Compensation Focus

3 Ways to Make the Most of Your Merit Budget

By Ken Abosch  |  October 2015

The most fundamental contribution human resources makes to the achievement of business results and organization effectiveness is to establish a strong tie between performance and rewards. Yet most organizations struggle to effectively differentiate performance contributions and allocate merit increases that truly reward differences in achievement. The primary reason given by companies for not differentiating their merit increases is the size of the merit budget according to the Aon Hewitt "U.S. 2015-2016 Salary Increase Survey." Three quarters of respondents indicated that budget constraints were getting in the way of rewarding high performers and high potentials. When we analyze the facts, we see that organizations are allocating merit increases today similarly to the way they did 20 years ago when budgets were much larger.

In reality, today's smaller merit budgets can be seen as an excuse for a lack of differentiation when the real issues are that managers have difficulty providing honest feedback and are not measured and rewarded for doing so. In addition, there is still a general belief that all employees deserve a raise even if their contributions are not strong.

Making the most of an organization's merit budget means looking for approaches that result in a stronger link between rewards and results. Employees feel they are being treated equitably when strong contributors receive the largest rewards and weak performers receive little or no reward. Contrary to popular opinion, employees perceive it to be inequitable when the merit budgets are spread to everyone with minimal differentiation, which is a practice used by two thirds of employers, according to the survey. In particular, high performing employees are attracted to organizations that recognize and reward for strong contributions; they will leave organizations that do not.

3 Methods

Some organizations are trying new strategies to direct a greater portion of their merit budgets to high potentials and high performing employees. The three most promising techniques include:

  1. Merit carve outs
  2. Automatic zeros
  3. Merit lump sums.

Merit carve outs take the approach of extracting a portion of the approved merit budget to form a separate pool reserved for the highest performers. An organization taking this approach might divert 0.5% of the overall 3% budget to fund a special pool. Employees are told that the merit budget is 2.5% and that it will be allocated based on levels of performance. The reserve pool is then used to provide additional merit increases for just the highest performers and high potentials allowing them to receive merit increases of 6% to 8% or greater.

Automatic zeros create additional funding for top performers by channeling merit spending away from weaker performers. Merit increase guidelines for average and below average performers are automatically set at zero, and the dollars that would have been spent on these employees are diverted to above-average and outstanding performers. This results in merit increases of 5% to 8% or greater for the top two performance categories.

Merit lump sums approach the funding challenge in a different way. Increases for the top performance level (outstanding) are provided as growth in salaries and are significant (6% to 8% or greater). Merit increases for above-average performers are a combination of growth in salaries and cash payments while increases for average and below-average performers take the form of cash payments that are not added to salaries. This allows the organization to fund larger salary increases for the highest performers since the cash payments to lower-level performers are not added to base salary expenses and do not result in compounding costs in subsequent years. In a sense, organizations fund higher payouts today for their top performers from future cost savings by not adding to their ongoing fixed costs for their lower performers.

Factors for Success

Communicating relevant employee expectations for their salary increases is a critical factor in the ultimate success of achieving pay for performance. Most organizations today provide the same guidance to the entire workforce without distinguishing between the expectations for high vs. average or low performers.

For example, most employers simply share the average size of the merit pool (e.g. 3%) and this becomes the point of comparison that employees use in interpreting the value of their raises. Average employees expect to receive the average of the pool or 3%. High performers expect to receive at least two times the average of the merit pool. With most organizations spreading the merit pool to all levels of performers, the result is that below-average performers receive average increases of 1%, average performers generally receive 2.5%, and high performers receive 3.5% to 4.5% increases. No employee's expectations are satisfied because of this one-size-fits-all approach.

A better solution is to create dual reward strategies based on performance contributions. Following this approach, the expectations shared with average and below-average performers include continued employment and moderate salary growth that results in salaries progressing to the 40th percentile of the market over time. High performer expectations would include significant salary increases (twice the average of the merit budget pool) that grow salaries over time to the 75th to 90th percentile of the market, access to other monetary and non-monetary forms of rewards, and rapid progression to higher career levels. This provides an outcome for employees which is consistent with the expectations they were given; it generally results in a perception of equity among employees.

Following some of these alternative methods for allocating merit increases in a more differentiated way as well as setting more relevant expectations for workers who contribute at different levels will improve an organization's overall effectiveness and allow for desired business results.

About the Author

Ken Abosch is a partner and broad-based compensation practice leader at Aon Hewitt.

Read the October edition of Compensation Focus.

Contents © 2015 WorldatWork. No part of this article may be reproduced, excerpted or redistributed in any form without express written permission from WorldatWork.

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