Why a Pay Philosophy Matters

By Ken Gibson

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An article that appeared in Entrepreneur Magazine’s  online edition late last year made the following observation about compensation:

Only 20 percent of people say they understand how their employer determines pay, according to compensation research firm Payscale.  But that doesn’t have to be the case, and it shouldn’t be. “Ten years ago, employers held all the cards.  Now, employees can be much better armed with data,” said Tim Low, PayScale’s senior vice president of marketing.  With sites such as PayScale and Salary.com, employees have a greater ability to research what their work is worth and a better opportunity to ensure they’re being paid fairly.

That view likely rings true with you if you lead a company.   At BonusRight, in our work with CEOs and other business leaders across the country, we hear countless stories about employees making the case for a certain level of pay based on the data they found on the internet.  Others recount instances of people in senior positions feeling they deserve equity in the business based on what competitive data say.  Those who pay annual bonuses tell tales of an entitlement attitude that has permeated their workforce.  “Employees think their bonus is just an expected part of their pay,” one chief executive lamented.   In each of these instances, there is a clear disconnect between company leadership and employees when it comes to decisions about pay.

In short, if you’re responsible for designing employee pay, it’s easy to be in the defensive when it comes to compensation issues. And if you don’t take appropriate steps to get ahead of the problem, it can become a real cancer in your organization leading to attrition, low morale and diminished performance.

Unfortunately, too many organizational leaders have a reactive response when approached by employees about pay issues.  As a result, they often end up making matters worse instead of better with their knee-jerk remedies and band-aid solutions.  For example, one leader might raise someone’s salary for fear of losing that person—in the process creating a precedent he can’t sustain.  I’ve seen others give out stock to a key employee because that person plays a critical role in the business only to find out later that the employee didn’t think it was enough and is frustrated she has no means of redeeming it unless there’s a transaction sometime in the future such as sale of the business.  In each instance, the business leader lives to regret their action because it either opened the flood gates to further requests or created an ad hoc approach to addressing something that should have been handled strategically.

The Role and Importance of a Pay Philosophy

What I’ve just described happens to companies that have no core philosophy guiding how they make compensation decisions and what their rewards strategy will be.  A pay philosophy is a written statement that company owners and senior strategy leaders draft to spell out a value system and construct that guides how people will be paid in the company and 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 organization’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 company.

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 the 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 the 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.

A philosophy statement may address more or less than those seven issues.  What’s critical is that an organization thinks through what it’s willing to “pay for” and why.  If it has made the effort to get clear in its thinking about the role it wants compensation to play, it can address employee challenges from a position of operational integrity.  When it can communicate a well thought-out philosophy, some employees may still disagree with it, but they can’t claim it’s unfair.  This is because the philosophy statement is merely reflecting the economic values of the organization in support of the company’s vision, business model, and strategy.

In a sense, 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, in essence, 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, the pay philosophy will bring that conflict to light.