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May 09, 2006
Why Companies Are Moving to Variable Pay

By Sean Dean, Associate Editor

Merit-pay increases are underperforming as a pay-delivery system, and a growing number of companies are moving to variable pay as a better way to attract, retain, and motivate employees, said Ken Abosch, business leader at Hewitt Associates, during WorldatWork's Total Rewards Conference & Exhibition in Anaheim, California.

Abosch described a "double-humped" performance distribution pattern that has developed under the merit-based pay for performance system, in which there are too many "top performers" and too few "low performers." At the same time, merit-increase budgets have declined so that it has become like "spreading peanut butter," he said.

He said executives and managers say that under the merit-increase system, there is too little money to truly differentiate performance, the company has managed out all the low performers, and that bonuses would be more effective than 1 percent more than the next employee. Meanwhile, employees say that that everyone receives the same increase no matter how well the employee performs and ask why they should work harder just for a 0.5 percent increase, he said.

Abosch said that Hewitt's research has shown that the limited success of the merit-increase system has resulted in a growing number of companies turning to variable pay. He defined variable pay as having a variable component that is delivered contingent upon extraordinary results. Types of variable pay include business incentives, stock-option plans, individual performance plans, team awards, cash profit sharing, gainsharing/productivity plans, and special recognition plans.

Hewitt's survey of Fortune 1000 companies has found that the portion of employers offering at least on variable pay plan increased from 51 percent in 1991 to 78 percent in 2005, Abosch said.

He said companies are offering variable pay plans to a broad spectrum of employees, including exempt and nonexempt workers. Eighty-four percent of employees of employers in Hewitt's Variable Compensation Measurement database were eligible for variable pay in 2005, up from 75 percent in 1999, he noted. Ninety-eight percent of eligible employees received some type of award in 2005, he said.

Abosch said that companies, investors, and employees see the benefits of variable pay. He said companies view variable pay as a competitive necessity, a driver of desired behavior among employees, and a better way to manage expenses by lowering fixed costs. He said investors see companies that have variable pay as a more attractive investment because variable pay links results with rewards. Employees look at variable pay as giving them more earning potential and greater control over total compensation, he added.

He said companies are spending more on variable pay while merit-increase budgets have decreased in recent years and he said he expects the trend to continue. For salaried employees, compensation awards increased from 8 percent of payroll in 1998 to 11.1 percent of payroll in 2005, according to Hewitt's research.

Abosch finished his presentation by noting Hewitt's research looking at the characteristics of the highest performing companies compared with those of the lowest performing companies with variable pay plans. He said the highest performing companies with variable pay plans offer greater incentive opportunity, have greater emphasis on communication, developed more accurate goal setting, and maintain realistic goals and targets.

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