Strategic Reward Systems I

Strategic Reward Systems I HR Management MBAO 6030

Strategic Reward Systems I: Pay for Performance Financial Rewards – Compensation 1. Base Salary 2. Pay Incentives 3. Employee Benefits Reward Systems consist of the following elements: Reward Systems consist of the following elements: Non-financial Rewards 1. Intrinsic Rewards – centers on the work itself 2. Praise, recognition, time off and other rewards given to the employee by peers or superiors.

Strategic Reward Systems I: Pay for Performance Reward Systems in most cases should be consistent with other HR systems. The Reward System is a key driver of: HR Strategy Business Strategy Organization Culture

Strategic Reward Systems I: Need for Consistency with Other HR Systems Culture Performance Management Employment Training Labor Relations Rewards Overtime pay rules in contract Sign-on Bonus Merit Pay Merit pay reinforces performance culture Skill-based pay

Strategic Reward Systems I Critical Thinking Question: 1. Should pay policies “lead” or “lag” the development of other HR systems?

Theoretical Models of Pay and Performance: Equity theory (Adams, 1963) Assumptions: People develop beliefs about what is a fair reward for one’s job contribution - an exchange People compare their exchanges with their employer to exchanges with others-insiders and outsiders called referents If an employee believes his treatment is inequitable, compared to others, he or she will be motivated to do something about it -- that is, seek justice.

Theoretical Models of Pay and Performance: Equity theory (Adams, 1963) I s /O s versus I r /O r O = Outcomes: the type and amount of rewards received I = Inputs: employee’s contribution to employer R = Referent: comparison person S = Subject: the employee who is judging the fairness of the exchange

Equity Theory – Exchange Scenarios Case 1: Equity -- pay allocation is perceived to be to be fair - motivation is sustained Case 2: Inequity (Underpayment) -- Employee is motivated to seek justice. Work motivation is disrupted. Case 3: Inequity (Overpayment) -- Could be problem. Inefficient. In other cultures employees lose face.

Consequences of Inequity The employee is motivated to have an equitable exchange with the employer. To reduce inequity, employee may… Reduce inputs (reduce effort) Try to influence manager to increase outcomes (complain, file grievance, etc.) Try to influence co-workers’ inputs (criticize others outcomes or inputs) Withdraw emotionally - or physically (engage in absenteeism, tardiness, or quit)

Equity Theory Implications There is tension between internal and external pay equity: Decide where to place the emphasis. Example: “In and out” versus “lifelong” employment system Let employees know who their pay referents are in the pay system: identify pay competitors and internal pay comparators. Strive for consistent pay allocations Monitor internal pay structure and position in the labor market for consistency.

Agency Theory Agency theory is a theory of governance in the workplace. It tries to solve the problem of separation of ownership (atomistic shareholders) and control (professional executives and non-owners) It also tries to solve conflicts of interest between managers and employees with delegated responsibilities.

Agency Theory 1. Principals = owners or managers who delegate responsibilities 2. Agents = managers or employees who manage firm assets for owners or other principals. 3. Information asymmetry = managers or other agents have greater access to strategic information than principals, who are not willing to bear the cost of directly monitoring the agents due to steep agency costs.

Agency Theory 4. Risk Preferences – principals are risk neutral and willing to bear greater risks than agents because their asset wealth is more likely to be diversified between corporate assets and other equities/investments. Agents are more risk averse than principals, because most of their wealth is concentrated in the firm and received in the form of pay and opportunities for promotion.

Agency Theory 5. Moral Hazard – agent is tempted (and some cases succeeds) in taking advantage of information asymmetry with principal and act opportunistically (defined as making decisions not aligned with principal’s interests) and use the firm resources to maximize wealth of the agent (often at the expense of the principal).

Agency Theory 6. Agency Contract – provides solution to moral hazard/agency problem, by establishing “rules of the game” to control agent opportunism – agent’s performance will be judged by outcomes (often financial benchmarks) not behaviors (which require direct supervision of agent’s actions). These outcomes will reflect principal’s goals and risk preferences.

Agency Theory 7. Incentive alignment – the agency contract will specify a compensation plan that aligns the interests of the principal and agent. This agency contract will be a type of pay for performance plan. Meeting or exceeding pre-agreed upon financial or non-financial outcomes triggers various forms of compensation (individual or group-based) for the agent. Some agency costs are borne by the principal in the form of financial incentives for the agent.

Tournament Theory 1. Tournaments are competitions between peers to achieve a promotion to a higher rank along with the pay and perks that go with it. 2. Tournaments are likely to result in a “winner take all” outcome. 3. Managers who enter the tournament must forego other alternatives (such as jobs with other firms, start own business, receive more pay with an alternative opportunity) to compete in the tournament.

Tournament Theory 4. A high pay differential (such as the CEO receiving much greater pay than any subordinates) attracts more “players” to the tournament. 5. Players must “invest” (work long hours, accept less pay, show loyalty to their boss) to enter the tournament – firm captures value from these players, more than what it gives up to the “winner” for the prize.

Controversies that Surround Pay for Performance Plans 1. Single Mindedness – “you get what you pay for” – no more, no less. The activities that are rewarded get done, to the exclusion of other activities that are not rewarded. Example: The dysfunctional behaviors that are observed when a sales representative is put on straight commission.

Controversies that Surround Pay for Performance Plans 2. Control – externalities can control the outcomes, positive or negative. There can be windfall affects (the bull market improving the stock value of all stock options) or negative externalities (a bear market or recession that lowers the value of all stocks). Employee performance results may be magnified or diluted by these effects.

Controversies that Surround Pay for Performance Plans 3. Measurement error – some measures can be “gamed” or manipulated and may not reflect “true” performance. Sales reps can withhold sales and report it in a different period so they are not penalized by a cap on sales commissions. Managers can use “creative accounting” measures to report greater profits than were actually experienced by the firm.

Controversies that Surround Pay for Performance Plans 4. Inflexibility – managers or employees may resist change of the basis of compensation because they are comfortable with current basis for pay and want to avoid risk of taking reduction in earnings in new system.

Controversies that Surround Pay for Performance Plans 5. Misalignment of incentives – if pay emphasis is on a goal that is no longer relevant, that goal will continue to be emphasized until the pay system places emphasis on a different objective. For example, managers may emphasize short-term goals, even if long-term goals are more relevant, until the pay system recognizes long-term goals to a greater extent than short-term goals. The reward mix for complex jobs with several goals must reflect the relative value of attaining the mix of goals.

Controversies that Surround Pay for Performance Plans 6. Line of Sight problem - division performance and corporate performance should be reflected in the pay system. If division performance and corporate performance are closely linked than both division and corporate performance should contribute incentives to the managers’ pay for performance plan. If division performance is independent of corporate performance, then the emphasis should be on rewards for meeting division goals.

Some Suggestions for More Effective Pay For Performance Plans Pay and Performance should be Loosely Coupled – this gives managers more flexibility to make changes when new situations arise. Example: a formula with a bonus based on a moving average of a 3-year historical performance period. A 3-year period smoothes out performance over a longer cycle.

Some Suggestions for More Effective Pay For Performance Plans It is Necessary to Nurture the Belief that Performance Makes a Difference – there are important cultural values that are supported with pay for performance even if the accuracy of the performance metrics and the fairness of the pay allocations fall short of an ideal situation. Abandoning pay for performance may be more problematic than having an imperfect pay system.

Some Suggestions for More Effective Pay For Performance Plans Pay for Performance systems should be designed to fit each firm’s unique situation – imitation of other firm’s plans should be avoided

Six Myths about Pay (Pfeffer, 1998) 1. Labor rates and labor costs are the same thing. 2. Labor costs can be reduced by lowering labor rates. 3. Labor costs are a significant portion of total costs. 4. Low labor costs are a potent source of competitive advantage. 5. The most effective way to work productively is through individual incentive compensation. 6. People work primarily for money.

Critical Thinking Questions 1. Sears Roebuck Auto Center paid its auto mechanics a commission based on the volume of services sold to each customer. This basis of pay resulted in law suits filed against Sears by angry customers who claimed they were over-charged for services they did not need. Sears was forced to pay millions of dollars of penalties to these customers which hurt its reputation. Pfeffer believes that Sears’ mistake was that it should have realized that individual pay incentives are dysfunctional. Do you agree with this conclusion?

Critical Thinking Questions 2. Charles Schwab, the discount broker, does not use commissions as pay incentives for its brokers, bucking financial services industry pay practices. Why do you think Schwab did this? 3. Do you think that the point of view of the author (of the “6 Myths of Pay”) would work at a Wall Street investment bank such as Morgan Stanley? 4. The author of the “6 Myths of Pay” article prefers group-based pay for performance rather than individual pay for performance plans. What is the reason behind this? Do you agree?

Strategic Reward Systems I

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Strategic Reward Systems I