Performance-related pay, Skills-based pay and Profit sharing

1. PERFORMANCE-RELATED PAY

Arguments about the advantages and disadvantages of individual PRP have been some of the most hotly contested in recent decades. The topic has formed the basis of numer­ous research studies and remains one which attracts much controversy, as was shown in recent debates about the introduction of PRP for teachers working in state schools. The main reason is the apparent contrast between the theoretical attractiveness of such systems – at least from a management perspective – and their supposed tendency to disappoint when operated in practice. While there are many different types of scheme available, all involve the award of a pay rise or bonus payment to individual employees following a formal assessment of their performance over a defined period (normally the previous year). Two distinct varieties of scheme can be identified.

1. Merit-based systems simply involve the immediate supervisor undertaking an appraisal of each subordinate’s work performance during the previous year. This will typically be done following a formal appraisal interview and often requires the com­pletion of standard documentation drawn up by an HR department. A proportion of future remuneration is then linked to a score derived from the supervisor’s assess­ment. Some systems require supervisors to award a percentage mark against different criteria, while others oblige them to assess individual performance as ‘excellent’, ‘good’, ‘satisfactory’ or ‘inadequate’. Merit-based systems are generally regarded as unsatisfactory because they allow considerable scope for assessors to make subjective judgements or to allow personal prejudice to colour their assessments. There is also a tendency to give undue weight to recent events at the expense of achievements taking place early in the appraisal period.
2. Goal-based systems are more objective, but are not appropriate for all kinds of job. They are, however, particularly well suited for the assessment of managerial work. Here the supervisor and subordinate meet at the start of the appraisal period and agree between them a list of objectives which the appraisee will seek to meet during the coming months. Examples would be the completion of particular projects, the establishment of new initiatives, undertaking a course of training or making sub­stantial progress towards the solving of a problem. Many employers nowadays seek to link individual objectives directly to defined organisational goals for the year as a means of reinforcing their significance and ensuring that all are pulling in the same direction. At the end of the year the employee is assessed on the basis of which objectives have or have not been met. A score is then derived and a bonus payment or pay rise awarded. Where performance in a job can meaningfully be assessed in this way, such systems are recommended because they are reasonably objective and straight­forward to score. Where the nature of the job involves the consistent achievement of a defined level of performance, and cannot usefully be assessed in terms of the achievement of specific objectives, the goal-based approach has less to offer. It may still be possible to assess part of the job in this way, but there will also have to be a merit-based element if the appraisal is to reflect all of a person’s activity during the appraisal period.

1.1. The attractions of PRP

It is not difficult to see why PRP has attracted the interest of managers, consultants and government ministers. Its theoretical attractions are considerable and include the following:

• attracting and retaining good performers;
• improving individual and corporate performance;
• clarifying job roles and duties;
• improving communication;
• improving motivation;
• reinforcing management control;
• identifying developmental objectives;
• reinforcing the individual employment relationship at the expense of the collective;
• rewarding individuals without needing to promote them.

In short PRP aims to provide a flexible and cost-effective means of distributing rewards fairly between the good and poorer performers while also contributing towards improved organisation performance. Moreover, it is based on principles to which most people, employees as well as managers, seem to adhere (Brown and Armstrong 2000, pp. 11-13). Most of us are very happy to see individuals rewarded for superior perform­ance and/or effort and would like payment decisions to be based on such criteria. The problems arise when attempts are made to put the principles into practice. A system which is fair and objective in theory can easily fail to achieve these objectives when implemented.

1.2. Critiques of PRP

Performance-related pay attracted a great amount of criticism from academic researchers in the 1980s and 1990s during a period when its virtues were frequently asserted by HR managers and consultants. The attacks came from several quarters.

Occupational psychologists tended to question the ability of PRP to motivate positively (e.g. Kohn 1993), while sociologists saw it as a means of reinforcing management con­trol at the expense of worker autonomy (e.g. Hendry et al. 2000). A further source of criticism has come from those who suspect that PRP is used as a means of perpetuating gender inequality in payment matters (e.g. Rubery 1995). However, the most colourful and damning criticisms have come from management thinkers such as W. Edwards Deming who advocate Total Quality Management approaches (see Chapter 11) and for whom PRP represents exactly the wrong kind of initiative to introduce. The whole basis of their philosophy is the substitution of ‘leadership’ for ‘supervision’, removing organisa­tional hierarchies and managing people with as little direction and control as possible. They see PRP as having the opposite effect. It reinforces the hierarchy, enhances the power of supervisors and strengthens management control.

For many critics, including those cited above, PRP has fundamental flaws which cannot be overcome. Kohn, for example, argues that incentives can only succeed in securing temporary compliance. Their use cannot change underlying attitudes, while the attempt to do so ultimately damages the long-term health of an organisation by under­mining relationships and encouraging employees to focus on short-term aims:

Managers who insist that the job won’t get done right without rewards have failed to offer a convincing argument for behavioural manipulation. Promising a reward to someone who appears unmotivated is a bit like offering salt water to someone who is thirsty. Bribes in the workplace simply can’t work. (Kohn 1993, p. 60)

A second stream of criticism is more moderate, arguing that PRP can have a role to play in organisations, but that its positive effects are limited. Moreover, while not funda­mentally flawed, PRP is very difficult to implement effectively in practice. As a result, systems fail as often as they succeed. The arguments are summarised well by Gomez- Mejia and Balkin (1992, pp. 249-55), Cannell and Wood (1992, pp. 66-101), Pfeffer (1998, pp. 203-4) and Purcell (2000). The major points made by these authors are as follows:

• Employees paid by PRP, especially where the incentive is substantial, tend to develop a narrow focus to their work. They concentrate on those aspects which they believe will initiate payments, while neglecting other parts of their jobs.
• PRP, because of its individual nature, tends to undermine teamworking. People focus on their own objectives at the expense of cooperation with colleagues.
• PRP, because it involves managers rating employees, can lead to a situation in which a majority of staff are demotivated when they receive their rating. This occurs where people perceive their own performance to be rather better than it is considered to be by their supervisors – a common situation. The result is a negative effect on the motivation of the staff who are unexceptional, but loyal and valued. These are often the very people on whom organisations depend most.
• Employees are rarely in a position wholly to determine the outcomes of their own performance. Factors outside their control play an important role, leading to a situ­ation in which the achievement or non-achievement of objectives is partially a matter of chance.
• Even the most experienced managers find it difficult to undertake fair and objective appraisals of their employees’ performance. Subjective judgements are often taken into account leading to perceptions of bias. Some managers deliberately manipulate ratings for political reasons, allowing their judgement to be coloured by the effect they perceive the outcome will have on particular employees. Low ratings are thus avoided, as are very high ratings, where it is perceived this will lead to disharmony or deterioration of personal relationships.
• In organisations subject to swift and profound change, objectives set for the coming year may become obsolete after a few months. Employees then find themselves with an incentive to meet goals which are no longer priorities for the organisation.
• PRP systems tend to discourage creative thinking, the challenging of established ways of doing things and a questioning attitude among employees.
• Budgetary constraints often lead managers to reduce ratings, creating a situation in which excellent individual performance is not properly rewarded.
• It is difficult to ensure that each line manager takes a uniform approach to the rating of his or her subordinates. Some tend to be more generously disposed in general than others, leading to inconsistency and perceptions of unfairness.
• When the results of performance appraisal meetings have an impact on pay levels, employees tend to downplay their weaknesses. As a result development needs are not discussed or addressed.
• PRP systems invariably increase the paybill. This occurs because managers fear demotivating their staff by awarding low or zero rises in the first years of a system’s operation. Poorer performers are thus rewarded as well as better performers.

1.3. Using PRP effectively

Despite the problems described above it is possible to implement PRP successfully, as is shown by the experience of case study companies quoted by Brown and Armstrong (2000), IRS (2005a and 2005b) and IDS (2005). It will only work, however, if it is used in appropriate circumstances and if it is implemented properly. Part of the problem with PRP has been a tendency in the HR press to portray it as universally applicable and as a panacea capable of improving performance dramatically. In fact it is neither, but is one of a range of tools that have a useful if limited role to play in some situations. Gomez- Mejia and Balkin (1992) specify the following favourable conditions:

• Where individual performance can be objectively and meaningfully measured.
• Where individuals are in a position to control the outcomes of their work.
• Where close teamworking or cooperation with others is not central to successful job performance.
• Where there is an individualistic organisational culture.

In addition, Brown and Armstrong (2000) rightly point to the importance of careful implementation and lengthy preparation prior to the installation of a scheme. More­over, they argue that PRP should not be looked at or judged in isolation from other forms of reward, both extrinsic and intrinsic. Success or failure can hinge on what else is being done to maximise motivation, to develop people and to improve their job security.

Ultimately PRP has one great advantage which no amount of criticism can remove: it helps ensure that organisational priorities become individual priorities. Managers can signal the importance of a particular objective by including it in a subordinate’s goals for the coming year. If the possibility of additional payment is then tied to its achieve­ment, the chances that the objective concerned will be met increase significantly. Organisational performance is improved as a result. Where the achievement of such specific objectives forms a relatively minor part of someone’s job, PRP can form a rela­tively minor part of their pay packet. Other rewards can then be used to recognise other kinds of achievement.

2. SKILLS-BASED PAY

A further kind of incentive payment scheme is one which seeks to reward employees for the skills or competencies which they acquire. It is well established in the United States and, according to IRS (2003), has attracted a good deal more interest among British employers. It is particularly prevalent as a means of rewarding technical staff, but there is no reason why the principle should not be extended to any group of employees for whom the acquisition of additional skills might benefit the organisation.

There are several potential benefits for an employer introducing a skills-based pay scheme. Its most obvious effect is to encourage multiskilling and flexibility enabling the organisation to respond more effectively and speedily to the needs of customers. A multi­skilled workforce may also be slimmer and less expensive. In addition it is argued that, in rewarding skills acquisition, a company will attract and retain staff more effectively than its competitors in the labour market. The operation of a skills-based reward system is proof that the sponsoring employer is genuinely committed to employee development.

Most skills-based payment systems reward employees with additional increments to their base pay once they have completed defined skill modules. A number of such schemes are described in detail in a study published by Incomes Data Services (1992). Typical is the scheme operated by Venture Pressings Ltd where staff are employed on four basic grades, each divided into 10 increments. Employees progress up the scale by acquiring specific skills and demonstrating proficiency in them to the satisfaction of internal assessors. New starters are also assessed and begin their employment on the incremental point most appropriate to the level of skills they can demonstrate. In many industries it is now possible to link payment for skills acquisition directly to the attainment of National Vocational Qualifications (NVQs) for which both the setting of standards and the assessment of individual competence are carried out externally.

A skills-based pay system will only be cost effective if it results in productivity increases which are sufficient to cover the considerable costs associated with its intro­duction and maintenance. A business can invest a great deal of resources both in train­ing its workforce to attain new skills, and in rewarding them once those skills have been acquired, only to find that the cost of the scheme outweighs the benefit gained in terms of increased flexibility and efficiency. Furthermore, in assisting employees to become more highly qualified and in many cases to gain NVQs, an employer may actually find it harder to retain its staff in relatively competitive labour markets.

The other major potential disadvantage is associated with skills obsolescence. Where a business operates in a fast-moving environment and needs to adapt its technology reg­ularly, a skills-based payment system can leave the organisation paying enhanced salaries for skills which are no longer significant or are not required at all. Employers seeking to introduce skills-based systems of payment therefore need to consider the implications very carefully and must ensure that they only reward the acquisition of those skills which will clearly contribute to increased productivity over the long term.

3. PROFIT SHARING

There are a number of different ways in which companies are able to link remuneration to profit levels. In recent years the government has sought to encourage such schemes and has actively promoted their establishment with advantageous tax arrangements. Underlying government support is the belief that linking pay to profits increases the employee’s commitment to his or her company by deepening the level of mutual interest. As a result, it is argued that such schemes act as an incentive encouraging employees to work harder and with greater flexibility in pursuit of higher levels of take-home pay. Other potential advantages for employers described by Pendleton (2000, pp. 346-51) are better cost flexibility, changed attitudes on the part of employees and the discouragement of union membership.

3.1. Cash-based schemes

The traditional and most common profit-sharing arrangement is simply to pay employees a cash bonus, calculated as a proportion of annual profits, on which the employee incurs both a PAYE and a national insurance liability. Some organisations pay discretion­ary profit bonuses on this basis, while others allocate a fixed proportion of profits to employees as a matter of policy. Gainsharing is a variation on cash-based profit sharing which is widely used in the USA and which can be used in non-profit-making organisa­tions as well as those operating in the commercial sector. Here the bonus relates to costs saved rather than profit generated in a defined period. So if a workforce successfully achieves the same level of output at lower overall cost, the gain is shared between employer and employees.

Between 1987 and 2000 the government operated an approved profit-related pay scheme which became increasingly popular. By 1996 there were over 14,000 schemes in operation, covering 3.7 million employees. The attraction was the ability profit-related pay schemes gave employers to give pay rises to all employees, while recouping the cost through tax concessions. The scheme was phased out and has now been replaced by the Share Incentive Plan (see below).

3.2. Share-based schemes

There are several methods of profit sharing which involve employees being awarded shares rather than cash. Here too there are government-sponsored schemes in operation which involve favourable tax treatment. There are several distinct schemes available for employers to use some of which are more tax efficient than others. Traditionally senior managers have been paid, in part, through share-based reward systems, but companies are increasingly seeing an advantage in extending these arrangements to a greater pro­portion of their staff. The purpose is to increase commitment by giving employees a significant financial stake in the future of the business they work for, at the same time helping to align employees’ interests with those of shareholders. The result should be improved staff retention and higher levels of individual performance, but it is difficult to prove that such outcomes result in practice from the introduction of these schemes. For most ordinary employees the level of reward is too low and the extent to which their actions impact on a firm’s performance too indirect, for there to be a clear-cut incentive effect. Cohen (2006) provides a concise and clear guide to the whole range of systems. The two most common are the following:

1. Savings-Related Share Option schemes permit companies to grant share options to directors and employees in a tax-effective manner. This means that they are given the opportunity to buy shares in their own companies at a future date, but at the current price. The hope is that the value will have increased in the meantime, allowing the purchaser to cash in a tidy profit. This particular government-sponsored scheme requires participants to put between £5 and £250 of their monthly pay aside and then to use the proceeds of the accumulated fund, after three, five or seven years, to buy shares at a discount of 20 per cent of the price they were when the plan started.
2. Inland Revenue Approved Share Incentive Plans (previously called All-Employee Share Schemes) allow employees to obtain shares in their own companies while avoiding tax and national insurance contributions. Employers can give such shares to employees to a maximum value of £3,000 per year. Some can be given in recognition of individual or team performance, making it possible to award some employees more shares than others. Where employees subsequently hold these shares for three years or more, there is no tax liability when they are sold. In addition, under the scheme, employees can buy up to a further £1,500 worth of shares out of pre-tax income and subsequently avoid a proportion of the tax owed when they are sold. Companies are also allowed to give ‘free’ matching shares for each share purchased by an employee under the scheme. Employers as well as employees gain tax advant­ages from operating these schemes. Deductions in corporation tax can be made equivalent to the amount of salary used by employees to purchase shares, as well as monies used in establishing and operating the scheme.

3.3. Disadvantages of profit-related schemes

The obvious disadvantage of the schemes described above from the employee’s point of view is the risk that pay levels may decline if the company fails to meet its expected profit levels. If no profit is made it cannot be shared. Share values can go down as well as up. Companies are not permitted to make guarantees about meeting payments and will have their schemes revoked by the Inland Revenue if they do so. In any event it is likely that profit-based incentives will vary in magnitude from year to year.

For these reasons it is questionable to assert that profit-sharing schemes do in fact act as incentives. Unlike PRP awards they do not relate specifically to the actions of the indi­vidual employee. Annual profit levels are clearly influenced by a whole range of factors which are both internal and external to the company. An employee may well develop a community of interest with the company management, shareholders and other employees but it is unlikely seriously to affect the nature of his or her work. Furthermore, both poor and good performers are rewarded equally in profit-related schemes. The incentive effect will therefore be very slight in most cases and will be restricted to a general increase in employee commitment.

Source: Torrington Derek, Hall Laura, Taylor Stephen (2008), Human Resource Management, Ft Pr; 7th edition.