Why does your organization provide base pay? Does your organization use variable pay—annual incentives or bonuses? If so, why do you? What about long-term incentives? Answers we hear to these questions vary. From the simple —”because we have to attract and retain employees.” To the now trite —”to help drive business/organizational results.”
The real purpose of the questions is to begin a discussion of the employment value proposition, how compensation fits into it and how pay elements should be defined to ensure that reward objectives are met. Each pay element carries its own message and should be treated as a tool to be maximized—nothing is a throw away in terms of how you want employees to view your organization or how you want employees to think about their value. Base salary is the biggest element among them all.
So, why does your organization provide base pay?
TDC Mix Framework
Before we discuss base pay in more detail, it is important to briefly touch on all components of total direct compensation (TDC), including long-term incentives. It is important because much of our discussion is really about the value of base pay relative to other available elements. TDC Pay Mix — the relative amounts of each element in employees’ TDC — is a concept most compensation professionals understand and is a primary tool by which direct compensation is fashioned to become part of an overall employment value proposition.
The Case for Base Pay
Base pay — the fixed and recurring compensation paid for performing specific job responsibilities — has garnered a bad reputation among cost-conscious organizations over the past several years. Like defined benefit plans, base pay has become viewed as a fixed cost that can only serve to cause financial challenges for the organization in the future. And, like defined benefit plans, the employer assumes the financial risk for payments in the future even if organizational financial performance is poor. Organizations of all types have moved, and continue move, toward variable pay in lieu of the increased future liabilities caused by base pay increases.
We understand the importance of managing the cost of payroll and understand equally that base pay represents a significant financial risk for employers, but that does not detract from the fact that base salary is probably the single best method to recognize, reward and motivate employees.
Why do we think so?
First, Consider the Obvious
For your broad-based employee population, base pay is where the money is. For you and your employer, it is the biggest portion of your compensation budget. A high-level perusal of general industry market data only puts numbers to facts we all know. Looking at only base salary and variable pay since long-term incentives are not a large component of TDC mix for the majority of employees, 90% or more of employers’ TDC is delivered as base pay. The table below illustrates the mix.
Base Pay is a True Investment
Base pay answers the question, “What can you do for me?” Variable pay answers, “What did you do for me?” Variable pay is a payment for services rendered whereas base pay is the commitment for future services at an agreed-upon price. The important element that does not exist today is flexibility in base pay — flexibility to increase or decrease an employee’s base pay rate in relation to the value of services they perform. Even today after our recent economic turmoil which caused base pay reductions and reductions-in-force, base pay is still viewed as a permanent entitlement by employees and employers alike.
If managed correctly, employees should feel that they have entered into agreement with you to provide services of defined quality and quantity and that, for providing these services, they will receive regular payment.
The practical question becomes how to determine what an employee’s base pay rate should be along the continuum of their career with you given their value at each point in time. Take into account also that people—your employees—are learners. Unlike capital investments that depreciate, your employees should be able to increase their value over time. While there may come a time when an employee has reached his or her maximum value, either because your organization does not need the additional ability or because their personal has reached its maximum, your employee’s value will grow and your need to adjust their pay will grow beyond normal wage increases.
Merit as Decision to Re-Hire
Our consultants have worked in pay and performance over the past 30 years and have not found nor been able to design/implement the “perfect” base pay increase system. There are several reasons why this process is so imperfect.
First and foremost is the lack of a basic language in which to discuss employee value and how changes in it should be communicated. Take for example a traditional performance planning and management system. Certainly the words and their definitions vary from organization to organization, but the ratings used to describe value to the organization – terms such as “exceeded expectations” or “fully met requirements” – speak little to what the employee’s role for the next year should be and whether that represents more or less value. There may be formal discussion of development needs or future career paths, but the majority of the review stops the conversation with what happened in the past.
The other major hurdle to a novel, but effective system is one of manager ability. The performance management systems in use today have been around for over a 50 years and managers still have a very difficult time using the systems. And, most if not all of your managers have been participants in a review system over their career and have developed their own sense of what a performance management should look like. This makes implementing and truly getting your managers to take ownership of a new approach — regardless of how potentially effective it could be — very difficult.
How do you determine an employee’s or candidate’s value at a point in time? The approach that we find most successful also requires the most development time and administrative focus, particularly for smaller employers. That approach is to define and verbalize job specific competencies along a career ladder and to assess an employee’s demonstrated ability relative to them. By job-specific competencies, we do not necessarily mean generic duties such as project management or financial analysis. We mean more specific competencies and related job duties that would allow you to differentiate a staff accountant from a financial analyst or an HR generalist from a senior HR generalist.
We are not suggesting that you pay someone based on what they can do. We are suggesting that, based on your assessment review of their past results, you increase the value of the work they do and, if they succeed, you increase their base pay. If they fail, and there are no reasons beyond the employee’s control, you decrease their base pay.
In many organizations, this may appear very similar to how they determine a new employee’s starting pay. Through the interview process and whatever assessment testing the organization uses, a determination is made not only to the candidate’s selection but also to his or her value to the organization. The process involves understanding the candidate’s personal characteristics and their level of proficiency relative to competencies required by the job. The process for determining base pay increases could look very similar with the major advantage being that it is much easier to assess the personal characteristics and job competency for a current employee.
Base pay is a valuable investment, but it requires better upward and downward management than is usually seen today.
Base Salary is a Long-term Incentive
Consider for a moment the graphic below that illustrates the time horizon that each TDC element recognizes. Long-term incentives may have some basis in past performance—the amount of grant is based on past performance or a newly-promoted employee may receive his or her first grant — but they primarily recognize performance that is to occur some time in the future. Variable pay is generally retrospective in that an employee receives a payment for a certain level of accomplishment that has occurred. In some instances, well-designed short-term incentives plans will actually engage employees prospectively. Base pay is much like long-term incentives in that its primary horizon is forward looking. Or should be forward-looking.
For base pay to be as relevant as possible in the TDC mix, we suggest employers move away from thinking that base pay is some type of accumulated fund based on past performance. Employers should be thinking of base pay as the amount they are willing to invest for the services they expect to receive for the next period.
What Do Employees Think About Base Pay?
Variable pay has been inculcated thoroughly enough in most organizations so that employees intellectually understand that a bonus or short-term incentive program is designed to create a direct link between a payment to them and the organization’s or the employee’s performance. We work very hard with clients to help them communicate this message.
However, there are other, less positive, messages that always seep through. Employees understand that variable pay is a means for employers to manage cost—employees take the risk that organizational performance will generate a payout. Essentially, employees understand that variable pay is compensation “with strings attached”.
Base salary expresses your organization’s confidence in identifying talent. It expresses that the organization trusts the employee and is confident that the employee will fulfill their potential.
What Do We Suggest?
Any time organizations consider how well they are using their rewards or one particular, we suggest that they start at the beginning, if only to confirm their reward strategy and its overall architecture still fits organizational needs. Regardless of the architecture and desired mix of elements, employers do need to maximize the value they receive from base pay. Important areas in which an organization should focus include:
• Begin to move away from base pay increases as a measure of how well an employee did. Move instead to redefining what the employee will do going forward and reconciling the new work to monetary recognition.
• We believe variable pay, well-used, should be an integral component of any organizations reward program. If an organization strictly adopts the type of base pay adjustment plan we discussed, then actual results must be measured and discussed. A variable pay program will allow you to recognize outcomes without clouding the purpose of base pay changes.
• Begin to change employee perception of base pay and what it should mean at least as part of your value proposition. Employees must understand that their base pay is set to the value of their future service.
• Lastly, keep in mind that the act of paying can have value. Certainly direct deposit is convenient for everyone, but a lot of value is lost because we barely even notice the pay stubs online. As a manager, take the time to deliver checks personally or finds other means to personalize the action.
About RSC Advisory Group
RSC Advisory Group, LLC is a management advisory and consulting firm specializing in performance and rewards. The RSC team has worked with clients in a multitude of market sectors and geographic areas. Their current client base includes household-name corporations, internationally known tax-exempt organizations, healthcare systems, as well as smaller, forward-thinking organizations. Their work has spanned start ups, high-performing organizations and those going through re-invention – all who need advice and guidance specific to their situation.
RSC Advisory Group, LLC