Performance Based Pay

Amogh Pai Vaidya, FSC, B201276625

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Definition of 'Performance-Based Compensation'

An incentive-based form of compensation that is reserved for hedge fund managers or elite portfolio managers. The compensation will almost always be based on a percentage of total assets managed, and will be paid out if the portfolio manager delivers returns above a prespecified level, such as performance in relation to the S&P 500. Many hedge fund managers are paid 20% of client profits if their investment returns are over a predetermined benchmark. Under this form of compensation, talented hedge fund managers that manage large funds can easily earn tens of millions of dollars (if not more). In our parents' day, salary was generally based on seniority; every employee in a comparable position earned the same, with annual increments and cost-of-living raises. Seniority was rewarded, youthful enthusiasm perhaps not. The obvious drawback to this system was a tendency for long-standing employees to become comfortable with their guaranteed salary and become less motivated. Additionally, there was little incentive for younger - possibly more ambitious and energetic - employees to shine since all they would receive as a reward for their efforts would be a pat on the back and the satisfaction of a job well done unless they shone brightly enough to be awarded a promotion. Performance-based pay would therefore seem to present a far better deal for both employers and employees. Rewarding the best performers seems only reasonable and is obviously the clear way to motivate employees. So is performance-based compensation the best way forward for most companies? Businesses involving sales have had a kind of performance-based pay structure for decades; their salespeople are rewarded with commissions, the more sales - the more commissions earned. However many other industries have instituted similar pay structures, some successfully, some less so. The benefits of performance-based pay structures are self-evident. There is a positive correlation between effort and performance and employee retention is likely to be enhanced since those who perform best, being rewarded for their efforts, are more likely to stay. Some companies have used a performance-based compensation scheme to not only reward their high achievers but also to weed out their weakest performers; good for company performance perhaps, maybe not so good for morale. There may well be an argument for cutting out the 'deadwood' in an organization as opposed to educating and motivating these employees but that is an argument for another day. Aside from the unfortunate employees who fall into the lowest category and lose their jobs, there are other drawbacks to performance-based pay structures. Implementation can be problematic and, perhaps more importantly, this supposedly motivating process can actually be damaging to self-esteem, teamwork and creativity. Teams anxious to improve their performance may avoid working with colleagues they perceive to be less able, leading to some employees being excluded from the more rewarding projects. Keen competition for limited rewards, while motivational, can also create a hostile working environment where trust and cooperation are sacrificed in the interests of self-promotion.

Additionally, projects can fail due to factors that are completely beyond an employee's control; delays in receiving supplies or a downturn in the economy. So, does this mean performance-based pay is a bad thing? Not necessarily. However, if it is to be successful, there must be reasonable, achievable and measurable goals that are potentially achievable by any employee. Achievements must be quantifiable, so a comprehensive system must be put in place to monitor and assess whether or not employees have met designated targets. Communication and transparency are essential; everyone must be aware of, and understand, the criteria. Training and education facilities should be in place to improve the performance of weaker employees and enable ambitious employees to widen their knowledge and skills and be able to hit targets. Additionally, implementation must not become too cumbersome. Shift iQ offers a performance management module that is both efficient and user friendly, allowing employers to develop and deliver performance management initiatives. At the same time, Shift iQ's compensation management system can be tied to all types of compensation programs while their learning management system offers a quick, easy way to deliver training, development and employee retention programs. Using cloud computing, implementation is cost effective and relatively simple and Shift iQ's solutions are customizable to any business. Example: Cornell University For staff employed in positions classified within bands A through I, pay advancement is achieved based on individual performance and pay improvement budgets. Staff who have notable experience and are consistently effective within their positions should be paid within the market range for the appropriate job family and pay band. Premium pay levels may be reached based on a combination of factors such as outstanding performance, long service, and market retention considerations. Merit Pay Improvement Programs Staffs are periodically eligible for base pay increases as indicated by demonstrated individual performance during the timeframe of a University Pay Improvement Program. Colleges and units provide department managers with guidelines for each pay improvement program. Position Enhancement When individual performance accomplishment, competencies and departmental objectives result in a substantial increase in the complexity or breadth of a staff members responsibilities within his/her current university job title classification, a base pay increase should be awarded to the staff member.

Promotions Reclassification: Staff receive an increase to base pay when the requirements for the occupied position change so significantly that the position is reclassified to a University Job Title in an upper band. Selection: When a staff members competencies and previous performance result in being selected for a position classified in an upper band, base pay is also increased.

One-band promotions are usually accompanied by equitable base pay increases. Variable Pay Awards that are not added to base pay may provide further incentives for staff to take extraordinary initiative to enhance their productivity in support of organizational objectives in areas such as: Improving processes and/or results; Enhancing customer satisfaction; Formulating and implementing new products or protocols; Providing innovation and cost-savings to operational methods; or, Performing, at managements approval, at a significantly higher level of complexity for a specified period of time due to workload demand or similar circumstance. Variable pay awards may also be used to recognize: Acting appointments; Uniquely designated special project completion; or Extraordinary accomplishment for unusual work requirements.

Importance:
Performance-based pay is a great way to encourage motivation among employees. The compensation variations come in many forms, and each form will present a variety of benefits and challenges, depending on the structure of your company. Therefore, it may take some experimenting to determine which form of performance-based pay works most effectively for your business. The following variations are some of the most common types of performance-based pay plans:

Performance Bonuses: Performance bonuses are quite common among companies, and they represent a fairly basic form of performance-based pay. A company rates the performance or productivity of an individual employee, a team of employees, or an entire department and then uses those ratings to award the employees a special bonus. These bonuses are often not awarded in predetermined amounts and are generally given only for exceptional performances. While this type of performance-based pay can be very effective, management must be extremely careful in the implementation of these types of awards. Because the bonuses are often not given in equal amounts or frequencies, arguments may be made for favoritism, which could actually serve to decrease employee motivation, giving you the opposite of the desired effect.

Gain sharing: Is a method of compensation that divides the financial rewards of a businesss improved performance among all levels of the company. Gain sharing encourages increased productivity among employees by awarding them a pre-negotiated percentage of the financial gains caused by their department or teams hard work. The basic premise is that as employees see how their work directly benefits the company, they will be motivated to continually increase their effectiveness in order to receive further financial rewards. Profit Sharing: Superficially, profit sharing is very similar to gain sharing, but the differences between the two plans are very important. Profit sharing is not linked to an individual or departments performance, but rather is related to the profits of the whole company. Like gain sharing, the increases in the companys profits are divided among employees according to a predetermined formula, but unlike gain sharing, the focus is not on the effect of one single employee or department. Instead, profit sharing aims to highlight the importance of teamwork in a business by dividing the rewards among all employees, not just those in a specific department or team.

Skills-Based Rewards: Skills-based rewards involve paying employees more based on the number of skills they obtain and apply directly to their job. Some companies, instead of giving automatic annual raises, opt to provide employees with opportunities to receive additional training. If the employees choose to attend these training sessions and employ these newly obtained skills in their jobs, they are then financially rewarded based on a set system. The reasoning is that everybody wins: The employee receives additional financial compensation, and the company receives the benefits of a highly skilled and productive employee. All types of performance-based compensation plans are an effective way to foster a motivational work environment. Employees who do not feel as if their hard work is appreciated are unlikely to remain loyal to their company or continue providing exceptional service. In contrast, however, if employees feel that they are compensated for their contributions and productivity, they will be more likely to continue those habits that help to improve your company.

Types or practical models of performance based pay

The top level has announced that the organization is shifting to a performance-related pay model. What does pay for performance mean? Arent we all performing already? Arent we getting paid for that? The real answer is probably not. The vast majority of compensation plans are based on a starting market value for specific jobs after which future compensation is guided primarily by time in the job, staying within an overall corporate merit pool target percentage, and the fact that you havent screwed up badly during that time. Performance compensation plans take a vastly different approach by asserting that there is a clear difference between ordinary and extraordinary performance that merits a distinct difference in compensation. Organizations are seeking and looking to pay-for-performance models to increase or strengthen the link between rewards and performance outcomes in a manner that makes good economic sense and rewards those who help the organization excel. Performance compensation plans can allow an organization to base pay on the achievement of certain improvements in corporate performance as well as overall employee effectiveness. Performance-related pay models have their supporters and detractors. The detractors state that more pay-for-performance models have been attempted and failed than have ever succeeded. Many, including Dan Pink, notable author and business consultant, go as far as to state that pay-for-performance models just dont work. Dan states that performance compensation plans actually hurt performance for most tasks and that for tasks requiring creativity and unknown solutions (basically knowledge work), performance actually decreases with traditional carrot and stick management. Since this writing supports pay-forperformance as a viable solution, Im going to throw you completely off for a minute by saying that I agree with Dan in part. I think that when performance related pay models become task-oriented they have the highest probability of failing. These models are most effective when the goals and performance measures are related to the overall enterprise goals and expected performance and to outcomes versus tasks. This is the part that is not easy for most organizations and the part where most failed pay-forperformance models completely missed the boat. This is the nexus the place where human behavioral science and business meet. Making this work involves providing clearly articulated goals, a sense of purpose, and increased individual, group, and overall enterprise accountability. Achieving complete organizational alignment mission, goals, objectives, performance, and pay - is much easier to talk or write about it than to do. This type of alignment takes commitment because it means starting from the highest aspiration for your organization and working your way down to identifying and inspiring the smallest outcome and/or behavior that will get you there. Organizations must ask themselves, What is it that we really, really, want to be? How do we get to be that? What will we need to do? Who will we need to do it? And, how will they do it? It is that final question How will they do it?- that becomes the basis for managing, measuring, and compensating your people for performance. Todays pay-for-performance models are essentially a reiteration and application of Victor Vrooms expectancy theory (1964) on motivation and management, in fewer words, of

course. An understanding of expectancy theory is important as organizations begin to determine what it is that they are to tie compensation to. As stated earlier, I believe linking to tasks is a non-thinking, guaranteed-to-fail approach. Vroom states that individuals have different sets of goals and can be motivated if they believe that:
There is a positive correlation between efforts and performance. Favorable performance will result in a desirable reward. The reward will satisfy an important need. The desire to satisfy the need is strong enough to make the effort worthwhile.

To get to the level of motivation Vroom describes requires an in-depth examination of each component and performance outcome needed to achieve the organizations aspired level of performance. This is why an approach to pay-for-performance that focuses on outcomes is far superior to tasks. Individuals have a need to feel trusted and valued for the outcomes they achieve that go beyond the tasks that comprise the achievement and that desire can be leveraged to improve performance exponentially. In this approach, a receptionist is valued not because he answers the phone but because he serves as a resource for information, provides an extraordinary level of customer service, and quite often as the first voice and impression of the organization serves as a determinant as to whether someone may or may not become a customer of that organization. Does it matter that in the past year, he fielded 40,000 calls, if the outcomes didnt result in higher positive customer experience ratings? Of course, it matters! That is the simplest example of how making a successful link between pay and performance must incorporate measures that clearly distinguish between ordinary and extraordinary performance.

Merit Pay
A common method which has long been in existence is pay increases - in the form of increments, for example, for individual performance. Its workability and effectiveness depend on the existence of a suitable performance appraisal system, which has often been found to be lacking. Due to its integration into the salary, it is not lost due to poor performance later, and therefore may cease to be an incentive.

Incentive Payments
Lump sum payments (such as sales commissions) are another traditional method. It is not added to base pay. Usually the formula and the relationship between performance and the payment of the lump sum are known beforehand. Sales commissions may often have little to do with performance because factors such as product quality, brand name and price may contribute more to sales than the ability of the salesman to convince the buyers. Appraisals are less significant to this category since the criteria (e.g. sales figures) are statistical and no further measurement is needed. Another traditional method of rewarding performance is piece rates. Unless related to a reasonable time frame within which the production should be completed, such rates would not be related to performance.

Group Incentives and Productivity Gain-Sharing Group incentive schemes are of three types. Gain-sharing refers to a compensation system which divides between the employer and employees the results of improved performance consequent upon the better use of human resources resulting in productivity gains. Sharing is according to an agreed, pre-determined formula. Second type, namely, profit-sharing, gives employees a share of the profits. Third type is employee stock ownership plans (ESOPS). Sometimes bonuses are paid to individuals based on their own performance appraisal ratings. In the case of group incentives, the Criteria could be either group or enterprise performance. Long Term Incentives Long term incentive plans are operated, especially for executives, both as an incentive to improved performance and in order to reduce fixed costs. Examples of such schemes are: share option plans to promote convergence of stockholder/executive interests bonus linked to long term performance (3-5 years) to encourage a focus on long term goals In the 1980s stock ownership plans (ESOPs) in the U.S.A. normally included only executives, while in Japan they usually excluded executives. A lower rate of termination of ESOPs in Japan contrasted with a higher rate of terminations in the U.S.A. Performance Bonus This type of bonus can be based on individual or group performance. Where it is individual based, the payment would depend on performance ratings. Since the 1980s there has been in the U.S.A. an increase in union agreements substituting bonuses for traditional wage increases. In many countries performance bonuses are commonest for executive staff. It is estimated that in the U.S.A. about 97% of the large and 86% of the medium sized companies pay such bonuses to their executives. In Western Europe the estimate is about 70% and in Singapore about 66%. As a percentage of base pay, the figure is highest in the U.S.A., though the variations are also large. Some of the criteria for the success of such bonus payments are: group over individual performance, the existence of objective criteria for distribution, and the fact that such criteria are capable of measurement to ensure that what is paid is related to it.