The Finer Elements of “Pay for Performance”


One goal of many pay for performance plans is to improve employees’ performance. Any close study of any pay policy assesses the effects on the performance of base-pay levels, merit increases, and one-time bonuses. It’s important to learn that both “how much” is paid (the amount of the reward) and “how” the money is paid (the metrics that exists between performance and pay) influence employees’ future performance levels. As expected, the results show that how much you pay is important—provided the link between pay and performance is clearly established.

“The widely held belief that an employee’s past performance is the best predictor of that person’s future performance is true, provided he operates in an identical environment”

What is not clear about pay-for-performance plans is whether the amount of award has the greatest effect or whether the method by which they pay is linked to performance matters more. There is definitely a need for transparent, objective and clearly communicated system to build credibility. In part, a key issue regarding pay-for-performance systems that are based on subjective evaluations is that an individual cannot be certain in advance what performance level is required to achieve a particular award level. For this reason, an employee’s experience with the system plays an important role in creating an expectation of the extent to which performance is actually rewarded?

This kind of system requires companies to develop a model that helps to envision future company value using various growth assumptions (base, target and superior for example). The purpose of the model is to determine what shareholder value will look like “down the road” if employees achieve the expectations it has set for them. With that picture in mind, the development of a performance-based compensation strategy starts by answering some key questions: How much of that increased value should be shared with employees? Which people should participate in that value-sharing? What form should that value-sharing take?

The answers to those questions will help to develop a philosophy that can guide in the development of a compensation approach that effectively rewards performance. As one then translate that philosophy into an overall pay strategy and specific plans, there are three  “Must Do”s that needs to be kept in mind. They will only seem relevant, however, if you have defined clear objectives for your performance-centered approach and identified the alignment your pay strategy is intended to create.

1 – It Must Align Performance Awards with Shareholder Objectives

All companies have a financial responsibility to their shareholders.  As a result, compensation should be measured like any other investment by the company.  Its effectiveness should be evaluated in the context of the financial outcomes (return) shareholders are expecting.  As a result, the question that should be asked when any compensation program is being considered is: “Will the company’s investment in this plan contribute to an increase in company value?”  There are really two potential parts to the answer.  One is the tangible impact—increased revenues, profits, cash flow, etc.  The other is the softer financial impact—Increased productivity, turnover reduction, improved customer service, etc.  When we look a compensation through a “pay for performance” lens, then we treat it as an investment.  This means we design plans that are “paid for” out of a superior value that employee performance creates.  When approached that way, compensation doesn’t really “cost” the company.

2 – It Must Result in Meaningful Money

In considering “pay for performance” strategies, business leaders should keep in mind that one of the intents of such an approach is to get employees to take ownership of the results their roles exist to produce. Employees are more likely to adopt a stewardship approach to their roles if they see a relationship between the value they create and the way (and how much) they are paid. And their earnings potential must be compatible with their personal wealth accumulation goals and ambitions. In other words, the payoff must be meaningful enough to get the employee’s attention. 

The balance you are seeking is to offer rewards that are motivational to the recipient while still being in line with shareholder (financial, structural and organizational) goals and expectations.

3 – It Must Effectively Communicate and Reinforce Rewards

Coaching and reinforcement are the keys to creating long-term focus and commitment in an organization. As a result, rewards should be viewed as a means of reminding employees what is expected of them—but more importantly, why it’s worth it to perform. In other words, pay should create a kind of virtuous cycle between employee roles, expectations and pay. The clearer individuals are about their roles, the better the chance that they will fulfill what’s being asked of them. As they do, they are rewarded, which encourages continued, consistent performance in their roles.

Compensation, then, is the way the company defines the financial partnership it wants to have with its people and represents a kind of agreement between the employer and the employee. By agreement; it defines an area of stewardship, establishes expectation levels for that area and provides a conditional incentive for its fulfillment. “If you can do this, here’s what it will mean to you.”

Pay for Performance Objectives

If effectively constructed, pay for performance compensation plans should help a company fulfill the following objectives:

• Recruit and retain the highest quality employees
• Communicate and reinforce the values, goals, and objectives of the company
• Engage employees in the organization’s success
• Reward value creators

To develop a pay strategy that rewards your people for their contributions to value creation, you will need to make some fundamental decisions. At a minimum, you must determine the right balance between guaranteed and variable compensation and between short and long-term incentives. Pivotal in that strategy development is how and to what extent pay will be tied to specific types of performance. This will differ from company to company. However, every business should be able to identify the particular outcomes it wants its people to achieve and how their fulfillment will impact the financial future of the company.


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