Jim Finkelstein and Barry MacLean want you to purge the phrase "merit increase" from your vocabulary. Speaking at a session of the SHRM 59th Annual Conference & Exposition, Finkelstein, President of CEO of FutureSense, Inc., and MacLean, Senior Fellow, Pay for Performance Solutions at VURV Technology, are proponents of pay for performance systems, but want employers to think about them in a new way.

"Pay for performance can be a very strong organizational driver for success," explained MacLean. "But don't confuse it with the merit system you're using today." The "traditional way" of looking at pay for performance is to link rewards to results. The goals of pay for performance have been to drive results and to attract, motivate and retain people. MacLean and Finkelstein say that in addition to these goals, pay for performance should also be viewed as a way to engage and excite people, transform organizations, and change behavior and attitudes.

In order to reduce turnover, which currently stands at 20%, employers need to look at both base pay and incentives, MacLean and Finkelstein contend. They provided a number of scenarios to show where traditional merit increase systems are doing a disservice to good performers and that turnover is a byproduct of such systems. One example included an employee who is hired at the minimum of their pay grade. The employee earns increases equal to "budget amount" of 3.8% and the salary range increases 2.5% every year (these figures are close to current averages for each). MacLean calculated that it would take 19 years (!) for this person to reach the midpoint of their pay grade.

Meanwhile, Finkelstein explained that current bonus levels "need a jolt" and aren't adequately motivating employees to perform. He asserts that any bonus that is less than 5% of pay is "insulting" while a 10% bonus is a "nice to have" but still isn't going to have a motivational impact. It's not until bonuses reach 15% of pay that "people begin to engage" and recognize they have a target bonus to work for. Raise it up to 20%, Finkelstein says, and employees "begin to make it happen" or start performing relative to the bonus they hope to earn.

The speakers suggested that employers "forget merit increases" and instead focus on "target pay." That is, for each employee, employers should "target the salary that is warranted by the employee's competency, performance and potential." Once that's been established, a "gap analysis" should be performed to "determine the gap between the current salary and the target pay." Upon completion of the gap analysis, employers should make the appropriate adjustments in salary, based on available budget.

MacLean illustrated by dividing a pay grade into quintiles (5 ranges of pay going from minimum to maximum of pay grade) and assigning a level of performance/type of employee to each. For example, the lowest quintile would be the target pay range for an employee who was a "new hire or newly promoted with minimal knowledge and skill for the job" while at the other end of the spectrum (highest quintile) would be employees who "have a mastery level of skills and competencies; exceed performance expectations, [and are] high potential candidates with immediate or near-term readiness."

Once you've established where an employee falls along this spectrum, you can determine what the gap analysis is. So, for example, let's say an employee's competency, performance and potential are equivalent to the rating given by the highest quintile and that range of pay (for the top quintile in his/her pay grade) is $57,046-$59, 947, while the employee's current rate of pay is $55,000. Then the gap analysis reveals a gap between the employee's salary and his/her target pay of between $2,046 and $4,947.

The speakers were clear on the fact that there is more than one way to approach your pay for performance system (and factors to consider when creating it) but they stressed that you should keep an employee's potential in mind when creating your pay for performance philosophy. Employers should "make an investment by retaining high potential people," Finkelstein explained, rather than making its attempts to retrain such people by making counteroffers in exit interviews (after a competitor--who also recognizes their potential--lures them away for more money).

Another factor Finkelstein urged employers to consider are the core values that your employees bring into the workplace: this is different from the type of culture the employer tries to create at the workplace (through mission statements, etc.) You need to understand why they think and act the way they do in order to truly motivate and engage them.