Is Your Compensation System Competitive?
The normative response when asking employees about their pay is that they feel underpaid. This is partially the result of cognitive bias. The tendency is for them to believe they are more competent and better performers than they are. After hearing numerous claims of being underpaid an organization may write them off as being self-serving. Yet research confirms we all are subject to feeling that way. We also tend to attribute success to our own efforts and failure to uncontrollable external causes. Finally, we will accept information that agrees with what we believe or wish to be true than information that conflicts with beliefs. So how does an organization evaluate the competitiveness of the compensation system? If it is found to be appropriately competitive how can employees be convinced?
Identifying talent competitors
Employers rely on external comparisons to determine whether their pay structures and pay rates are competitive. Competitors for talent are identified and serve as the primary basis for comparison, although overall labor market comparisons may also be made. Information on their pay levels must be gathered and analyzed to determine competitive position. The organization then decides what its’ competitive posture should be: meet prevailing levels? exceed them? lag them? by how much? The desired posture should be specified in the compensation philosophy statement that guides how the system is administered.
The identification of talent competitors can be guided by experience. An analysis can be done to determine where new employees have come from and where departing employees have gone. Exit interviews will inevitably indicate people left for more money, although the real reasons may be other causes that may be difficult to disclose. Yet the reality is that those organizations should be the principal frame of reference.
Other criteria that may be used for competitor selection. Geographic proximity, size and nature of products/services provided are often considered. Another consideration is whether the competitors for some occupations differ than those for other occupations. A software firm may compare to a manufacturing firm and a hospital when identifying competitors for administrative occupations, but not for IT occupations.
Performing an analysis of current competitive position
When analyzing the competitive position one of the most common errors is to use average pay rates as the metric for comparison. The compensation system consists of two parts:
1. Pay structures and
2. Pay rates.
Pay structure analysis
Pay structures are created by first classifying jobs into grades based on relative internal equity. Pay ranges are then assigned to the grades based on competitive pay levels in the relevant labor markets.
Ranges become the range of pay opportunity an employee has while being assigned to a job. Ranges vary from 20 – 50% wide, with the center (midpoint) generally set at market average or at the level dictated by the competitive philosophy. Setting the structure above market average usually is based on a belief that paying more attracts and retains a higher quality of employee. Although logic would support that belief there is no valid research that makes it a certainty. Conversely, organizations may not be financially capable of matching market levels, forcing them to set the ranges below the average. When the structure is shown to be positioned at the desired level it can be considered competitive.
Critical principle: Pay range competitiveness skould be determined by comparisons with the pay ranges of competitors,not with their average pay rates. Pay rates are a result of an organization’s administrative philosophy, using policies that result in rates being consistent with the philosophy. Some organizations use longevity to determine where incumbents are paid within the pay range. Steps within the range are established and people progress through the range automatically over time. The GS system used for much of the federal workforce is a time-based system and most collective bargaining populations progress at the rate specified in the contract. Other organizations use open range systems that progress people based on their competence relative to job qualifications and on their performance over time. These two approaches make it unwise for an organization to compare its average pay rate for current incumbents to the average pay rate prevailing at competitor organizations. The averages will be determined by the individual characteristics of each organization’s policies and the longevity of their incumbents.
Many compensation surveys created by consulting firms or professional associations use pay rates as the metric, with little attention paid to pay ranges. Using these surveys as the sole source for determining competitiveness can result in reaching the wrong conclusions about competitive position. For this reason, it is advisable to obtain competitive information on pay structures. It may be necessary to contract with an expert to conduct an analysis since the third party can guarantee anonymity to organizations asked to provide their data. Public sector organizations must make their information public, which greatly simplifies data collection. But asking a direct competitor in the private sector may not be feasible.
Pay rate analysis
Once an organization has evaluated the competitive position of its pay structure(s) a further analysis of pay rates is required. Although competitive ranges of pay opportunity are in place individual pay rates must be appropriately administered. Incumbents who are fully competent relative to their job requirements and who have met performance standards for an extended period would be expected to be paid in the middle part of the range. Developing employees would be expected to be paid in the lower part of the range and those who have mastered job requirements and sustained high levels of performance would be expected to be paid in the upper part of the range.
During a recent compensation study for a consulting client, we worked with management to select the talent competitors that would be the basis for comparison, acquired the competitor pay strurcture information and calculated competitive pay range averages. When we presented our findings they indicated that their pay structures were competitive, lagging by an average of 2 -3%. Since “at market average” means within + or – 5%, due to the impact of random error, this finding was the equivalent of an all-A report card. Yet management’s reaction was that the report must be flawed, since employees often complained about being significantly underpaid and a considerable number of them reacted by finding a new employer. Although we had been instructed to evaluate the pay structure it became apparent that further examination was needed. When we analyzed where current employee pay rates fell within the pay ranges we found over 90% were paid in the lowest quartile of their range. Since many incumbents had been in their roles for ten or more years and were considered to be fully competent it became apparent that the pay structures were competitive, but administrative practices resulted in pay rates that were not consistent with the established philosophy and policies. The only option for the organization was to fund adjustments to realign pay rates to the appropriate position in the competitive pay ranges.
The Bottom Line
A competitive compensation system will provide competitive pay ranges and administer pay rates in a manner that is consistent with an organization's compensation philosophy and sound compensation management principles. Cognitive bias will make convincing employees that they are competitively, equitably and appropriately paid a challenge. Training managers and employees in compensation fundamentals, the organization’s compensation philosophy and how pay rates are administered is a pre-requisite for acceptance. Allowing employees to speculate on why they are paid what and how without having accurate information is a critical error.
About the Author:
Dr. Robert J. Greene is an expert in human resource management, serving as the CEO of Reward Systems, Inc., Consulting Principal at Pontifex, and faculty member for DePaul University’s MSHR and MBA programs. A well-respected global speaker and educator, Greene has a passion for empowering organizations to thrive by unlocking the full potential of their people. He has authored four books and hundreds of influential articles and is an advocate of using scientifically valid research to make the business literature more responsible and less tainted by opinions that are only speculative and that encourage fad adoption.
Books: