the last 20 years to talk about this," says Peter LeBlanc, senior vice president of Sibson Consulting in Raleigh, N.C. "It's a major opportunity for companies now."

The devil is in the details, however. Executing such a system can be treacherous.

Seizing the Opportunity

Performance can be assessed based on individual or team contribution, on business unit results or on corporate profit or share price. It can be rewarded through traditional salary adjustments but also through variable pay techniques such as one-time or recurring bonuses.

Surveys show that about two-thirds of U.S. companies have some sort of variable pay, and about 10 percent of all compensation is variable.

Rewarding "top-performing employees" does not mean rewarding solely high-level employees. Organizations are using performance pay for middle managers, professionals and hourly workers, determined not to let the depressed business climate lead to a depressed workforce.

"It's not an economic issue. You need performance whether it's a good economy or a bad economy," says Ed Lawler, an author, professor and director of the Center for Effective Organizations at the Marshall School of Business in Los Angeles.

Paying top pay for best performance is a marked shift from just a few years ago. Many firms established generous but somewhat haphazard pay systems when the economy was hot in the 1990s. "We were just throwing money at talent," says Jay Schuster of consulting firm Schuster-Zingheim and Associates in Los Angeles.

Today, "companies are being much more careful about who gets incentive pay," says Bremen. In some organizations, "we're seeing fewer people getting variable pay. Those who are getting it are getting more than they did before."

Some experts say this increased use of performance pay could mark the end of an era of entitlement in employee compensation. The bedrock of that era has been a merit pay system predicated on lifetime employment with steadily rising, virtually equal wages for all workers in a grade or job category.

The shift from a manufacturing economy to a knowledge-based economy, a more mobile workforce and the economic downturn have changed the way people look at pay, experts say.

"People used to fear the day that merit increases went below 10 percent, then 5 percent. We're now dealing with numbers so small that it is difficult to differentiate" between the best and worst performers with traditional salary adjustments, says Bremen.

Research shows that "you need [a] 7 percent or 8 percent [compensation increase] just to catch anybody's attention," says Robert Heneman, a professor of management and HR at Ohio State University. Anything below that is welcome but doesn't lead to significantly greater effort on the part of the employee to drive business results.