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The 3 or 4 percent “merit” or base pay increase budget has been the norm for so long now that many employees, managers and HR professionals have never experienced anything else. According to the WorldatWork 2005/06 Salary Budget Survey, the average salary increase budget for any employee group (nonexempt, exempt, and executive) has been less than 5 percent since 1991. Sibson's projections indicate that this trend is likely to continue (see Compensation Projections in this issue of Perspectives) and therefore organizations need to figure out how to make merit matter rather than simply hoping for more money to work with or a “system says” solution that alleviates the responsibility of the manager for applying discretion in making important pay decisions.

Not surprisingly, the term “merit” has been losing its meaning in many organizations as the distinction between the top base pay increase and the average increase is only 1 or 2 percent. Some HR professionals have wondered, “Why bother?”, and indeed some organizations have begun to give almost everyone the same annual base pay increase – thus reinforcing an entitlement mentality and approaching the “cost-of-living” increases that merit was designed to replace so many years ago.

Though merit budgets are relatively small, they still represent a large sum of money, even before annual compounding. A company with 5,000 employees with average pay of $50,000 per year and a 3.5 percent merit budget adds almost $9 million to its cost base each year. Although the merit pay increase keeps the organization as a whole competitive with the labor market, it may be doing little to support the execution of business strategy or reward the achievement of key business results.

In some organizations, managers have learned to "game" the system to provide their employees with more money. They flood the system with job re-evaluations and promotions, inflate performance evaluations, or similarly back into desired pay increases by gaming the performance assessment process. The ideal situation is not for managers to have to game the system or to increase costs without a clear benefit. The key is to make merit matter. In the case of the 5,000-person company above, the goal is to earn a larger return on the $9 million investment.

Based on recent experiences and research, we have learned several strategies for making merit matter:

1. Set aside a special pool of money for the highest performers. When budgeting, the word usually gets out that “there is a 3.5 percent merit budget,” and then employees feel slighted if they get anything less. Managers anticipate employees' reactions and avoid telling a good performer that they are getting anything less than the overall budgeted amount. Rather than budget for one overall base pay increase, it is sometimes helpful to budget in pieces: (i.e., 3 percent for merit, .5 percent additional for top performers, and 1 percent for promotions.) This stratification ensures that high performers really do receive more money in absolute dollars per person and also more proportionally as a key talent segment. If .5 percent of total salary is budgeted for high performers and 20 percent of employees are designated high performers, then each high performer will receive an additional 2.5 percent increase. This approach of designating a special pool just for high performers is a good way for organizations to ease back into more pay differentiation. The high-performance award also can be paid in a lump sum “merit cash” award as an alternative approach.

2. Calibrate performance ratings and merit increases among managers and units. Some organizations have gone to forced ranking or distribution as a way of ensuring a fixed number of high and low performers. However, many other organizations prefer not to drive a forced distribution but still want to differentiate in a formal manner. For them, an approach that works is to calibrate performance ratings and merit increases across peer managers prior to finalizing. This process involves each manager in a unit submitting draft ratings and merit recommendations and then reviewing them with peer managers within their work unit, usually in a meeting. Managers who tend to rate high will usually be encouraged to differentiate more, and managers who are hard raters will be encouraged to make their ratings and merit increases better align with the unit's performance. Calibration meetings create stronger and healthier norms about what performance really justifies the highest rating and what performance justifies the lowest ratings, and in almost every case leads to stronger linkages between pay and performance. Another good reason to calibrate performance reviews and merit increases is to ensure that every manager must complete performance evaluations so they can support their recommendations.

3. Calculate merit percentages after the distribution of performance ratings is determined. It is no secret that some managers in some organizations back into desired merit awards through the manipulation of performance distributions. This can be avoided using very simple techniques. A large entertainment company, for example, does not complete the “merit matrix” until the distribution of performance ratings is known. Some organizations take this step following the calibration meetings. Others ask managers to submit all their performance ratings in advance and then create the merit distribution matrix according to the distribution of performance ratings. For example, the highest merit increase will be a greater percentage if only 15 percent of employees receive the highest rating and a lesser percent if 30 percent of employees receive the highest ratings. This approach teaches managers not to flood the system with inflated ratings because it only serves to lower the rewards for top performers. Conversely, it also teaches managers that if they differentiate, they will have more money for top performers. The entertainment company targets the highest merit increase to be two-to-three times the average, depending on how many employees receive the top performance rating.

4. Make leaders accountable for merit budgets. This idea is so simple that many organizations seem to have forgotten about it. Some companies moved away from managerial accountability for merit increase budgets because of the concern that small departments cannot really differentiate pay when there are only three or four employees in the department. This concern is legitimate, but with a simple solution: aggregate departments up to the next higher level so that a merit budget covers units of at least 30 employees, usually under three or more managers. This approach also tends to force a form of calibration, so that one manager does not give everyone the top merit increase, forcing other managers to give smaller increases. Usually if groups of managers are required to meet an overall merit budget of, for example, 3 or 4 percent, they will find a way to award more money to some employees and less to others, either based on position in market, range, or performance evaluations, even if not provided a formal merit matrix by HR.

5. Link the merit matrix or budget to the performance of the units. One retailer had a business unit seriously underperforming, thus pulling down the performance of the overall corporation. In this case, it could be argued that the company could expect to have fewer “exceeds ratings” than other units and that the overall merit spend should be less. In most organizations, the norm is to have the same merit budget and merit matrix in all business units, and then it should be no surprise that merit has become more like a cost of living increase. One way to break this mentality and put the merit back in merit is to give outperforming units more and underperforming units less merit dollars, or at least skew the merit matrix so that the expected distribution of ratings would be lower in the lowest performing units. This approach should not be confused with “forced ranking,” and is instead is a form of “forced distribution.” Forced ranking usually requires that every year, regardless of performance, some percentage of employees are identified as low performing and high performing. Forced distribution is a way of shifting the expected distribution according to an overall unit's performance.

In most organizations, merit was once synonymous with performance, and the intent of merit pay was to create a stronger link between pay and performance, a still-worthwhile endeavor. As organizations are going back to the future, and attempting to put more merit into merit pay, some are broadening the concept of performance to be more along the lines of contribution, where the degree of impact is used as a second factor along with performance to determine merit budgets and awards. This approach involves funding larger merit budgets for business units that have a greater impact on overall value creation for the enterprise and delivering larger merit awards to individuals who are high performers and who work in jobs that directly contribute to the competitive advantage of the enterprise (does not have to be an executive role). While not widespread, more and more organizations are considering this kind of approach in their quest to achieve a greater return on their significant merit pay investment.

Each of the approaches outlined above has been used successfully in organizations for putting the merit back in merit pay. Careful diagnosis of the organization's current and desired performance culture is a good starting point. A formal definition of the role of merit pay in the total compensation strategy and system is another key step. A third step involves beginning to measure the return on merit pay along such dimensions as productivity and retention. Employing these steps and choosing one of the proven practices we have described will go a long way in making merit pay matter again in your organization.

Jim Kochanski is a Senior Vice President with Sibson Consulting, a division of The Segal Company, and National Practice Leader of Sibson's Employee and Organizational Effectiveness Practice, in Raleigh. Contact Jim at jkochanski@sibson.com.

Christian M. Ellis is a Senior Vice President with Sibson Consulting, a division of The Segal Company, in Raleigh. Contact Christian at cellis@sibson.com.