18

Compensation: An Introduction

Five dollars a day is what Henry Ford paid to assembly line workers in 1914. It was more than double what his competitors were paying. Why did Ford take this revolutionary approach? He wanted to attract the best and the brightest—the best mechanics and workers for his plant.

Lead, lag, or meet the market—which compensation strategy should an organization follow? How and when should this be decided? Compensation, as part of the total rewards structure, is a key strategy for successful organizations. In order to meet its mission, it must attract and retain people who have the appropriate knowledge, skills, aptitudes, competencies, and attitudes to get the work done.

    A company leads the market when it decides to pay its employees more than the identified market rate.

    A company lags the market when it decides to pay its employees below the established market rate.

    A company matches the market when it pays the “going” rate.

The challenge for organizations is to develop a compensation philosophy and a pay system consistent with their objectives and that will reinforce the culture, the climate, and the behaviors needed for the organization to be effective and successful. The approach taken and the pay system implemented must fit the organization’s strategy and management style. Further, compensation philosophy needs to be reviewed frequently to ensure that it still meets the business needs and continues to align with the vision and mission of the organization. As an organization moves through different stages of its organizational life style, its compensation philosophy needs to be revisited and may need to be adjusted.

Compensation has progressed since Henry Ford paid his workers five dollars a day. In addition to direct compensation or pay systems, employers today must consider indirect compensation or benefits as part of its total rewards system. A total rewards program includes base pay, pay differentials, bonuses and cash incentives, and stock-related rewards. These elements are discussed in this chapter. Other elements include employee benefits, performance feedback and recognition, opportunities for career growth, and workplace flexibility, which are discussed in other chapters.

A compensation system must be:

    Compatible with the organizational mission and strategy.

    Compatible with the culture.

    Appropriate for the workforce.

    Externally competitive.

    Internally equitable.

Developing a Pay System

The first step in determining how to pay employees is to develop a salary structure, which involves analyzing, evaluating, and pricing the jobs in the organization.

    See Chapter 19 (Developing a Salary Structure).

With this structure in place, pay systems can be developed. Pay systems, which focus on pay adjustments or increases, can be structured in a number of ways, and must fit the culture and align with industry standards.

    Pay for performance or merit pay systems tie pay increases to an employee’s performance. Organizations that implement these systems often want to distinguish and reward performance excellence, and discourage a culture of entitlement. Seniority and years of experience are not factors that are considered. Increases are often tied to performance appraisal ratings. The challenge for employers is that they must be able to defend differences in salary increases and performance appraisal ratings to assure fairness and equity.

Employers are turning to variable pay to reward employees for performance. Contributing to this trend are salary budgets, which in recent years remained relatively flat and low, and emerging trends in performance management, which are putting less emphasis on ratings or rankings. According to a survey conducted by WorldatWork in 2016, the percentage of companies using variable pay rose to 84 percent, and a combination of awards based on both organizational success and individual performance continues to be the most popular variable pay program.¹ Variable pay is a type of incentive pay, which is also discussed in this chapter.

    Single-rate or flat-rate systems generally pay one rate to all incumbents in a job, regardless of performance or seniority. These systems are often found in the public sector, for elected jobs, or in union hourly positions. The rate of pay is generally the market rate.

    In a time-based or step-based system, the rate is based on longevity, and pay increases occur on a predetermined schedule, such as an automatic step-rate, in which an employee who reaches a certain seniority level advances one step in the pay scale. In variations of this system, the size or the time of the increase may vary (the employee advances two steps rather than one) if the employee exhibits exceptional performance. Seniority is the basis for any pay adjustment.

    In a productivity-based system, pay is determined by the employee’s output. Variations include a straight piece rate where there is a base pay rate plus additional compensation for output, or a differential piece rate, in which the employee is paid one piece rate up to the standard and a higher rate after the standard is exceeded. These are most common in assembly and manufacturing situations.

    Person-based systems pay people based on their value, rather than on the marketplace value of the job they hold. Examples include:

    Skill-based pay, which is easy to apply in a production work group in manufacturing, where it is easy to identify tasks and needed skills. Employees earn pay increases at a rate commensurate with their ability to acquire new skills.²

    Knowledge-based pay typically centers on career ladders, which identify expertise levels within the same occupation or discipline. For example, analysts at all levels of expertise perform work of the same basic type, but do so at varying levels of knowledge, skill, responsibility, and complexity of work. The vast majority of scientific, engineering, and professional occupations lend themselves to this approach. Their knowledge and expertise in their field grows over time and it becomes the metric for shaping their roles in their organizations.³

Other ways that base pay can be adjusted include:

    Cost of Living Adjustments (COLAs), which are across-the-board wage and salary increases that bring pay in line with increases in the cost of living to maintain real purchasing power. They are based on the consumer price index (CPI).

    Lump-sum increases, which are one-time payments that typically do not affect or increase an employee’s base pay.

    Market-based or equity increases, which occur when a market study (or salary survey) is conducted to determine if salaries are still competitive. The results may be individual employees receiving adjustments to their base salary and/or salary grades being adjusted.

Another consideration in developing pay systems includes pay differentials. Pay differentials are adjustments or additions to base salary. They can include:

    Overtime, as required by the FLSA.

    Geographical differentials, which are adjustments to pay rates based on location and are often used to attract workers to a certain location.

    Shift pay or shift premiums, which are paid to workers who work other than the day shift. They may be a percentage of base pay or be factored into the hourly rate.

    Emergency-shift pay, which occurs when employees receive extra pay when they are called back into work for an emergency, such as a power failure or when a computer system crashes.

    Premium pay, which is paid to employees in some industries when they work holidays or weekends, or in other extenuating circumstances.

    Hazard pay, which is additional pay for working in dangerous and/or extremely uncomfortable working conditions.

    On-call or call-back pay, which may be required under the Portal-to-Portal Act.

    See Chapter 17 (The Legal Landscape of Compensation) for more about the Portal-to-Portal Act.

On-call pay is received when employees are on call but not actually working. Call-back pay is paid to employees who are called to work before or after their scheduled work day.

    Reporting pay, which is paid when an employee is called into work and there is no work available.

    Travel pay, which is paid to employees traveling to work assignments.

    This is also discussed in Chapter 17 (The Legal Landscape of Compensation).

Incentive Pay

Incentive pay rewards employees for their individual and organizational results. Measures of success can include profits, customer satisfaction, or overall organizational performance.

Individual incentives are paid to employees who achieve goals and objectives that have been determined in advanced and achieved within a certain, defined time period. Individual incentive plans must be separate from base pay and can take the form of commissions, cash bonuses, recognition programs and awards, or piece rate awards, which allow workers who are more productive to earn more money.

As more companies are offering variable pay to reward employee performance, a combination of awards is often used—awards based on both organizational success and individual performance. Many employers are offering variable pay programs throughout their organizations, from hourly workers through the executive suite, in an effort to promote teamwork and cultivate a culture that everyone contributes to the overall success. These organizations view such programs as a way to attract and retain better talent at all levels.⁵

Group incentives are often implemented to increase productivity and foster teamwork while sharing success and financial rewards with employees. They do not take into account individual performance. One example is gainsharing programs, which involve employees and managers in improving productivity as well as sharing the benefits of success. When a profitability goal is met, each member receives the same cash reward.

In group performance plans, another type of group incentive, members are rewarded for meeting or exceeding performance standards. The performance criteria can be qualitative or quantitative and standards are often predetermined.

Finally, there are organization-wide incentive plans. Profit-sharing plans allow employees to share in a company’s profits. They can be:

    Cash bonuses or payments in addition to normal base pay, which are considered direct pay and taxed accordingly; or

    Qualified plans under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code, which distribute pre-tax dollars to eligible employees, are typically based on a percentage of the base salary.

    The ERISA is discussed in Chapter 20 (The Legal Landscape of Employee Benefits).

Performance-sharing plans are similar to group performance plans, in which the criteria are based on qualitative factors such as customer satisfaction and quality.

Finally, there are stock ownership plans that allow employees to receive or purchase company stock and share in its ownership. Employee Stock Ownership Plans (ESOP) are generally a defined contribution plan in which the employer makes contributions of cash or stock to a tax-deductible trust in the employees’ names.

Sales Compensation

Common methods for paying sales personnel include:⁶

    Salary only (or straight salary), which provides a specific amount each pay period and covers all expenses incurred by the salesperson in the performance of assignments.

    Sales commission (or straight commission), which is usually a percentage of net sales. If no sales are made, no money is received by the salesperson.

    Salary plus commission/bonus, which combines the two previously mentioned methods and provides a level of security in periods of economic downturns or depressed demand.

    Salary plus bonus, with the bonus based on individual or group performance and tied to some performance indicator.

    Commission plus bonus, with the bonus providing an additional incentive to accomplish a desired target.

Compensating Employees in a Global Environment

Organizations with employees in other countries face added challenges and complexities, including tax implications, in their compensation design and strategy. It is best to develop a global compensation and benefits strategy early and to seek professional advice from consulting or accounting firms with international specialists for expatriate and foreign national employment situations.

Common approaches to determining compensation packages for employees on international assignments include:

    Straight negotiation, where a package is mutually negotiated between the employer and employee.

    Headquarters-based balance sheet, in which the all expatriates working in the same position are paid the same based on standard of living in the headquarters’ country regardless of their country of origin. Expatriate salaries are kept in line with staff at headquarters rather than their home-country peers or assignment-country peers.

    Home-country-based balance sheet, in which the expatriate receives a differential between his or her home-country costs and the costs of the country to which he or she is assigned (local or host country) to keep expatriate salaries in line with their home-country peers, not with those of their assignment-country colleagues.

    Pure localization approach, in which the expatriate receives the same compensation as local nationals working in the same position.

    Higher-of-home-or-host country, in which the expatriate is compensated at the higher cost of living, determined by comparing the standards of living of the home country and host country.

    Lump-sum, in which the expatriate receives a lump-sum payment rather than allowances or differentials.

Executive Compensation

Executive compensation varies by industry and organizational culture, but the majority of the plans have components of long-term and short-term incentives.

    Short-term incentives are generally cash bonuses, which represent a significant percentage of pay and are typically driven by annual objectives linked to company objectives.

    Long-term incentives typically include some sort of stock award, such as stock options, restricted stock, or others.

A common use of a deferred compensation plan occurs in the area of retirement planning. In many 401(k) plans, certain executives might not be able to defer their full desired amount under the plan because of non-discrimination testing issues. Companies faced with this issue often create a “401(k) excess plan” or a “401(k) wrap-around plan.” These are non-qualified plans not subject to the same IRS regulations as those plans that aim to provide a benefit to all employees. This type of plan could allow the executive to defer an additional sum to the 401(k) plan over and above the amount allowed under the more restricted non-discrimination testing scenario.

Other components of executive compensation include:

    Perquisites, or “perks,” which are additional benefits that provide comfort and luxury to the work and/or personal environment. They may include generous pension plans, access to a company jet, club memberships, limousine services, annual tax/financial planning allowance to provide professional assistance in an area that is often time-consuming and a distraction to senior staff, or increased disability coverage because these programs have maximum dollar limits that cover less than the desired percentage of an executive’s compensation.

    Golden parachutes that provide special payments in the event they lose their position, especially if there is a change of control because of a merger or acquisition. These are generally clauses written into their employment contracts.

Section 402 of the Sarbanes-Oxley Act, which applies to publicly held companies, bans personal loans to executives or members of the board of directors in for-profit companies. Executives include company presidents and vice presidents in charge of a principal business unit, division or function such as sales, administration or finance. It does not apply to loans taken from a 401(k) account, or loans for business purposes.⁸

    The Sarbanes-Oxley Act is discussed further in Chapter 20 (The Legal Landscape of Employee Benefits).

Discussion Questions

1.    Describe circumstances when a company would want to:

    Lag the market.

    Meet the market.

    Lead the market.

2.    Describe the elements of your organization’s total rewards program. What is the underlying philosophy of the program?

3.    Describe any incentive plan that your organization has implemented. Have you considered other ways to reward your employees other than an annual raise?

4.    If you were to design a pay system for sales employees in a large retail store, what would you consider and why? How would you set it up and why?