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Merit Pay, Is It Worth It?

A CCA Briefing October 12, 2011

Barbara Manny, Benefits & Compensation Resources (BCR), LLC Dale Moyer, CPS Don Hubbartt, Siemens Jeff Newman, HSBC

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The Agenda

n  Overview n  Merit Pay Landscape n  2 Companies Approach: —  Siemens —  HSBC n  Breakout Discussions on 4 Major Questions n  Panel – Open Forum n  Conclusion

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Why Do They Exist?

n  Merit pay systems have been around in some form since the early part of the 20th Century.

n  Objectives of a Merit Pay System: —  Attract, retain and motivate. —  Develop a method to distribute pay equitably based on

performance. —  Use of merit increase guidelines tied in with objective

performance measures.

Current Economic Outlook

n  Inching up of consumer price index that will affect inflation n  Jobless claims are slightly down but

doesn’t capture under employment n  Political gridlock because of election year n  Lack of job expansion n  Lack of economic expansion n  Consumers’ confidence is low n  Organizations are hoarding cash but not spending n  Employee engagement is at an all time low n  High potentials are at risk

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Current Economic Outlook

Organization Goals: During recovery maintain a lean posture and operate more efficiently with less people è work harder and smarter.

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Era of employees happy to have a job accompanied with an attitude of distrust and disenfranchisement and an unwillingness to align their efforts with organizational

goals.

Motivating By Pay

n  Expectancy Theory

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Components Description Instrumentality The relative pay received is higher for high

performers than low performers. Pay distribution is contingent on high-performance.

Valence The differential between low performance pay and high performance pay is significant to the individual.

Expectancy Good performance is clearly defined and under the influence/control of the individual.

Conditions For Success

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Type of Conditions Impact Results In

Value Individuals must value increased pay more and be willing to work harder or spend more time meeting performance goals (Valance).

Higher performance.

Differential The differential in raises for high performance should be substantially higher than that awarded average or low performing individuals (Valence).

When differential is high increased effort is warranted.

Clear Communications

The criteria for good performance should be clear and communicated to employees (Expectancy; Role Expectations).

Employees don’t need to guess what they need to do to get good performance reviews.

Trust Employees must trust managers. There must be trust in the evaluation system so that employees do not perceive favoritism (Expectancy) and trust in the allocation system (Instrumentality).

Higher level of performance equals a higher raise.

Non-Zero Sum Everyone who meets high performance expectations receives a high increase.

When systems are zero sum, only the best employees receive the highest raises so middle and lower ranked employees lose instrumental motivation because even if they improve performance they don’t believe they’ll be rated higher than the “stars”.

Flaws In Merit Increase System

n  Some Design Flaws With Merit Pay Systems —  Zero sum feature. —  Timing – annual performance evaluations and pay

adjustments. —  Annuity feature disconnect. —  Small differentials between average and exemplary

performance. —  Inequity. —  Breakdown in group cohesiveness and cooperation.

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Snapshots n  Average Salary Increases

—  2009: 1.8% —  2010: 2.4% —  2011: 2.7% —  2012: 2.9% (projected)

n  Variable Pay Spending —  2009: 12.0% —  2010: 11.3% —  2011: 11.6% —  2012: 11.5% (projected)

n  Salary Increase vs. Variable Pay: 1991 vs. 2011

9 Source: Aon Hewitt Survey – U.S. Salary Increases 2011/2012

Pay Component 1991 2011

Salary Increases 5.0% 2.7%

Variable Pay 3.8% 11.6%

Where Are We Heading?

n  Variable pay plans continue to grow. n  Variable pay from employees’ perspectives:

—  Lead to higher pay. —  Minimize perceived negative consequences of performing well. —  Create additional positive outcomes.

n  From a research study, companies believe that variable pay is: —  More effective motivational tool than merit pay. —  Creates a better platform to improve employee performance.

n  Variable pay is the wave of the future, even globally.

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Where Are We Heading? n  Truly differentiate pay to motivate and improve

performance. —  Salary increases will start taking on new forms to create value to

employees. —  More careful tracking and monitoring of high potentials.

•  Cost is 9 X pay to replace. —  Better training and tools for managers to increase their

understanding of pay differentiation. —  Paying closer attention to targeted audiences.

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Dale Moyer Officer Compensation and Benefits, CPS

Viewing the Merit Pay Process

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Merit Pay Process

From beginning to end, the merit pay process involves several collaborating functions: n  Finance n  Compensation n  IT/HRIS n  Communications n  Payroll n  Others

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Merit Pay Process

Results -- n  Economy continues to show downward pressure on

wage growth n  Small salary increases not commensurate with work

effort or performance n  Employees derive little economic or psychic motivation

from small increases

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Merit Pay Process

Maintain a traditional,

conventional and expected salary increase process

Move to a more variable

model

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Choice for Firms May be a Trade-Off

There are Pros and Cons for Either Decision

Jeffery Newman EVP NA Performance and Reward

HSBC: Life Without Merit

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HSBC Reward Strategy

The 7 'Key' elements of the strategy are: n  Link variable pay funding to business performance - Commercial

approach to variable pay funding pool ensures linkage to business performance.

n  Support total compensation approach - Single reward decision rather than individual elements (salary, incentive, shares).

n  Base reward on market-oriented and competitive data - Use the right market comparison based on Group-wide and country specific competitor companies; fixed pay typically at market median, using full market range to differentiate performance.

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HSBC Reward Strategy con’t

The 7 'Key' elements of the strategy are:

n  Differentiate performance through leveraged variable pay - Based on individual performance and contribution to business goals; the higher the performance, the higher the share of available rewards.

n  Disconnect variable pay as a percent of salary - Allows more reward flexibility without pressuring fixed costs.

n  Emphasize line management judgment in variable pay decisions - Provides necessary flexibility to ensure that compensation reflects performance, contribution and market conditions.

n  Present long-term awards in form of restricted shares - Use of HSBC Restricted shares drives consistency and aligns employees' interests with shareholders' interests.

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HSBC Pay Transformation

One Shot Implementation in 2008 for 2009 actions —  Moved from prior merit and target driven pay approach to 100%

discretionary —  Imposed strict limitations on base actions for those at or above

median base Reinforced approach and philosophy in 2009

—  Enhanced guidance and training —  Webinar created to explain role of market and its impact on

reward decisions —  No restriction on manager’s actions —  Provided annual salary increase budget; relied on managers to “reserve” for off-cycle actions

Business As Usual for 2010 forward —  Improved training to address gaps —  Continue to monitor

HSBS – Post Transformation Highlights Salary Action Participation Rates

—  2009 – 52% received a salary action during annual cycle; artificially low due to restrictions on “above market pay”

—  2010 – 58% participation; influenced by turbulent market and prior year restrictions

—  2011 – 62% participation; variation in rates based on market conditions (and leadership capability)

Position to Market —  Achieved an aggregate Base compa-ratio of 98% —  Varies by performance —  Top performers at 103%; Strong 97%

Variable Pay Differentiation —  Top performers have averaged 2.25 to 2.40 dollars of variable

pay for every dollar awarded to strong performers

Lessons Learned

Highlights —  Do it all at once – don’t delay the transformation —  Don’t apologize for change —  Get in front of employees – frank and honest conversations

about impacts and careers

Opportunities —  Incredible complex job and market structures hinders ease of

use —  Business ownership of “HR” initiative —  More emphasis on the business impact

Don Hubbartt Director Compensation, Benefits, HRIS

SIEMENS

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Merit Pay – Is it worth it?

YES •  However, the look/feel of merit pay will continue to evolve

–  Given the external market trends, expect that merit spend will reduce over time in favor of other means to reward/retain people

•  Need to consider your audience / workforce in your organization •  Need to balance merit pay with other programs available to

employees •  Understand the objectives that your merit program can…..and can’t

achieve.

Base Pay Merit Pay

& Benefits

Recognition Awards

Gainsharing Project Incentives

SPIFFs

Short Term Incentives/Bonus

Stock & Equity

Perquisites, other

Pyramid and Hierarchy of Needs …….from a compensation/benefits standpoint

Pay for performance, market, and career progression

Frequent reinforcement of behaviors

Job-specific rewards

Reward financial results

Ownership culture

Flexible perqs

Self Actualization

Esteem

Love / Belonging

Safety

Physiological

Fixed pay or Variable pay?

*Source – Hewitt / Kenexa / Applied HR Strategies January 2011

Fixed pay Variable pay

Extreme pressure to hold down fixed costs Clear linkage with company results

High benefits cost impacts ability to increase base salaries

Scales with cost/profitability

Arguably, less impact on employee performance, “hygiene” factor

If well-designed, can help to drive the organization’s strategic objectives

In 10 years we will likely see an average merit budget of 2%*

…. and a variable pay budget of 16% of payroll (up from 11-12% for 2010)*

Most employees still expect merit pay to address cost of living, stay competitive with market

Generally seen as ‘on top’ compensation in most professions

Continue to see value in merit pay programs for the foreseeable future

Expecting to increase variable target spend over next two fiscal years

Best practices: Successful merit pay

•  Market-reflective budget (i.e. 3.0%); then ‘hold back’ portion of merit spend for mid-year / off-cycle adjustments (i.e. 0.25% to 0.5%)

0.5% allows for additional 5% increase to 10% of your population • “Career progression” increases are valued by employees and enhance the merit program • Implement a “pay for performance” metric – i.e. average increase of high rated must equal 1.5 – 2x average of average and lower rated employees • Consider performance, but also market competitiveness • Balance objectives of merit program with other programs (i.e. annual bonus, recognition, etc) • Ensure leadership, finance, organizational buy-in and understanding of the program

Merit Pay

Discussion

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