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Chapter 10
Pay-for-Performance:
Types of Plans

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 What Is a Pay-For-Performance Plan?

Many different compensation practices are lumped under the name pay-
for-performance but many omit the starting point – merit pay.

• Incentive plans.
• Variable pay plans.
• Compensation at risk.
• Earnings at risk.
• Success sharing.
• Risk sharing.
• And others – they are not interchangeable.

Pay-for-performance plans signal a movement away from entitlement

toward pay that varies with some measure of individual or organizational
performance.

© McGraw-Hill Education 2
 How Widely Used is Pay-for-Performance (PFP)?

The use of variable pay in general has increased and can be traced to
two trends.
• First, the increasing competition from foreign producers forces
American firms to cut costs and/or increase productivity.
• Second, today’s fast-paced business environment means employees
must be willing to adjust what they do and how they do it.

Other evidence points to the very strong overall reliance on PFP,

including variable pay, especially in private sector organizations.

© McGraw-Hill Education 3
EXHIBIT 10.2 Estimated Short-Term Incentive/Variable (Bonus) Pay
as a Percentage of Salary and Performance Basis, by Employee
Group

Note: The “All Organizations” column estimates reflect an adjustment for the fact that not all organizations use such plans and for the fact that
organizations that do use such plans do not use them for all employee groups. The term “nonexempt” refers to employees covered by the Fair
Labor Standards Act and the term “exempt” refers to employees not covered by the Act. See Chapter 17.

Note: Although “merit bonus” (for a significant role for subjective performance) and “short-term incentive” (primarily for objective performance) are defined
differently, the terms tend not to be as distinct in surveys.

Access text alternative for this image.

© McGraw-Hill Education Source: Data are from: WorldatWork and Deloitte Consulting LLP, “Incentive Pay Practices Survey: Publicly Traded Companies,” 2018. The logic for developing the A X B estimate is covered in: Barry Gerhart and Meiyu Fang, “Pay for (Individual) Performance: Issues, Claims, Evidence and the Role of Sorting
Effects,” Human Resource Management Review 24 (2014), pp. 41–52; Barry Gerhart, “Incentives and Pay for Performance in the Workplace,” Advances in Motivation Science 4 (2017), pp. 91–140.
4
 EXHIBIT 10.3 Allocation and Use of Long-Term Incentive
Plans

Median Percentage of Long-term

Long-Term Incentive incentive plans
Employee Group Grants Allocated
CEO 13%
are more likely to
Officers/executives (excluding CEO) 50%
be used by
Exempt. salaried 25% executives and
Nonexempt, salaried 0% other higher job
Nonexempt, hourly nonunion 0% levels.
Practices/Use The lowest job
Percentage of organizations using long­-term 91%
incentive
levels receive a
Number of long-term Incentive plans used
tiny percentage of
One plan 18% the value of long-
More than one plan 82% term incentives
granted by
Note: The term “nonexempt” refers to employees covered by the Fair Labor Standards
organizations.
Act and the term “exempt” refers to employees not covered by the Act. See Chapter 17.

© McGraw-Hill Education
Source: Barry Gerhart. “Incentives and Pay for Performance in the Workplace,” in Advances in Motivation Science 4 (2017), 91–140; updated using: WorldatWork and Deloitte Consulting LLP, 5
“Incentive Pay Practices Survey: Publicly Traded Companies,” 2018.
The Important Role of Promotion (internal or external) in PFP

Merit pay is widely used by organizations and for all types of employees.
• The average merit pay increase is about 3% per year.
• It would take an employee about 23 years to double their salary.

Salary increases due to promotion are much larger than 3%, ranging
around 15% - salary would double after 5 promotions.
• Given that promotion is based importantly on performance,
• Any discussion of how strongly pay and performance are related
• Must recognize it is about more than merit pay increases, which are
within-grade increases.
• For many employees, their high performance leads to promotions to
higher levels.

© McGraw-Hill Education 6
 EXHIBIT 10.4 Merit Increase Grid Example

A merit pay system links increases in base pay (called merit increases) to
how highly employees are rated on a performance evaluation.
Most organizations use a merit increase grid.

Recommended Salary Increases by Performance Rating and Compa-Ratio

Compa-Ratioa Compa-Ratioa Compa-Ratioa

Performance rating 80-90% 91-110% 111-120%
Exceeds expectations 7% 5% 3%
Meets expectations 4% 3% 2%
Below expectations 2% 0% 0%

a
Employee salary divided by midpoint of their salary range.

© McGraw-Hill Education 7
EXHIBIT 10.5 Distribution of Performance Rating and Average Merit
Increase and Short-Term Incentive Payout by Performance Rating

Short-Term
Performance Percent of Incentive Payout
Rating Employees Merit Increase (as% of Target)
Highest rating 7% 4.8% 140%
Next highest rating 30% 3.8% 119%
Middle rating 57% 2.9% 99%
Low rating 5% 1.1% 51%
Lowest rating 1% .2% 8%

Note: Incentive payouts from 2016/2017 survey. Merit increases from 2019/2020 survey. Merit increases
nearly identical (4.7%, 3.6%, 2.6%, 1.0%, 0.1%) in 2016/2017 survey.

© McGraw-Hill Education Source: Mercer 2019/2020 United States Compensation Planning Survey and 2016/2017 United States Compensation Planning Survey. 8
 Pay-For-Performance: Merit Pay Plans

At the end of a performance year, an employee is evaluated for the plan.

• A key feature of a merit pay increase is that, unlike variable pay
programs, the increase is added into base pay.

There are concerns about merit pay.

• It increases fixed compensation costs.
Keep in mind the
• It becomes costly if too many high performance idea of incentive
ratings are awarded. and sorting
• Merit pay differentials based on performance are effects
too small to motivate performance. If merit pay is to
• Individual performance is a deficient measure live up to its
potential, it must
when work is interdependent.
be well-managed.
However, evidence for the effects of merit pay plans
is positive.
© McGraw-Hill Education 9
 PFP: Short-Term Incentive Plans (Individual-Based) Merit
Bonuses aka Lump-Sum Bonuses and Spot Awards

Merit bonuses differ from merit pay increases in that employees receive
an end-of-year bonus that does not build into base pay.
• Because employees must earn this increase every year, it is viewed as
less of an entitlement than merit pay.
• Helps employers by reducing fixed salary costs that can grow rapidly
through merit pay increases.

Base pay rises quickly under a merit pay plan.

• Cost-conscious firms report switching to merit bonuses.

Spot awards are seen by many organizations as being effective.

• Usually awarded for exceptional performance or for performance that
so exceeds expectations as to be deserving of an add-on bonus.

© McGraw-Hill Education 10
PFP: Short-Term Incentive Plans (Individual-Based) Individual
Incentive Plans

All incentive plans have one common feature.

• An established standard against which worker performance is
compared to determine the magnitude of the incentive pay.
• For individual incentive systems, this standard is compared against
individual worker performance.

A number of different individual incentive plans exist and their differences

can be reduced to variation along two dimensions.
• The first dimension on which incentive systems vary is in the method
of rate determination.
• The second dimension on which individual incentive systems vary is
the specified relationship between production level and wages.

© McGraw-Hill Education 11
 EXHIBIT 10.8 Individual Incentive Plans

The variations in these plans occur in either the way the standard is set
or the way wages are tied to output.

Access text alternative for this image.

© McGraw-Hill Education 12
 Individual Incentive Plans: Returns (But Also Risks)

Individual incentive plans receive attention but they are not widely used.

• There is strong evidence that individual incentives, on average, have

substantial positive effects on performance.
• Incentive plans can lead to unexpected, and undesired, behaviors.
• A common problem is employees and managers end up in conflict.
• Individual incentives may do such a good job of motivating employees
that they do whatever they get paid for and nothing else.
• Although subjectivity (judgment) in assessing performance is assumed
to be a problem, a subjective assessment (rating) is often necessary.
• One of today’s biggest success stories is the merger of individual
incentives with efforts to reduce health care costs – like at Jet Blue.
• Lincoln Electric has the longest-running successful individual incentive
plan – going back to before World War I.

© McGraw-Hill Education 13
 PFP: Short-Term Incentive Plans (“Group”-Based)

When we start focusing on people working together, we shift to group

incentive plans.
• A standard is established against which group performance is
compared to determine the magnitude of the incentive pay.

Failures of team incentive plans can be attributed to at least five causes.

• With so many varieties of teams, it is hard to argue for one consistent
type of compensation plan.
• A second problem with rewarding teams is called the “level problem.”
• Complexity—some plans are simply too complex.
• Control—some companies factor uncontrollable elements into the
process of setting performance standards.
• Communications—team-based pay plans simply are not well
communicated.

© McGraw-Hill Education 14
 EXHIBIT 10.13 Short-Term Incentive (Bonus) Performance
Measures and Formula versus Discretion in Determining Payouts

Although there is much pessimism about team-based compensation,

many companies still seek ways to reward groups of employees for their
interdependent work efforts.
Percent of Companies Using
Performance Measure
Financial (for example, revenue, income) 93%
Individual (performance, goal achievement) 57%
Operational (for example, customer satisfaction, 24%
safety, efficiency)
Formula versus Discretion in Determining
Payouts
Combination of formula and discretion 54%
Formula (only) 42%

© McGraw-Hill Education Source: WorldatWork and Deloitte Consulting LLP, Incentive Pay Practices Survey: Publicly Traded Companies, 2018. 15
 Comparing Group and Individual Incentive Plans

Setting up incentive plans really boosts performance.

• An individual, rather than group, incentives prove the most productive.
• Individual incentives yield higher productivity gains.
• But group incentives often are right in situations where team
coordination is the issue.

The type of task, organizational commitment to teams, and the type of

work environment may preclude one or the other type of incentive plan.
• Experts agree that individual incentive plans have better potential for
delivering higher productivity.
• Group plans can suffer from the free rider problem but it can be
lessened through use of good performance measurement techniques.

© McGraw-Hill Education 16
 Large Group Incentive Plans Gain-Sharing Plans

Gain sharing looks at cost components of the income ledger and

identifies savings over which employees have more impact.
• Gain-sharing plans can lead to the sorting effect and changes to group
plans may lead to turnover.

Key elements in designing a gain-sharing plan.

• Strength of reinforcement (and what performance metrics are and are not
included in the plan).
• Productivity standards.
• Sharing the gains split between management and workers.
• Perceived fairness of the formula.
• Ease of administration.
• Production variability.
• (Lack of) line of sight.

© McGraw-Hill Education 17
 EXHIBIT 10.16 Three Gain-Sharing Formulas

The plans are differentiated by their focus on either cost savings (the
numerator of the equation) or some measure of revenue (the
denominator of the equation).

Scanlon Plan
(Single Ratio
Volume) Rucker Plan Improshare
Numerator of ratio Payroll costs Labor cost Actual hours
(input factor) worked
Denominator of Net sales (plus or Value added Total standard
ratio (output factor) minus inventories) value hours

© McGraw-Hill Education 18
 Gain-Sharing Plans

Scanlon plans are designed to lower labor costs without lowering the
level of a firm’s activity.
• Incentives are derived as a function of the ratio between labor costs
and sales value of production (SVOP).
The Rucker plan involves a somewhat more complex formula than a
Scanlon plan for determining worker incentive bonuses.
• Essentially, a ratio is calculated that expresses the value of production
required for each dollar of the total wage bill.

Improshare (Improved Productivity through Sharing) is a gain-sharing

plan that has proved easy to administer and to communicate.
• First, a standard is developed that identifies the expected hours
required to produce an acceptable level of output.
• Any savings arising from production of the agreed-upon output in
fewer than the expected hours is shared by the firm and the workers.
© McGraw-Hill Education 19
Implementation of the Scanlon/Rucker Plans Similarities and
Contrasts

Two components are vital to the implementation and success of a Rucker

or Scanlon plan: a productivity norm and effective worker committees.
• Companies must have supervision, a cooperative union-management
attitude, strong top-management interest and participation, and
management who is open and flexible.
Scanlon and Rucker plans differ from individual incentive plans in their
primary focus on organizational behavior variables.
• The key is to promote faster, more intelligent and more acceptable
decisions through participation.

There are two important differences between the two plans.

• Rucker plans tie incentives to a wide variety of savings, not just the
labor savings focused on in Scanlon plans.
• This greater flexibility may explain why Rucker plans are more
amenable to linkages with individual incentive plans.
© McGraw-Hill Education 20
 Large Group Incentive Plans Profit-Sharing Plans

Profit sharing continues to be popular as the focus is on the measure that

matters most to the most people: a predetermined index of profitability.
• On the downside, most employees do not feel their jobs have a direct
impact on profits.
The trend in recent variable-pay design is to combine the best of gain-
sharing and profit-sharing plans.
• A company specifies a funding formula for any variable payout that is
linked to some profit measure – the plan must be self-funded.
• Dollars going to workers are generated by additional profits gained from
operational efficiency.
• Along with having the financial incentive, employees feel they have a
measure of control.
• Such a program combines the need for fiscal responsibility with the
chance for workers to affect something they can control.

© McGraw-Hill Education 21
 Large Group Incentive Plans Earnings-at-Risk Plans

Management probably should not separate earnings-at-risk plans as a

distinct category – any incentive plan could be an at-risk plan.
• Incentive plans falls into one of two categories: success sharing and
risk sharing.
These plans shift part of the risk of doing business from the company to
the employee.
• The company hedges against the devastating effects of a bad year.
• These plans appear to be met with decreases in satisfaction with both
pay in general and the process used to set pay.
• In turn, this can result in higher turnover.

© McGraw-Hill Education 22
 Group Incentive Plans: Advantages and Disadvantages 1

Group pay-for-performance plans are gaining popularity in today’s team-

based environment.
Advantages
1. Positive impact on organization and individual performance of about 5
to 10 percent per year.
2. Easier to develop performance measures than it is for individual plans.
3. Signals that cooperation, both within and across groups, is a desired
behavior.
4. Teamwork meets with enthusiastic support from most employees.
5. May increase participation of employees in decision-making process.

© McGraw-Hill Education 23
 Group Incentive Plans: Advantages and Disadvantages 2

Disadvantages
1. Line-of-sight may be lessened, that is employees may find it more
difficult to see how their individual performance affects their incentive
payouts.
2. May lead to increased turnover among top individual performers who
are discouraged because they must share with lesser contributors.
3. Increases compensation risk to employees because of lower income
stability. May Influence some applicants to apply for jobs in firms
where base pay is a larger compensation component.

© McGraw-Hill Education 24
EXHIBIT 10.19 Corporate Examples of Group Incentive Plans

All incentive plans can be described by common features: the size of the group that participates in the
plan, the standard against which performance is compared, and the payout schedule.

GE Information A team-based incentive that also links to individual payouts. Team and individual
systems performance goals are set. If the team hits its goals, the team members earn their
incentive only if they also hit their individual goals. The team incentive is 12 to 15
percent of monthly base pay.
Corning Glass A gain-sharing program (goal sharing) where 75 percent of the payout is based on
unit objectives such as quality measures, customer satisfaction measures, and
production targets. The remainder is based on Corning's return on equity.
3M Operates with an earnings-at-risk plan. Base pay is fixed at 80 percent of market.
Employees have a set of objectives to meet for pay to move to 100 percent of
market. Additionally, there is a modest profit-sharing component.
DuPont Fibers Earnings-at-risk plan where employees receive reduced pay increases over 5
years resulting ln 6 percent lower base pay. If department meets annual profit
goal, employees collect all 6 percent. Variable payout ranges from O (reach less
than 80% of goal) to 19 percent (150% of goal).

© McGraw-Hill Education 25
 PFP: Long-Term Incentive Plans

Long-term incentive plans focus on performance beyond the one-year

time line used as the cutoff for short-term incentive plans.
• Spurred by a desire to motivate longer-term value creation.
• There is very little empirical evidence that stock ownership by
management leads to better corporate performance.
• There is some evidence that stock ownership is likely to increase
internal growth, rather than more rapid external diversification.

As of June 2005, companies were required to report stock options as an

expense.
• Prior to this date, they were, (wrongly) viewed as a free good under old
accounting rules.

© McGraw-Hill Education 26
PFP: Long-Term Incentive Plans Employee Stock Ownership
Plans (ESOPs)

ESOPs are the most common form of employee ownership.

• On the negative side, they can carry significant risk for employees.
• ESOPs can be attractive to organizations as they have tax and
financing advantages and can serve as a takeover defense.
• ESOPs have little impact on productivity or profit.
• Critics argue that companies don’t use these programs effectively.
• Should be combined with high goal setting, improved communication,
and greater participation in decision-making.

© McGraw-Hill Education 27
 PFP: Long-Term Incentive Plans Performance Plans
(Performance Share and Performance Unit)

Performance plans typically feature corporate performance objectives for

a time three years in the future.
• They are driven by financial earnings or return measures, and they
pay out for meeting or exceeding specific goals.

© McGraw-Hill Education 28
 PFP: Long-Term Incentive Plans Broad-Based Stock Plans
(BBSPs)

BBSPs are awards in the form of stock grants or stock option grants
available to employees broadly, not just select groups like top executives.
• Depending on distribution, they can either reinforce a strong emphasis
on performance or inspire greater commitment and retention.
• There is evidence that the incentive effect of BBSPs is relatively small
and declines as the number of employees included grows.
• The hope is to align interests of managers and employees so they
think like owners.

Starbucks uses a BBSP to grant restricted stock units.

• The employee must remain employed at Starbucks to actually take
ownership of the stock units (vesting).
• Half of the grants vest after one year, the other half after two years.

© McGraw-Hill Education 29
 Combination Plans: Mixing Individual and Group

The goal is to motivate individual behavior and to insure that employees

work together, where needed, to promote team and corporate goals.
• These combination programs start with the standard individual and
group measures.
• Variable pay level depends on how well individuals perform and how
well the company does on its macro measures.
• A typical plan might call for a 75–25 split.
• An alternative might be a completely self-funding plan.

© McGraw-Hill Education 30
 Does Variable Pay (Short-Term and Long-Term Incentives)
Improve Performance Results? The General Evidence

Pay-for-performance plans seem to have a positive impact on

performance if they are designed well.
• Too often the plans have too small a payout for the work expected.
• Or plans may have unattainable (or too easy) goals, outdated or
inaccurate metrics, or even too many metrics.

A quite different problem is that the payouts are quite large for high
performance.
• But the behaviors taken to achieve those particular aspects of
performance cause major problems.
• As such, incentive pay plans are sometimes described as high return,
but high-risk plans.
• When they go wrong, they go wrong in a big way.

© McGraw-Hill Education 31
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