In the ever-evolving landscape of pay-for-performance, merit pay serves as the foundation for the recognition of individual excellence and contributions. As we delve into its rich history, we uncover the roots of performance-based compensation and its significant role in shaping modern corporate structures.

The Genesis of Merit Pay

The concept of pay for performance and merit pay is not a recent phenomenon.   Pay for performance can be traced back to the late 19th century and early 20th century with the advent of Scientific Management when Frederick Winslow Taylor published “The Principles of Scientific Management” in 1911.   In the more than 100 years since its publishing, the idea of pay for performance has proliferated, and so too has the criteria for performance-based rewards. Companies and governments began to integrate various metrics such as sales targets and project completion rates into their compensation structures, giving birth to the modern concept of merit pay that we are familiar with today.

Current Trends in Merit Pay

In recent years, the approach to merit pay has undergone significant transformations. Private companies have had some form of pay for performance, or merit-based pay for hundreds of years, and in 1978, Jimmy Carter introduced merit pay for federal employees with the Civil Service Reform Act of 1978.  As the labor market continues to evolve, so too are companies evolving their merit pay approaches and adopting flexible and dynamic performance measures that align with changing business objectives. The evaluation process has become more holistic, considering not only hard performance metrics but also an individual’s overall contribution, including soft skills and teamwork.

Variations and Alternatives: A Cross-Industry Perspective

Merit pay manifests differently across various industries. In the tech and startup sectors, traditional merit pay is often complemented with stock options and equity bonuses. Warehouses and distribution centers may offer piece-rate pay programs based on worker output.  The sales sector predominantly utilizes commissions based on performance, while the healthcare sector might tie performance bonuses to patient outcomes and satisfaction rates. The education sector has also experimented with merit pay, linking it to student performance, although this remains a subject of controversy. 

Parallelly, some companies are exploring alternatives to merit pay, such as profit sharing, skill-based pay, and team-based bonuses, aiming to foster a more collaborative and skill-driven work environment.

The Mechanics of Merit Pay

In an ideal world, merit pay rewards high performers and ensures steady performers’ pay remains in line with the compensation philosophy.  We are not, however, in an ideal world.  Merit increases are awarded on a number of factors, many of which are subject to bias and subjectivity.  Understanding the mechanics of merit pay and the opportunities where it may go awry are critical to ensuring the objectives are upheld. 

Understanding the Responsibility for Merit Increases

When it comes to implementing merit pay, several key players within an organization hold significant roles. Typically, the compensation team sets the merit increase guidelines, maintains pay scales, and works with HR Business Partners to ensure compliance with company policies and external regulations. Simultaneously, Direct Managers and Supervisors play a crucial role in evaluating the performance of their direct reports, providing feedback, and recommending merit increases. In larger organizations, Compensation Committees may review and approve the recommended merit increases, ensuring a balanced and fair approach that represents shareholder (or stakeholder) interests.

Factors Considered in Determining Merit Increases: A Balanced Approach

Determining merit increases is a nuanced process, and numerous factors must be considered to ensure a balanced approach. HR and compensation teams will usually consider compa-ratio, performance reviews over 1 or 2 years, previous pay increases, recent promotions, market data, and pay equity.  Although there are numerous factors that may go into consideration, the merit matrix is the most common and generally looks at two factors:  (1) performance and (2) the employee’s position within the pay range.

Recognizing and Retaining Top Performers: The Merit Pay Advantage

Done correctly, merit pay may serve as a powerful tool to motivate and retain top performers in an organization. By offering tangible recognition through merit increases, companies can incentivize peak performance, ensuring that employees are motivated to consistently deliver their best. This approach not only recognizes excellence but can reduce turnover of regrettable losses, as high performers who feel recognized may be less likely to seek opportunities elsewhere when their efforts are rewarded appropriately.

Although this article focuses on merit pay, the author would be remiss not to discuss the importance of personalized awards for employees.  Few employees are 100% financially driven and studies have shown that recognition and appreciation alone can create greater employee satisfaction than financial awards. 

How Much More Should High Performers Receive?

It depends and determining the right amount for merit increases is a nuanced process. While the exact figures can vary based on various factors such as industry, company size, and geographical location, a core tenet of pay for performance is that merit increases for high performers should be significantly above the average percentage given to other employees. This strategy ensures that their compensation reflects their market value, fostering a culture of excellence and competitive advantage. The reality, however, is quite different. 

According to a 2019 study conducted by WTW and published by World at Work shows that only 20% of companies reported that top performers receive merit increases that are more than 1.5x the average performer.  While merit budgets have hovered between 3.0% – 4.5% for the past several decades, practically speaking, a 1.5x difference will usually mean a less than 2.0% difference in total pay between a high performer and an average performer.  Or, put into numbers:

The difference between the high performer and average performer in this scenario is a mere $625.  Hardly more than $10 per week, and not enough to drive any meaningful performance. 

The Emotional Quandary: Managers Navigating the Emotional Landscape of Merit Pay

Merit pay attempts to introduce an element of fairness into the compensation program by linking pay to performance through objective metrics.  However, executing a merit pay strategy may present a significant emotional quandary for managers. When tasked with fostering a positive work environment while adhering to the pay-for-performance philosophy, managers may struggle with the potential human repercussions of awarding minimal increases or providing large increases to performers.  When faced with a finite merit budget, one employee’s large increase may feel like stealing from Peter to pay Paul.  Especially if their team consists of a high-performer named Paul…

When faced with a finite merit budget, one employee’s large increase may feel like stealing from Peter to pay Paul.

The reluctance to award minimal increases can create a ripple effect on team dynamics, potentially undermining the essence of a merit-based system. When low performers receive pay increments comparable to their higher-performing peers, it can foster a sense of injustice and dissatisfaction among the team. To navigate this complex landscape, organizations must equip managers with the skills and tools to communicate the rationale behind pay increases effectively, fostering a culture of transparency and understanding.  Managers who don’t fully understand the importance of merit pay and differentiating pay between high and low performers may apply the “peanut butter” approach, where the merit increases are spread evenly across their team. 

Peanut-buttering merit increases can have detrimental effects on an organization. By offering a uniform percentage increase across all employees, irrespective of performance, companies risk demotivating high performers and encouraging a culture of mediocrity. The peanut butter approach dilutes the impact of merit pay, undermining its potential to foster excellence and innovation in the workplace.  To reduce the chance for peanut butter, HR and compensation teams may provide pay guidance in the form of a merit matrix. 

The Merit Matrix: The Most Common Tool for Determining Merit Increases

The merit matrix serves as one of the most common tools used to help managers calculate merit pay. A merit matrix provides suggested merit pay increases for employees (usually) by combining performance ratings and the employee’s position in the pay range. This approach ensures that high-performing employees earning less than the midpoint for their role receive higher percentage increases, fostering a fair and balanced merit pay system. 

For many Organizations, the merit matrix may serve as a guide rather than a rule, allowing managers to deviate from the suggested pay ranges.  According to a 2019 study by WTW and published by World at Work, 48% of organizations reported that the managers have discretion to provide merit percent increases outside of the suggested ranges.  Although not perfect, a merit matrix can be used to fairly distribute a finite budget and can reduce internal pay inequities over time. 

Communication of Merit Increases: Transparency at its Best

According to a 2022 study by Gartner HR Research, only 32% of employees believe they are paid fairly.  As pay transparency proliferates and employees have greater access to what pay companies are offering, manager communication around compensation is important.  Clear communication is pivotal in the successful implementation of merit pay and is often the responsibility of the direct manager or supervisor. Merit increases are usually communicated during annual or semi-annual performance reviews and for effective conversations, managers should understand the company’s compensation philosophy and how the employee’s pay aligns.  Providing manager training to have effective compensation conversations is a critical role that the HR and Compensation team should take a proactive role in.  Moreover, to maintain clarity and reduce disputes, the employee’s performance evaluations should be documented and discussed with employees frequently, ensuring a seamless process.

Frequency of Merit Increases: Aligning with Organizational Goals

The frequency of merit increases can vary significantly between organizations. While annual reviews aligning with fiscal year-end evaluations are most common, some organizations opt for more frequent reviews, especially in fast-paced industries or roles with clear, short-term targets. This approach ensures that merit pay is closely aligned with the dynamic goals of the organization, fostering a culture of continual growth and achievement.

What are the Criticisms of Merit Pay?

Like any system, merit pay comes with its set of challenges and criticisms. Some of the most common criticisms of merit pay include:

Addressing Subjectivity and Potential Biases in Performance Evaluations

Central to the concept of merit pay is the performance evaluation process. However, this process can sometimes be marred by subjectivity and potential biases. Managers’ perceptions, recency bias, and comparisons with peers can sometimes cloud objective assessments, leading to disparities in merit increases. A successful merit pay program must address these potential biases and ensure measures are put in place to eliminate them. Many organizations have also moved to more agile performance measures or gotten rid of performance ratings, altogether. 

The Risk of Discouraging Teamwork

While merit pay aims to reward individual accomplishments, in some cultures and within some teams, an overemphasis on individual achievement may discourage collaboration. Inter-team competition and a reluctance to collaborate can undermine broader organizational goals. To navigate this challenge, organizations must foster a culture that balances individual recognition with teamwork and collaboration and may even include teamwork and collaboration as an employee objective.  Organizations may include teamwork and collaboration in their HR mission statements to emphasize it’s importance. 

Varied Interpretations of Performance Metrics

The interpretation of performance metrics can sometimes vary significantly between managers, leading to disparities in merit increase recommendations. Organizations must work towards standardizing the interpretation of performance metrics, ensuring a fair and balanced approach to merit pay.  Compensation and HR teams may work together to provide various training materials to supervisors and people managers.   Training materials should be varied and may include: one-pagers, employee handbooks, lunch and learns, live training sessions as well and recorded presentations.  Providing training through various mediums will address the different learning styles. 

The High Pressure of Continued High Performance

Merit pay can sometimes create a pressure-cooker environment, where employees feel the need to consistently deliver high performance. This pressure can lead to burnout and a reluctance to take risks. Organizations must foster a culture that encourages innovation and risk-taking, balancing the demands of high performance with the need for well-being and job satisfaction.

Does Merit Pay Drive Employee Performance?

In the earlier example between two employees earning $50,000 each, one being a high performer and the other being an average performer, we highlighted how a much larger performance percent increase may only result in a nominal difference in actual pay.  As the demand for pay equity continues to grow, some Organizations may lean more heavily on variable pay and promotions to recognize high performers.  Leaning more heavily on variable pay and promotions allows the business to provide meaningful financial awards and recognition to high performers, while more easily balancing pay equity.  Of course, promotions and incentives should be tied to objective measures to reduce the opportunity for bias. 

Expanding Beyond of Merit Pay: Incorporating Promotions and Bonuses

In the evolving narrative of employee compensation, merit pay has long been one of the cornerstones of rewarding employee excellence. However, to fully harness its potential, organizations must look beyond mere salary increments and understand what motivates their employees, how to align employee objectives to business goals, and what makes sense in a practical manner, rather than on paper or in a spreadsheet. 

Promotions: Elevating High Performers to New Heights

Promotions serve as a milestone in an employee’s career, marking their growth and contributions to an organization. In the context of merit pay, promotions act as a powerful tool to differentiate high performers, offering them avenues for greater responsibilities and leadership roles. Promotions not only foster a culture of recognizing achievement but also ensure that employee pay is closely aligned with the employee’s career trajectory, fostering a symbiotic relationship between individual growth and organizational success. 

Author’s Note:  Promotions should not be made in lieu of a merit increase or purely for employee retention, but there must be a business justification for the promotion, such as introducing a greater scope of responsibility to the employee’s role that exceeds their current job.

Bonuses: Recognizing Exceptional Contributions with Tailored Rewards

Bonuses add a dynamic layer to the pay program, offering (sometimes) immediate and tangible recognition for exceptional contributions. Variable pay programs allow organizations to reward high performers without creating significant disparities in base pay. Variable pay programs may include short-term incentives, spot bonuses, long-term incentives, and project-based bonuses.  By linking employee performance directly to financial rewards, bonuses have the distinct advantage of being able to quickly recognize performance directly related to specific behaviors the business wants to encourage, thus, fostering a culture of innovation and peak performance.

Conclusion

Although the idea of merit pay is nothing new, the concept remains a pivotal tool for recognizing and rewarding individual excellence and contributions. Tracing its origins to the early 20th century, merit pay has evolved to incorporate sophisticated criteria, aligning with changing business objectives and work cultures. Today, merit pay programs are diverse and varied, but merit tools exist to manage even the most complicated programs that vary across industries. Moving forward, merit pay will continue to evolve and adapt as organizations consider a more holistic approach to employee compensation, incorporating promotions and bonuses to fully realize the potential of merit pay in fostering a culture of excellence and competitive advantage.