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Pressured by the tight labor market, companies are redesigning nonexecutive pay to attract — and keep — top performers.
Roy Harris, CFO Magazine
February 1, 2007
When Xcel Energy wanted to reward its rank-and-file for taking the initiative, it created Xpress Ideas, a rewards scheme that pays bonuses on the spot for useful suggestions. The program has been a hit among the company's 11,000 workers; last year they offered 6,133 ideas, most of which were implemented. After one worker pointed out that the Minneapolis-based utility was making unreimbursed repairs to streetlights owned by other parties, for example, the company began to label its transformers, saving about $2,250.
But those good ideas come at a price. While the company wrote employee reward checks to the tune of $427,400 last year, Xcel management felt it couldn't gauge the payback for the program. "Intuitively, people say they know this increases performance and makes us a better company," says Michael Connelly, Xcel's vice president of human resources. "Still, the hard metrics aren't there."
Like the nonexecutive-pay systems at many companies, Xcel's aims to reward work that measurably improves corporate performance, attracts new talent, or motivates top performers. Ironically, because the Xpress Ideas program for rewarding good ideas doesn't fit neatly into that strategy, it may itself not be a good idea. And, in response, Xcel is considering shifting some of that money into its short-term incentive program, which rewards top employees with annual bonuses based on a combination of individual, business-unit, and corporate performance.
As it attempts to adjust the mix of compensation components, Xcel finds itself part of a growing trend. Across the country, companies are reacting to a shrinking labor pool and a strong economic recovery by improving their ability to recruit and retain superior employees. Often, that comes down to cash — and delivering that cash in ways that assure top performers that their contributions are recognized.
There is definitely grumbling in the ranks. A recent Watson Wyatt Worldwide employee survey found that 71 percent of high achievers list concerns about pay as one of the top three reasons for leaving a job, more than twice the number citing a failure to get promoted or a poor work-life balance. In CFO's own survey of senior finance executives, only 7 percent of respondents believe their companies' current pay policies greatly improve the ability to attract and retain high achievers, while 39 percent see a modest advantage and 32 percent detect no advantage at all (see "Mass Appeal").
Designing different levels of rewards, however, is far from easy. "The processes must be seen as credible to all employees, or there can be resentment," says Laura Sejen, Watson Wyatt's global practice director for strategic rewards. "I'm curious to see what kind of responses Corporate America will come up with for rewarding its top employees. It's almost like tectonic plates shifting — something's gotta give."
Putting the Merit in Merits
One likely starting place is the "merit pool" — the percentage of payroll earmarked for performance-based raises — which critics have long contended represents a missed opportunity for rewarding top employees. Rather than allocating money according to well-defined and carefully enforced achievement rankings, many companies simply apportion merit raises evenly (or close to it) across the entire eligible population. The reason? "Managers aren't interested in doing things that are going to have a negative impact on people's morale," so they rate employees higher than they should, says David Sirota, founder of Sirota Consulting and co-author of The Enthusiastic Employee (Wharton School Publishing, 2005). The national average for merit-increase budgets is less than 4 percent of payroll, making the actual amounts at stake relatively small. "Still, the reaction of top people is to ask why, after all their excellent work, they get, say, only 2 percentage points more [than the average]," he adds.
If designed properly, however, "merit pay recognizes employees' sustainable and growing skill set and their ability to contribute," says Myrna Hellerman, senior vice president of Sibson Consulting. Combined with an annual bonus, merits become part of a powerful dual performance–based incentive system.
At Xcel, management has decided that the way to unleash that power is to have some divisions cap managers' merit increases at 2 percent, creating a larger pool from which to reward top employees. While Xcel's merit pool is 3.5 percent of payroll, the cap allows certain employees to earn more than the average — sometimes substantially more.
"We step back and look at the whole organization's needs, and we address the merit issue holistically with that money," says CFO Ben Fowke. "That does two things: it puts more merit cash in the hands of productive employees, and it starts to send a signal about how you can be rewarded if you're a performer." Xcel hopes to bring the same thinking to its incentive bonuses, increasing the gap between high achievers and those who do an average job. The utility gives heavy weight in those bonus payouts to individual performance and business-unit achievement predicated on reliability, safety, cost-cutting, and other targets.
The Beauty of the Bell Curve
Chicago-based hardware retailer True Value Co., which operates as a cooperative, decided that it didn't need to create new standards for merit raises so much as make sure that the old standards stuck. As is the case at many companies, True Value had drifted away from its performance-review guidelines even though managers had a 5-point rating system to apply to the 3,000-member workforce. They routinely handed out 4's (outstanding) or 5's (superior), and almost everyone received some pay boost from a pool of approximately 3.5 percent of payroll. That, of course, meant that top performers made little more than their less productive peers. "We found that we were really hurting the better performers with that approach — they got frustrated," says Amy Mysel, True Value's senior vice president of human-resources and communications. "When you don't have a bell curve, then everything comes unglued."
Things began to be reassembled in 2005, when veteran Sears executive Lyle Heidemann became True Value's CEO. Joining the company during midyear performance reviews, he saw how ineffective the system was. "His message to employees was that he himself had often been rated as a 3 [strong contributor], and he wasn't ashamed of it," says Mysel. "He said that in his entire career he'd worked with only a couple of 5's. That sent a strong signal."
Helping to tamp down grade inflation is a system in which every merit decision is reviewed by a manager's supervisor. With a collective eye cocked toward potential abuse, True Value has shrunk the number of 4's and 5's being doled out, and the gap has been restored between the average merit raise and that earned by top performers. "At the end of the day, the difference may be only a couple hundred dollars a month," says Mysel, "but the symbolism counts."
Getting It All Right
At Agilent Technologies, a Santa Clara, California-based measurement-products company with a 21,000-person global workforce, an oft-used "three-band" rating system separates the top 20 percent of employees (high performers) from the next 70 percent ("core" performers) and the bottom 10 percent (who receive no raises or bonuses). High performers receive a larger share of the 2.5 percent merit pool than do core employees. (The pool, incidentally, can run much larger in other countries if competition dictates; in India, Agilent's merit pool is a hefty 12 percent.)
At Agilent, however, bonuses represent the biggest incentive opportunity. But even there Agilent sees it as vital to use its merit-pay policy to help reward top performers because the company "must be competitive in the total reward package: base pay, short-term and long-term incentives, and in the way we provide equity," says its vice president of compensation and benefits, Dominique Grau. Thus, the same three-band system is used to qualify high-achievers for short-term bonuses twice a year and for an annual bonus paid in restricted stock units (RSUs). High-achiever status is determined by performance against goals established during reviews. One-third of the bonus rating reflects individual performance, while two-thirds reflects business-unit and corporate return on invested capital.
Grau especially likes the three-band system. "Having multiple bands simplifies communication with your employees," he says. "It's basically the two extremes you have to focus on. And for the top performers, you focus on the rewards."
But just as Xcel has difficulty in quantifying the value of its good-ideas fund, other companies struggle with measuring payback from incentive compensation plans. Agilent, for example, looks carefully at its turnover rate, and at its win rate when it bids against rival companies for the best and the brightest. "The problem isn't so much retention," says Grau. "We have very low attrition. The problem is attracting the right people — and there the switch to RSUs is a great thing."
That switch was prompted by a study last year of which equity forms provided the strongest motivation. Agilent, a longtime user of stock options, changed course because "employees wanted to have a bit more assurance of the potential cash flow they will have," Grau says. RSUs gave them full-value stock, without the concerns about the fluctuating worth of options.
In Xcel's case, too, the success of its incentives is measured by the quality of the people it attracts. As the utility industry moves away from the paternalism of past years and its attendant low turnover rates, "we're very much competing for talent with an entrepreneurial market," says Fowke. If the retooling of merit pay alone isn't enough, Xcel may set up a long-term incentive plan for top-performing nonexecutives, rewarding them with the same restricted stock awards that senior executives receive as part of their bonus program.
At True Value, the link between pay and performance for some employees is more concrete. Under a "gain-sharing" plan, "when warehouse workers hit certain productivity targets, they actually see it in their paychecks each week. It's very motivating," says Mysel. "If they're working for $10 an hour and productivity goes up, they'll make $10.50 or $11." While the additional amount is a bonus rather than a merit increase to base pay, she says that workers "really don't like to see that hourly pay go down." So the productivity goals often are met in succeeding weeks as well, keeping the whole company's productivity climbing. (True Value regularly monitors the targets set for warehouse productivity, Mysel says, to make sure they stay accurate.)
However it is measured, "the fairness of the paycheck remains extraordinarily important for worker morale and performance," says consultant Sirota. And these days, a consideration of fairness should take into account the lavishness of executive-pay packages. Forced to pass on higher health-care premiums to employees, for example, Xcel also announced recently that executive perks such as no-deductible medical coverage, reimbursed financial-planning services, and company-paid home security systems were being eliminated.
"Employees understand that executives are going to be paid more," says Xcel's Connelly. "But they also respond well when they see a company being consistent in its actions." Applying standards that distinguish between top performers and everyone else — and reward them accordingly — may not be easy. But as Sibson Consulting's Hellerman notes, "If you're going to give merit raises and add to your fixed costs, you might as well do it well."
Roy Harris is a senior editor at CFO.