Compensation Philosophy Statement
All organizations need to think through a core philosophy that guides how its leadership makes compensation decisions and what the company’s rewards strategy will be. That pay philosophy is formulated by company owners and senior strategy leaders and should be formalized into a written statement. The statement spells out the economic value system and structure that will guide how employees within the organization will be paid—and, perhaps most importantly, why. It is written so it can be easily shared and referenced both when leadership makes decisions about specific pay strategies and when it communicates the nature of the company’s pay system and its components to employees. It acts as a kind of compensation “constitution” for those charged with envisioning, creating and sustaining the rewards strategy of the business.
A philosophy statement may be short or long, broad or narrow. What’s critical is that it articulate what the business is willing to “pay for”—and that those values be codified and communicated. When a company has made the effort to be clear about the role it wants compensation to play, it can speak to its employees about rewards from a position of operational integrity. As it communicates a well thought-out philosophy, some employees may disagree with it, but they won’t be able to claim their pay is “unfair.” This is because the philosophy statement reflects the economic values of the organization in support of its vision, business model and strategy. It makes a clear declaration of what’s important and, therefore, what will be rewarded.
A compensation philosophy becomes a kind of screening device for recruiting and retaining talent. If someone doesn’t relate to the rewards values of the business, there’s a good chance that person is not a good fit for the organization. After all, the pay philosophy describes the nature of the financial partnership company leadership wants to have with its employees. If an employee is looking for a different kind of economic relationship with his or her employer, the pay philosophy will bring that conflict to light.
A good compensation philosophy statement will define and articulate the following:
1. How owners define value creation. This means establishing and communicating the threshold at which owners feel that business performance is attributable to the people at work in the business and not just the shareholder capital (already) at work.
2. How and with whom owners believe value should be shared. This addresses what happens with the value that is created through the productivity and performance of individuals and teams in the organization. Will the company share equity? If so, under what circumstances? If not equity, how will value be shared? And so on. (See also #5.)
3. How increased earnings opportunities can be realized. Organizational leaders need to decide, for example, whether they want high earnings to be achieved by moving up through salary grades or whether value sharing will be the primary means of increasing one’s compensation. This means that, philosophically, leadership needs to spell out the extent to which pay levels will be driven primarily by performance factors—be they individual, team/department or company.
4. The balance the business wants to maintain between guaranteed and variable compensation. This a further refinement of #3 that defines how the company will address its pay construct in real life terms and on what basis. For example, where does the company want to be relative to market pay for salaries? What about for total compensation? If it believes it should be at the 80th percentile for salaries, what will this mean for how much emphasis will be placed on value sharing opportunities? Will the balance between salary and variable pay differ for each pay grade or tier? (Probably) And why does the company believe this is the right balance to strike?
5. The rewards emphasis the company wants to put on short versus long-term value creation. This is really a decision about whether the company will be focused more on immediate or on sustained results. Business leaders need to determine whether they want employees focused on performance “sprints” (of say 12 months or less) or longer-term outcomes. Again, will this vary by tier or other employee classification? If so, what is the right balance at each level?
6. How the company will finance its value sharing plans. This is easily determined if company owners have been clear in their value creation definition as described in #1. For example, a business might say that value sharing must be “self-financing”—meaning benefits will only be earned when sufficient value has been created—and will be paid solely out of a productivity profit. A business’s productivity profit is the net operating income that remains after accounting for a capital “charge” (from operating income) to protect the return shareholders expect on their capital contribution.
7. How the company will address merit versus cost of living increases. If an organization has clearly defined what value creation means, and is committed to the concept of a productivity profit, the philosophical framework is in place to define what it intends for merit pay. When the other six factors listed here are addressed properly, cost of living increases will likely only apply to limited positions within the organization. All increases will be merit-based. In conjunction with #4, leadership just needs to determine how much weight it will place on guaranteed compensation versus incentives and on the former, what performance criteria will drive the salary increases for which employees can become eligible.