Strategic Reward Systems

HR Management

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Strategic Reward Systems : Pay for Performance

Reward Systems consist of the following elements: Financial Rewards Compensation
1. Base Salary 2. Pay Incentives 3. Employee Benefits

Non-financial Rewards
1. Intrinsic Rewards centers on the work itself 2. Praise, recognition, time off and other rewards given to the employee by peers or superiors.
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Strategic Reward Systems : Pay for Performance

Reward Systems in most cases should be consistent with other HR systems. The Reward System is a key driver of: HR Strategy Business Strategy Organization Culture

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Strategic Reward Systems : Need for Consistency with Other HR Systems

Skill-based pay

Training
Overtime pay rules in contract

Culture
Merit pay reinforces performance culture

Labor Relation s

Rewards

Performance Management Employment

Merit Pay
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Sign-on Bonus

Strategic Reward Systems

Critical Thinking Question: 1. Should pay policies lead or lag the development of other HR systems?

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Theoretical Models of Pay and Performance: Equity theory (Adams, 1963)

Assumptions: People develop beliefs about what is a fair reward for ones job contribution - an exchange People compare their exchanges with their employer to exchanges with others-insiders and outsiders called referents If an employee believes his treatment is inequitable, compared to others, he or she will be motivated to do something about it -- that is, seek justice.
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Theoretical Models of Pay and Performance: Equity theory (Adams, 1963) Is/Os

versus

Ir/Or

O = Outcomes: the type and amount of rewards received I = Inputs: R = Referent: S = Subject: employees contribution to employer comparison person the employee who is judging the fairness of the exchange
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Equity Theory Exchange Scenarios

Case 1: Equity -- pay allocation is perceived to be to be fair - motivation is sustained Case 2: Inequity (Underpayment) -- Employee is motivated to seek justice. Work motivation is disrupted. Case 3: Inequity (Overpayment) -- Could be problem. Inefficient. In other cultures employees lose face.

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Consequences of Inequity

The employee is motivated to have an equitable exchange with the employer. To reduce inequity, employee may

Reduce inputs (reduce effort) Try to influence manager to increase outcomes (complain, file grievance, etc.) Try to influence co-workers inputs (criticize others outcomes or inputs) Withdraw emotionally - or physically (engage in absenteeism, tardiness, or quit)
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Equity Theory Implications

There is tension between internal and external pay equity: Decide where to place the emphasis. Example: In and out versus lifelong employment system Let employees know who their pay referents are in the pay system: identify pay competitors and internal pay comparators. Strive for consistent pay allocations Monitor internal pay structure and position in the labor market for consistency.
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Agency Theory

Agency theory is a theory of governance in the workplace. It tries to solve the problem of separation of ownership (atomistic shareholders) and control (professional executives and non-owners) It also tries to solve conflicts of interest between managers and employees with delegated responsibilities.

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Agency Theory
1. Principals = owners or managers who delegate responsibilities 2. Agents = managers or employees who manage firm assets for owners or other principals. 3. Information asymmetry = managers or other agents have greater access to strategic information than principals, who are not willing to bear the cost of directly monitoring the agents due to steep agency costs.

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Agency Theory
4. Risk Preferences principals are risk neutral and willing to bear greater risks than agents because their asset wealth is more likely to be diversified between corporate assets and other equities/investments. Agents are more risk averse than principals, because most of their wealth is concentrated in the firm and received in the form of pay and opportunities for promotion.

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Agency Theory
5. Moral Hazard agent is tempted (and some cases succeeds) in taking advantage of information asymmetry with principal and act opportunistically (defined as making decisions not aligned with principals interests) and use the firm resources to maximize wealth of the agent (often at the expense of the principal).

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Agency Theory
6. Agency Contract provides solution to moral hazard/agency problem, by establishing rules of the game to control agent opportunism agents performance will be judged by outcomes (often financial benchmarks) not behaviors (which require direct supervision of agents actions). These outcomes will reflect principals goals and risk preferences.

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Agency Theory
7. Incentive alignment the agency contract will specify a compensation plan that aligns the interests of the principal and agent. This agency contract will be a type of pay for performance plan. Meeting or exceeding preagreed upon financial or non-financial outcomes triggers various forms of compensation (individual or group-based) for the agent. Some agency costs are borne by the principal in the form of financial incentives for the agent.
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Tournament Theory
1. Tournaments are competitions between peers to achieve a promotion to a higher rank along with the pay and perks that go with it. 2. Tournaments are likely to result in a winner take all outcome. 3. Managers who enter the tournament must forego other alternatives (such as jobs with other firms, start own business, receive more pay with an alternative opportunity) to compete in the tournament.
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Tournament Theory
4. A high pay differential (such as the CEO receiving much greater pay than any subordinates) attracts more players to the tournament. 5. Players must invest (work long hours, accept less pay, show loyalty to their boss) to enter the tournament firm captures value from these players, more than what it gives up to the winner for the prize.

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Controversies that Surround Pay for Performance Plans

1. Single Mindedness you get what you pay for no more, no less. The activities that are rewarded get done, to the exclusion of other activities that are not rewarded. Example: The dysfunctional behaviors that are observed when a sales representative is put on straight commission.

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Controversies that Surround Pay for Performance Plans

2. Control externalities can control the outcomes, positive or negative. There can be windfall affects (the bull market improving the stock value of all stock options) or negative externalities (a bear market or recession that lowers the value of all stocks). Employee performance results may be magnified or diluted by these effects.

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Controversies that Surround Pay for Performance Plans

3. Measurement error some measures can be gamed or manipulated and may not reflect true performance. Sales reps can withhold sales and report it in a different period so they are not penalized by a cap on sales commissions. Managers can use creative accounting measures to report greater profits than were actually experienced by the firm.

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Controversies that Surround Pay for Performance Plans

4. Inflexibility managers or employees may resist change of the basis of compensation because they are comfortable with current basis for pay and want to avoid risk of taking reduction in earnings in new system.

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Controversies that Surround Pay for Performance Plans

5. Misalignment of incentives if pay emphasis is on a goal that is no longer relevant, that goal will continue to be emphasized until the pay system places emphasis on a different objective. For example, managers may emphasize short-term goals, even if long-term goals are more relevant, until the pay system recognizes long-term goals to a greater extent than short-term goals. The reward mix for complex jobs with several goals must reflect the relative value of attaining the mix of goals.
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Controversies that Surround Pay for Performance Plans

6. Line of Sight problem - division performance and corporate performance should be reflected in the pay system. If division performance and corporate performance are closely linked than both division and corporate performance should contribute incentives to the managers pay for performance plan. If division performance is independent of corporate performance, then the emphasis should be on rewards for meeting division goals.
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Some Suggestions for More Effective Pay For Performance Plans

Pay and Performance should be Loosely Coupled this gives managers more flexibility to make changes when new situations arise. Example: a formula with a bonus based on a moving average of a 3-year historical performance period. A 3-year period smoothes out performance over a longer cycle.

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Some Suggestions for More Effective Pay For Performance Plans

It is Necessary to Nurture the Belief that Performance Makes a Difference there are important cultural values that are supported with pay for performance even if the accuracy of the performance metrics and the fairness of the pay allocations fall short of an ideal situation. Abandoning pay for performance may be more problematic than having an imperfect pay system.

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Some Suggestions for More Effective Pay For Performance Plans

Pay for Performance systems should be designed to fit each firms unique situation imitation of other firms plans should be avoided

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Six Myths about Pay (Pfeffer, 1998)

1. Labor rates and labor costs are the same thing. 2. Labor costs can be reduced by lowering labor rates. 3. Labor costs are a significant portion of total costs. 4. Low labor costs are a potent source of competitive advantage. 5. The most effective way to work productively is through individual incentive compensation. 6. People work primarily for money.
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