Compensation for Business Leaders

Does Pay-for-Performance Really Work?

Pay-for-Performance (PFP) is a priority for businesses. The majority of U.S. organizations look to align compensation decisions to performance measures, but they often fall short in the execution. With the advent of analytics software and performance dashboards, measuring the effectiveness of such pay programs has been greatly enhanced. Companies are also being more transparent about their PFP programs and results, so they showcase the impact of such programs. They are openly communicating about the PFP programs clearly differentiating high performance and low performance. The strategic objective of such programs is to achieve and sustain long-term competitive advantage by retaining, motivating, and rewarding their best people.

Still, it can be difficult for managers to see the performance-reward connection for the following reasons:

• Timeliness. Many of the rewards are deferred, so that the time frame is too long. Managers don't experience the connection between performance and reward.
• Vague goals. The goals are not always clearly expressed, so the manager does not know what needs to be achieved.

When some organizations do not have explicit PFP programs, they will measure performance through annual appraisals and assign performance ratings that tie into pay decisions. For each employee, a common practice is setting three to five goals that align with and support organization or department goals. The best goals are SMART goals, which is a branded goal setting methodology that means:

• Specific
• Measurable
• Attainable
• Relevant
• Time specific

Examples of SMART Business Goals:

1. Reduce overall budget costs by 10% by year end
2. Increase market share by 5% by year end
3. Increase revenues by 20% by year end
4. Increase customer satisfaction by 5 pts by year end

A more recent expansion of this goal setting approach is SMARTER goals (Evaluate, Re-evaluate). This broader use incorporates the need to review the SMART goals on an on-going basis to make sure they are still relevant in light of unexpected shifts in business plans. Some organizations use SMART goals concepts in defining Key Performance Indicators for BSCs.

Measuring performance is essential to differentiate pay and align organizational resources to business objectives.

It is easy to argue that pay-for-performance does work. The difficult part is determining the optimal level of pay that fosters the best performance. There is no definitive answer to this question except that when an organization’s goal is to be a high-performance organization, a PFP process should be adopted that has on-going reviews to ensure alignment of goals and measures.