Paying for performance

The recent history of performance management is inextricably linked to contemporary developments in UK remuneration. If organisations wish to reward individual or team performance then they need a system by which this is measured and managed. Although the main aim of the many performance management systems is principally developmental (see chapter six ), in some organisations the process also plays a crucial part in informing decisions on pay. The 1998 CIPD survey reported that 43% of organisations linked the performance management process in some way to pay, while Towers Perrin's survey of managerial employees in 300 large organisations found as many as 73% linked their performance appraisal process to employee reward.¹

With performance management such an integral part of the pay determination process, attention has increasingly focused on how the level of performance or contribution can best be assessed and summarised. A number of studies have pointed to real problems with the effectiveness, fairness and operation of performance management processes and their links to employee reward. The Towers Perrin study, for example, found that a third of participants reported poor or weak links to pay as major issues, while a survey of merit schemes conducted by IRS identified a range of problems relating to issues of motivation, training, communication, appraisal and administration.^{1, 2}

These widely shared criticisms of individual-performance pay schemes have been accompanied by rising concerns about the performance management systems that have traditionally been used to underpin them. Over recent years, a new approach to pay and performance management has emerged which is increasingly consigning the old top-down, ratings-driven model of performance-related pay to the past. As we have noted elsewhere, these developments are in tandem with a more balanced approach to managing performance that concentrates not just on the outputs (performance and contribution) achieved, but on the inputs (skills and competencies) required to deliver them. Rather than abandoning individual performance-related pay, organisations are adapting their schemes to improve the "fit" between reward and business strategy. As Duncan Brown and Michael Armstrong, authors of Paying for contribution: real performance-related pay strategies, have observed:

"Companies are working to improve the links between their organisations' strategic goals and performance, and the work, contribution and results of their employees, through a wide variety of more effective and truly performance-related pay and reward schemes."³

PAYING FOR PERFORMANCE

Although performance-related pay is not a necessary condition for a performance management system, its growing use over the past two decades has been a key driver in shaping the way organisations have sought to manage and assess the performance of individual employees. Individual merit pay schemes proliferated during the 1980s and early-1990s. In the private sector, firms squeezed by growing competition sought to establish a closer link between remuneration practice and organisational objectives. And public sector organisations have endured government-imposed financial constraints and a more "business-like" approach which has tried to ensure that productivity and performance become the key drivers of public sector pay. In general, this move to merit pay has tended to replace pay progression systems based on length of service with those in which the employees' grade or scale advancement is based on some measure of assessed performance.

But the rapid growth in individual merit schemes witnessed a decade ago has abated. Recent years have seen a period of consolidation, with "all new" merit schemes increasingly rare. Figures from IRS show that almost a quarter of all recorded settlements in the year to August 2000 were based wholly, or partly, on merit assessment - a figure that has remained largely unchanged for the past three years.⁴

Nevertheless, performance-related pay schemes are still the most common type of reward strategy in use. The latest IRS pay prospects survey found 53.8% of organisations operated merit schemes for one or more of their main employee groups. However, this represented the third consecutive yearly fall in the proportion of respondents operating these arrangements - down from a high of seven in 10 recorded in 1997.⁴

Setting merit awards

Merit payments are typically based on an assessment of employee performance against a series of pre-set objectives. An IRS survey of merit pay schemes covering 85 separate employee groups found that in the vast majority of cases (78%), the merit award is based on individual appraisal, with the level of payment linked to an overall performance rating, or a series of performance categories.² Most appraisal systems tend to use between three and six ratings, depending on the level of analysis required. This was confirmed by the IRS survey, which reported that over 90% of merit schemes are based on between three and six performance ratings. The most common number was five (used for almost 40% of employee groups) and more appraisal schemes operated an odd number of ratings (59%) than an even number (41%).

A third of employee groups (35%) are awarded a set cash or percentage rise for each performance category, with the remaining awards determined by line managers' discretion. In this regard, employer practice was found to vary: some managers are given complete discretion to determine the size of individual merit rises within an overall percentage award, while others must follow strict guidelines and seek final approval from the company chief executive or board of directors.

The IRS survey also revealed that a variety of assessment criteria are used by employers during the appraisal process. Respondents were asked to specify whether these were based around the assessment of pre-set objectives, the performance of the employee on the "whole job", an aggregated result of ratings for different factors, or based on competency or skills acquisition (see figure 5.1 ). The findings were as follows:

Figure 5.1: Methods for determining merit increases

Source: IRS (2000)

Problems and issues

The relative slowdown in the take-up of individual merit schemes has coincided with a mounting body of research suggesting that performance pay does not actually deliver what its advocates claim. Although the research evidence suggests that employees generally agree with the principle of paying for performance, many question whether the current system gives them a real incentive to work beyond the requirements of the job. In many schemes, and in the context of the current low inflationary climate, performance differentials have been narrowed and the link between pay and performance has become increasingly blurred. As Brown and Armstrong have observed:

"There has been a remarkable reversal in commentaries on the practice [of individual merit pay], until we have reached a stage where the criticisms are so vehement and the lack of effectiveness so widely accepted that it is hardly seen as an issue worth defending".³

These commentators have pointed to the problems that have resulted from "applying a uniform merit pay, objective-based appraisal system throughout the organisation". The outcome is that:

The difficulties outlined by Brown and Armstrong were confirmed by a recent IRS survey which identified a range of problems associated with merit schemes relating to issues of motivation, training, communication, appraisal and administration.² In almost two-thirds of schemes (65%) employees suffered because the pay awards were too small to motivate them to make any significant changes to the way they worked. The role of line managers in determining merit awards was also raised. In 52% of schemes, employees have questioned their line managers' judgment, and in 38% of cases, staff perceived that line managers were inadequately trained for the job. A quarter of performance pay schemes were said to take up too much management time, and suffer from poor communication (27%). Employees believed pay awards were limited by a quota system. The survey also revealed that problems were more prevalent in schemes covering staff groups and among those operating in the public sector.

FROM PERFORMANCE TO CONTRIBUTION

Although linking pay to performance remains the most common reward strategy in use, recent years have a witnessed a growth in alternative remuneration systems which aim to reward staff for their contribution to personal and business achievements (see figure 5.2 ). This "pay for contribution" approach aims to reward staff not just for their results but also for the competencies, skills and behaviours that determine how results are achieved. Growing numbers of employers have embraced competency-based pay as a way of rewarding employees for their performance, for showing greater flexibility, working to broader and more customer-focused results, and to compensate for the scarcity of promotion opportunities.

Figure 5.2: Model comparing 1980s style pay for performance approaches with pay for contribution

Source: Paying for contribution, Duncan Brown and Michael Armstrong (1999)

The Industrial Society's survey of 344 organisations showed that a third either had or planned to introduce a system of competency-related pay.⁵ Since 1995, the annual survey of pay trends conducted by the Pay and Benefits Bulletin has recorded a growing proportion of respondents operating or considering competency- and skills-based pay systems. The latest survey found that over a tenth of respondents (12.5%) were linking pay to the combined competencies, behaviours and attributes of employees, while a fifth were planning to introduce such arrangements in the future, by far the most popular area of change identified.⁴

In addition, a survey by Competency concluded that the practice of linking competencies to reward is now "a significant force and is set to grow further".⁶ Competency found that over a third of respondents were linking competencies to pay in one of four ways:

The research clearly shows that competencies are making inroads into the grading structure, influencing promotion decisions and affecting pay progression and annual pay awards (see figure 5.3 ). But current use of competency-based pay should not be overstated. Few organisations use competencies as the sole determinant of pay and, while they have become an increasingly important determinant of pay levels and rates of increase, they are invariably used alongside other measures, such as performance results, job size and market comparisons.

Alongside competency-based pay, the past decade has also witnessed a growth in the use of team-based incentives. Although it remains on the margins of current reward practice, the principle of linking pay to some measure of team performance has gained ground. The latest PABB annual pay survey found that team reward was used by 5% of respondents, with one in 10 planning to introduce a scheme in the coming year (up from 7.4% in 1999).⁴

Figure 5.3: The criteria for a successful performance-, competence- or skill-related pay scheme

Source: Reward Management, Michael Armstrong and Helen Murlis (1998)

LATEST TRENDS

In tandem with the recent move from individual merit schemes to successor initiatives such as competency- and skills-based pay, recent research suggests that we are also witnessing a fundamental change in the approach to managing performance. Central to this concept is the idea of using reward strategically to deliver organisational goals and introducing pay systems that reward employees for their contribution to personal and business achievements.

In place of the traditional "top-down" model, based on a system of performance appraisals and ratings, a more balanced approach has emerged characterised by a greater focus on career development, performance improvement and employee involvement. This new approach recognises that effective performance management means establishing a shared understanding about what is to be achieved and how. The focus is on processes rather than systems, and of thinking holistically about what is needed to achieve success. Instead of a concern with the appraisal of performance outputs (results), the emphasis has now been extended to include the assessment of inputs (knowledge, skills and competence). As Armstrong and Helen Murlis, authors of Reward management: a handbook of remuneration strategy and practice, have observed:

"This is a mindset that is a long way from the preoccupation with bureaucracy, ratings and forms and the implications of (at worst) 'search, find and punish' under-performers that went with the crudest transactional view of 1980s style performance-related pay."⁷

A number of studies have confirmed that a growing proportion of organisations are in the process of revising and improving their systems of performance management. The IRS survey of performance pay found that over half the organisations had recently made changes to their merit systems.² The most common were:

More than half the sample were also found to be planning to make similar changes in the near future.

Towers Perrin's study revealed that 75% of the 303 surveyed organisations were planning changes to their performance management systems over the next three years.¹ The most popular options were multi-rater or 360-degree appraisal, and integrating the individual, team and company aspects of performance in a total performance management approach.

The CIPD research also suggests that a fundamentally different concept of performance management is emerging. This is characterised by what Brown and Armstrong have described as:

"An emphasis on multi-directional and bottom-up involvement and performance improvement, rather than top-down performance appraisal and control".³

Central to this new way of thinking, as we have acknowledged elsewhere, is the idea that performance management should involve a continuous process of two-way discussion and development that seeks to increase skill acquisition, improve personal and team performance and reward people fairly according to their contribution to business goals. That means paying employees according to both the achievement of objectives and the application of competencies. If performance-related pay is to be an effective management tool, it needs to be based on an effective performance management process that is clearly linked to organisational objectives. When relating pay to performance, therefore, the focus needs to be on issues that emerge from the business planning process. As Armstrong and Murlis point out:

"The assessment upon which pay decisions are made should be based not only on performance in achieving objectives, contribution to organisational success and the levels of skill and competence achieved, but also on the degree to which the behaviour of individuals supports corporate values in such areas as teamwork, total quality management, customer service and innovation."⁷

PUBLIC SECTOR DEVELOPMENTS

This new approach to pay and performance management has also been reflected in the Government's plans to introduce new performance pay systems covering civil servants, school teachers and NHS staff. These, in turn, reflect the aims of the Government's Modernising government White Paper that has sought to deliver more effective systems of performance management, largely based on meeting a wide range of targets and standards. In the face of widespread criticisms about the fairness and efficacy of individual merit schemes, the Government has put forward a series of initiatives that aim to move away from the system of fixed formulas that link pay to the achievement of individual objectives.

In the civil service, the Makinson report Incentives for Change called for the abolition of individual merit pay and the introduction of team-based performance bonuses.⁸ A pilot project was run in HM Customs & Excise in 2000, with the system due to be introduced more fully from April 2001.

Instead of an assessment of individual achievement, the report says that performance should be measured against clear operational targets (as set out in the public service agreements). Payments should "wherever possible aim to reward team achievement" and every employee should have an opportunity to earn a bonus worth "at least 5% of base salary". The report also recommended that merit awards should not be consolidated into existing pay scales; and discussions of performance rewards should be kept separate from the review of pay progression and that targets and incentives should be SMART (see chapter three ).

The concept of team bonuses also forms part of the Government's plans for a new pay system for NHS staff. Although discussions on the Government's Agenda for Change document are proving protracted, the negotiating parties are currently examining "how effective arrangements could be made within the NHS for team bonuses to reward team performance".⁹ The document also proposes to replace automatic annual increments with career progression based on "responsibility, competence and satisfactory performance". This is part of a broader initiative aimed at introducing a new reward system, with three overlapping pay spines for doctors, nurses and the professions allied to medicine, designed to encourage flexibility, break down traditional job demarcations and make it easier to reward staff for what they actually do.

To underpin this move, new national service frameworks are being developed for particular groups that will include measurable outcomes of care, relating to quantity and quality of treatment. Some government advisers have even suggested that by achieving such targets hospital teams could be rewarded with pay bonuses or with a combination of extra pay and extra resources for their hospital or department.¹⁰

The Government is also on the brink of introducing its delayed performance pay plans for classroom teachers in England and Wales. This introduces a new nine-point pay spine above which there is a performance threshold. Teachers who apply to cross this point and who are assessed as meeting the national performance standards set out by the Government will receive a £2,000 salary increase and move to a five-point upper pay range. Although these awards were supposed to come on stream in September 2000, legal wrangling over the Government's failure to consult adequately on the standards against which teachers are to be assessed have seriously delayed its introduction.¹¹

The Government's reward agenda for public servants, still very much in its infancy, is being developed in tandem with a new approach to managing performance. An IRS survey of public sector performance management found a "rapid picture of change". The majority of surveyed employers reported that they had made changes to policies and practices on performance management in the past three years, and a similar proportion planned to make further changes in the future.¹²

DEVELOPING A REWARD STRATEGY

But what do all the recent developments, in both the private and public sectors, tell organisations about the best way to develop and improve their own pay performance management systems? Clearly, there is no single way forward. Each case will depend on the history, culture and business strategy of each individual organisation. While there is no simple, single solution, there are some key issues that all organisations need to address:

¹     Performance management: The new realities, Michael Armstrong and Angela Baron (1998), Chartered Institute of Personnel and Development, ISBN 0 8529 2727 4; "Learning from the past: changing for the future", Towers Perrin, March 1997.

²     "The truth about merit pay", Pay and Benefits Bulletin 501, August 2000.

³     Paying for contribution: real performance-related pay strategies, Duncan Brown and Michael Armstrong (1999), Kogan Page, London, ISBN 0 7494 28996.

⁴     "Pay prospects for 2000/01- a survey of the private sector", Pay and Benefits Bulletin 507, November 2000.

⁵     "Competency-based pay", Managing Best Practice 43, Industrial Society, 1998.

⁶     "Employers' practice in using competencies for pay, progression and grading", Competency & Emotional Intelligence, Autumn 1999.

⁷     Reward management: a handbook of remuneration strategy and practice, Michael Armstrong and Helen Murlis (1998), 4th edition, Kogan Page, London, ISBN 0 7494 2507 5.

⁸     Incentives for change: rewarding performance in national government, J Makinson, HM Treasury: public enquiries@hm-treasury.gov.uk

⁹     Agenda for change - modernising the NHS pay system, February 1999, Department of Health.

¹⁰    Reported in the Financial Times, 5 February 2000.

¹¹    Pay and Benefits Bulletin 502, August 2000.

¹²    "Target practice", IRS Employment Review, 701, April (2000).

¹³    Improving productivity through performance appraisal, G Latham and KN Wexley (1989), Addison-Wesley, Reading.

¹⁴    "Policing performance: the ethics of performance management", D Winstanley and K Stuart-Smith, Personnel Review 25(6), 1996.