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3 Ways to Make Compensation Decisions Without Performance Ratings

3 Ways to Make Compensation Decisions Without Performance Ratings

Free Resource

In most organizations pursuing a pay-for-performance model, compensation decisions are tied directly to employee performance ratings. The model is simple: rate every employee, give those in the top-scoring bucket a healthy raise and a generous bonus, give the next group a smaller increase, and so on. On the surface, it's fair, transparent, and justifiable.

But there is a growing chorus of thought leaders and industry professionals debating the merits of eliminating performance ratings, particularly forced rankings. Opponents of ratings cite the cognitive biases inherent in them, particularly anchoring and halo effects, as well as the immense organizational time commitment needed to review, rate, and calibrate.

This has put HR executives under pressure to rethink their company’s performance management processes. However, while many are ready to embrace a world without ratings, there is one big question that stops them in their tracks.

What do we do about compensation?

The challenge is keeping the wheels on your compensation plans once you've pulled the linchpin. It’s not trivial. After all, pay is the reason employees show up to work each day. If you’re fundamentally redesigning how you determine their pay, then you need a clear plan that’s clearly communicated.

Ratingless compensation strategies

Companies have tried a number of strategies. Here are three, along with tips for addressing employee concerns.

Market Rate

Under this approach, a company chooses a point within the market range for each role as the target pay, e.g., a Senior Engineer is paid 10% above the Market Reference Point (MRP). Commercial salary data is used to keep the MRP up-to-date, and each year the company adjusts salaries based on current market data.

As market rates rise, employee salaries follow. If an employee is promoted, then they move to the new salary accordingly. The key is that employees are paid the same as their peers, regardless of the outcome of a particular performance review.

For many, this is a fairly radical change since pay isn’t tied to performance. But Tom DiDonato, SVP Human Resources at Lear Corporation, argues that pay-for-performance isn’t necessary to motivate employees. He may have a point: Lear shares have risen more than three-fold since 2010 when they eliminated reviews and moved to market-based pay, at a minimum suggesting performance hasn’t suffered from the change.

Benefits

  • Pay rationale is extremely transparent
  • Employees have added motivation to be promoted

Drawbacks

  • Prohibitively expensive for roles with hyper wage inflation (e.g., engineers)
  • Loss of granularity to differentiate skill or experience within a role

Manager Discretion

 In this model, each manager is given autonomy to make pay decisions. The process is simple: each manager is allocated a budget and is responsible for determining the pay/bonus of direct reports. Any number of approaches can be used to set budgets including annual increases, cascading from above, based on market rate, or a mix.

This approach is the most common among companies that have moved away from ratings systems. For organizations that want to retain pay-for-performance, it’s a natural choice to give control to managers, the people with the best vantage point to evaluate how performance should translate to pay. While it might sound like an invitation for managers to play favorites, it’s largely a myth that performance ratings offer an unbiased way to set pay in the first place.

Benefits

  • Managers have wide latitude to reward high-performers
  • Employees are motivated by pay-for-performance

Drawbacks

  • Compensation decisions lack transparency and can seem arbitrary
  • Managers might subconsciously reward their "favorite" employees

Shadow Ratings

In this case, management conducts a rating exercise that isn’t shared with employees. Each employee is scored or ranked purely from a compensation perspective. Performance will obviously influence the rating/ranking, but there is not an explicit link.

This differs from pure manager discretion in that the ratings are typically reviewed collectively by management and calibrated across employees. Salary increases and bonuses are also bucketed by score, preventing extreme pay variance.

Benefits

  • Managers have discretion within certain guidelines
  • Calibration meetings force managers to justify decisions

Drawbacks

  • Entire process is opaque to employees, making it the least transparent option
  • Employees may feel like their performance is being rated in secret

Putting it into practice

Most other methods are variations or combinations of the above in order to mitigate drawbacks. To design the best approach for your organization, you first need to determine your priorities along the dimensions of transparency, financial incentive, fairness, and managerial influence.

There is no single answer, as it is very culture dependent. But here are several important considerations, no matter which approach you choose.

Over-communicate your new process and the reasons behind it. Otherwise, there can be a perception that eliminating the performance review/rating was an easy way for management to stop giving raises
Make the compensation process separate from any formal review or performance discussions. If your goal is to eliminate ratings from your compensation process, then you need to decouple the processes themselves. Put at least a month of distance between them.
Diligently review manager decisions to prevent unconscious bias. Whether it’s having a manager’s manager review, conducting training sessions, hosting read-across / calibration meetings, or all of the above, you should consider how to teach and monitor your managers.

Last, ensure that you and your managers are continually communicating how promotion and compensation decisions are being made. Communication is the cornerstone of employee satisfaction. For example, if you’ve opted to give managers discretion when setting pay, then train your managers how to communicate their decisions effectively and motivate employees. Otherwise, you run the risk of failing to make meaningful change and looking less competent in the eyes of your employees.