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Benefits & Compensation International
December 2005

In Search of the Well-Balanced Pay Package

Peter Newhouse

To engage their workforce most organisations seek to maintain an appropriate balance between the various elements of the pay package. But is the role and purpose of these elements always clear? What are the considerations which influence their relative size and composition? Is there any evidence that different package configurations are more or less attractive to recipients? By what yardstick might we measure an ideal balance?

Last year the Reward Technology Forum set itself the task of searching out the well -balanced pay package.  Through a series of interactive sessions, representatives of 22 diverse organisations tackled the above questions.

In exploring employee engagement and the well-balanced pay package, the Forum used the framework of familiar pay elements, namely:

• salary,
• benefits,
• short term incentives,
• long term incentives, and
• retirement income plans.

There are, in addition, other reward considerations (see later).

The Forum set itself the objective of developing an “anatomy of pay” to identify the kind of linkages that make sense of the relationship between these elements of the pay package; both with each other and within the whole.  In discussion it became evident that strong common themes and linkages were shared between the different elements.  For example ‘pay for performance’ is a thread running through salary and incentives. Likewise, market practice and market matching are forceful drivers across all elements of the package. Tax considerations are significant drivers for benefits, long-term incentives and retirement income plans.

Neither the role nor the dividing line between pay-package elements is always as clear as it appears at first sight. Participants agreed that quantum is a factor in considering any pay-package element. It is not just a question of whether an element is included in the package or not but how much it is worth. The higher the bonuses that people are used to receiving, the more difficult it is to reduce them by a significant degree. How much of a habitually large annual bonus is genuinely performance related and how much is really fixed as a market-related ‘guarantee’?  Bonuses might be performance related but only above a level that is required to retain key staff.

In reflecting on the group discussion, two ‘straw men’ for an anatomy of pay were developed.  The first model continues to use the familiar pay-package elements and relates these elements in an orderly fashion – ‘inside the box’.  The second, more radical model ‘deconstructs’ the pay-package elements to help us reflect on the pay package ‘outside the box’.

In developing the first straw man, participants were conscious that a number of factors were identified as key linkages and drivers.  A model for the anatomy of pay would need to relate as many of these factors as possible within an overall system.

When the workgroups looked ‘other’ reward considerations (those outside the five principal pay-package building blocks), it was agreed that these play a significant role in employee engagement. They can also shape the pay-package elements and influence their relative importance.  An anatomy of pay would need to identify these factors and take them into account. From the various discussions, other reward considerations boiled down to five key areas, each of which may be traded off against pay, as follows:

Role.  What an employee actually does may hold significant value to him or her.

Opportunity.  Training, development, career prospects, the possibility of mobility and so forth may represent a trade-off against the employee’s current rewards.

Organisation’s industry, size and scope.   An employee may perceive value in his or her organisation’s footprint and its role in society.

Organisation’s reputation.  There may be a premium or a discount value inherent in the way an employer is perceived by the employee, his or her peers, family and friends.

Organisation’s Culture & Values.  The ‘employment experience’ may be traded off against money.

Having looked at these ‘other’ reward elements, the workgroups were left with the 10 building blocks: the five pay-package elements and the five organisational considerations.

Clearly, employees make trade-offs across the 10 building blocks. These trade-offs are most likely to be influenced by employee demographic factors, such as age and length of service.

In addition, the relative importance of the factors is likely to vary depending on the circumstances, as follows:

• when people consider employment offers (attract);
• when people reflect on whether to stay with an employer (retain); and
• when people react to the organisation seeking to influence their behaviour and outputs (motivate).

This categorisation opens up opportunities for research around employee perceptions of reward. By pair matching across the ten factors it is possible to gain an impression of employee reward preferences and a clear insight into which aspects of the reward proposition are foremost in employees’ minds at critical points in the employment cycle.

Figure 1 below provides an example of this analysis subsequently undertaken with a participating company.  Based on pair matching the entire set, the bars represent answers to the question ‘which is the most important element to you?’.  A score of 100% would mean that all the respondents rated that factor as more important than every other factor.

Figure 1 (Zoom in)

From this research it is possible to start establishing ‘customer segmentation’ – developing package configurations that best fit groups of employees with similar characteristics in terms of their role and stage in life. It is also possible to develop a firm foundation for optimising the value of the reward proposition (for example, by reducing those employment costs wasted on rewards that employees do not value).

To maximise the value of the pay package to the recipient a model is required to interrelate the elements in a pay system that could be balanced in different ways.  The simplest way to see this – inside the box - is to organise the elements of the pay package according to whether they are of fixed or variable value from the employee’s point of view. This results, for example, in a defined benefit retirement income plan being on the ‘fixed’ side of the system and a defined contribution plan being on the ‘variable’ side.  From the employer’s point of view, these positions are reversed – the defined contribution plan fixes the cost to the employer while the defined benefit plan has a variable cost.

In pursuing this arrangement, the straw model revolves around the ratios between the principal elements of the package that determine its balance, including:

• the ratio between the value of fixed and variable elements in the package,
• the ratio between the value of fixed non-cash benefits and fixed cash salary,
• the ratio between the value of fixed retirement income plan (contributions or benefits) and fixed cash salary, and
• the ratio between the value of variable long-term and variable short-term incentives.

To understand the variable components better, it is necessary to connect them to drivers - not just to market drivers like best practice, internal and external equity but also to performance drivers. Key performance indicators represent a potentially bewildering variety but could be organised around the performance of:

• the individual,
• the team,
• the business,
• the group,
• the industry, and
• the market.

Different parts of the package tend to be connected to different points within this hierarchy of drivers. Salary is related more closely to individual performance, while pension is related to market performance, i.e. returns on long-term investments external to the company, and long-term incentives tend to focus on group or industry performance. The more distant from the individual the driver is, the more likely it is to be used to drive longer-rather than shorter-term variable pay elements.

Clearly, linkages like the minimum legal obligation, the tax impact and the cost of delivery are specific to particular territories and package elements. They are neither universal nor are they entirely under the control of the company. In effect, these three factors represent a ‘platform’ on which each package element sits.

If the combination of tax treatment, cost of delivery and employee perception makes a specific benefit less costly to provide than its perceived value to the employee, the overall impact is positive from the point of view of employment cost. By contrast, where the combination makes an element more costly to provide than its perceived value to the employee, the overall impact is negative. In other words, engagement can be priced only if it is known what employees value.  In recognition of this, the Forum has developed a series of Web-based survey tools to assess employee reward perceptions and performance management metrics, producing data against which organisations can benchmark their employees’ reward perceptions.

Employee perception data should reveal the delta between the cost to the company of providing the package and its perceived value to the employee. Once perceived value is better understood, both the structure and the communication of pay plans can be better focused.

In reflecting on the first straw man, while it seems to be on the right track, it may be too close to what is already accepted practice. How much can it tell us that we do not already know?  How can we deconstruct the pay-package elements that we currently use?

For a more radical model of the anatomy of pay we need a key concept that can break down the pay-package elements. In the group discussions, ‘time’ was a theme that was constantly close to the surface when trying to distinguish between the pay-package elements. The concept of time is close to the heart of the second straw man.

In the Forum’s view, the timeline for the pay-package elements starts with benefits, which are constantly accessible to the employee in the here and now.  Some of the organisational considerations, like role, culture and values, have a similar characteristic. Then follows the sequence of cash payments, from salary to short- and long-term incentives, to retirement income.

Using time, the pay-package elements can be separated into benefit and cash flows, as follows:

• fixed non-cash employee benefits, e.g. health care, life assurance and company cars,
• variable non-cash employee benefits, such as recognition plans and incentives in kind,
• fixed cash flow during employment, such as basic salary and allowances,
• conditional variable cash flow during employment, such as short- and long-term incentives, and
• cash flow and benefits post-employment, such as retirement health insurance and pension.

This arrangement may allow us to relate the five organisational considerations more closely to the sequence and time-scale of benefit and cash flows.  For example, the organisation’s industry and size typically determines the scale and type of fixed non-cash benefits – a miner may get free coal, a banker may get cheap money.  Role (together with performance) determines the extent and type of variable non-cash benefits, fixed cash flow, i.e. salary, and variable cash flow, i.e. incentives over the short and long term. Opportunity/potential may well influence the employee’s access to fixed, short- or longer-term variable cash flows. The ‘grieving widow at the factory gate’ may negatively impact the organisation’s reputation.

If we compare the two anatomy of pay models, in the second one drivers and linkages can more easily be related to the benefits and cash flows in terms of their degree of impact or relevance. This model comprises a relatively small number of ‘moving parts’ to categorise highly complex pay systems: five package elements, five organisational considerations, 12 linkages, the dimension of time and, say, up to five company-specific factors (for example, business unit, age, length of service, performance rating and potential rating.

To aid segmentation and optimisation of package’s value, the model could be developed into a diagnostic tool – to categorise what is currently being delivered to groups of people through the pay system and to identify any gaps.  Equally, it could be used as a design

tool to help specify what a new pay plan should seek to deliver to people within the context of their total package. It could, for example, facilitate the translation of senior management priorities and ideas about pay into concrete pay plans or help rebalance a pay package in a desired direction.  The same framework could be used to interpret employee perceptions:  do the people on the receiving end view the package the way it is designed to be seen or do they view it differently?

These applications could enable a closer alignment of pay delivery with the target employee group’s perception of value - increasing the efficiency of the package, driving out wasted expenditure on pay and improving employee engagement.

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