Five Ways To Align People's Pay With Their Value?

Episode #412 Five Ways To Align People's Pay With Their Value?

WHAT DETERMINES YOUR PEOPLE’S PAY?

Can you explain clearly why the people on your team are paid what they’re being paid? 

Not with vague platitudes like “They’re paid market rates”. I mean specific, individual reasons. 

If you can’t, you may have a hidden problem eating away at your meritocracy. In this newsletter, I reveal five ways to align your people’s pay with their value.

We’ve produced a few podcast episodes over the years on remuneration structures, with a particular focus on how to link incentives to performance. This newsletter is all about the gap between what people believe about merit-based pay and what actually happens when you try to put that into practice.

Timing… negotiation skill… historical anomalies… skill shortages… there’s a long list of barriers that conspire to stop you from paying people what they’re truly worth. And most of them are completely outside of your control. 

That’s why I’m going to give you five specific, practical steps that you can take to rebalance the scales of merit-based pay. And even if you’re working within rigid remuneration structures, you’ll at least get to a place where you can explain (with a high degree of confidence) why your people are paid what they’re being paid.

IT’S HARD TO GET REMUNERATION RIGHT

Even before we try to undertake the tricky process of aligning pay, effort, contribution, and value, we run into a philosophical divide: what criteria do you think should determine how people are paid?

• If you believe that everyone in the same role should be paid the same, regardless of their contribution and performance, that’s fine (but if that’s the case, this newsletter may not be for you);
• You may believe that experience and tenure are the best criteria to determine differences in pay; or
• If you’re anything like me, you may believe that pay should be based on merit; in other words, it should be a function of the value you bring to your organisation.

Measuring this and making decisions based on it is hard; and every leader has a slightly different view, even when they’re philosophically aligned.

So, to answer the question on what criteria you should use, let’s at least agree that people should be paid based on the value they create: the meritocracy principle.

Equity in remuneration isn’t about paying everyone the same. It’s about paying people according to their contribution… but it almost never works this way.

I’m going to talk about some of the barriers shortly, but I want to start with an article I came across in Fortune Magazine about pay transparency. It’s titled Most Companies Can’t Explain Why They Pay What They Pay. Given that transparency is supposed to be the silver bullet for resolving pay inequality, I was intrigued.

The hypothesis of the article is that, if companies simply showed consistency between what they say drives their pay decisions, as opposed to what actually drives them, the pay gap would be eradicated.

Look, I’m not sure that I agree with that, but it does raise an interesting point: Would greater transparency make a difference to how pay decisions are made?

No matter how well HR crafts its pay policies, consistency is almost impossible. Why?

• Because decisions are decentralised;
• Because recruiters talk up the scarcity of the candidate pool;
• Because, often, pay rises go to the loudest, not the best;
• Because timing differences can be significant; and
• Because (like all decisions that leaders make) the lure of short-term expediency will always outweigh the benefit of long-term consistency.

But the fact remains, people don’t know why they’re paid what they’re paid.

Even the fundamental principle that base salary is calibrated with the external employment market, while short-term and long-term incentive payments are based on performance? Well, that’s not really well-understood.

There are a couple of fairly recent episodes, where I outline the basics of remuneration systems:

• Ep.358: How To Pay People Properly; and
• Ep.359: Paying For Performance.

These just cover the mechanics of how paying people should work. They don’t in any way account for the variations that you’re going to come across as a leader in the field.

In the next few paragraphs, I want to give you the opportunity to be in the same position that I was able to put myself in as an executive: I knew exactly who was paid what and I knew exactly why. And, if anyone asked, I could explain this situation to them very clearly.

Making pay decisions on a case-by-case basis doesn’t necessarily adhere to all the HR rules. So, you have to be deliberate, and conscious, and very judicious about how and why you make them.

Personally, I don’t really think that transparency at the policy level can make a huge difference. But at the individual level, it is everything.

THE 8 BARRIERS TO MERIT-BASED PAY

There are a number of barriers that will work against you as you try to align people’s pay to their value. I’m going to go through eight of these with a practical example of each.

1. Seniority

As you rise through the ranks, each promotion takes you to a new level, with a higher pay grade. The natural cycle of promotion guarantees higher pay, regardless of contribution.

It could well be argued that much of the value is delivered by people at the lower levels, but there are good reasons why increasing seniority comes with increasing rewards:

• Higher levels require you to take on more accountability;
• The decisions you make are more complex;
• The materiality of those decisions is much, much greater; and
• At the highest levels, there are many factors that could cause you to fail that are completely outside of your control.

But of course, it’s not always the case that the more senior leaders create greater value.

I recall one of my executive peers at Aurizon. How can I describe him? Let me see… Oh yeah, he was a complete muppet.

His contribution to the value of the company was negligible, but he’d managed to ingratiate himself to the CEO. Now of course, he would argue vehemently that he was worth every dollar of his stratospheric pay packet. But having worked closely with him, I knew the truth of the matter.

If his role had remained completely unfilled, the organisation would not have skipped a beat.

The moral of that story is that sometimes, even the most senior people earning the highest salaries add little value.

2. Historical anomalies

You see this particularly with long tenured employees. They come in at a senior technical level and they earn generous (and most likely appropriate) pay increases each year.

After 35 years, though, they’re often being paid well above what the market would offer at that same role level.

One of the most senior people at CS Energy was an engineer who was one of the sharpest and most experienced in the business. However, he wasn’t a leader of people. The scope of his role didn’t really increase over the years, and his accountability was limited.

Although he was really good at what he did, he’d been getting paid more and more every year. Eventually, he was one of the highest paid people in the head office, but I could easily list a dozen people who contributed more value than he did.

It wasn’t that he was a bad person; he was just overpaid relative to everyone else.

3. Timing

Like all markets, the labour market has peaks and troughs. Occasionally, there’s a lot of value available, and you can hire a really good person into a senior role without paying through the nose.

At other times, very ordinary candidates attract really big money. This is just a natural part of any market cycle, but the impact it has on pay equality in your team can be substantial.

I once had a situation where an extremely talented finance person was being paid less than $200,000 a year. When she went to market to hire someone for a lower level role (reporting to her), the labour market had moved a lot.

To hire a direct report with this particular specialisation, she had to pay roughly 20% more than she was being paid herself. This scenario can obviously create friction in a team, and you can’t be constantly realigning people’s pay with movements in the labour market. That would just be silly.

4. Scarcity of skills

Sometimes, the sheer unavailability of talent can force you to pay a premium. Think about remote workforces. Because of labour scarcity, people can get paid a lot more than the equivalent job would pay in a more liquid market.

The resources sector is the poster child for this. An electrician who goes to work in a remote mine site can earn two, three, even four times as much as a person with equivalent skills in a major city center.

That’s why fly-in/fly-out (FIFO) workforces became so popular. The company solved its labour shortage problem by flying people in to work in stints of 5 (or 8, or 15) days, paying a premium to workers who did so.

And any individuals who were prepared to work in remote locations could make significantly more money than they could otherwise. They could also have some pretty nice blocks of time off in between their shifts.

But, hey, that’s a tough way to make a living, and those guys earn every cent of it, believe me!

5. Budget pool caps

When a company is budgeting for its annual salary and wages cost, executive management often places a cap on the allowable budget increase. They generally don’t care how the money’s distributed, as long as each manager remains within their cap.

There were many times in my corporate career that I was given a cap of, say, 4.5% to increase my overall salary and wages spend. But 4.5% is a very small amount of money when you’re trying to differentiate between those who are doing an awesome job, and those who are getting a free rider effect.

Even if you give a 1% pay rise to an underperformer and a 6% pay rise to a star, it doesn’t look like a big difference in absolute terms: maybe it’s a couple of thousand dollars, at most?

So, why would they bother?

There are, of course, creative ways to deal with this. On several occasions, I reduced the number of roles in my team, and replaced them with higher-paid people who generated much greater value. This gave a massive uplift in performance, and still protected my overall salary and wages cap.

I knew some other leaders, though, who preferred to play the pea and shell game. They’d get rid of permanent staff and replace them with contractors, which just shuffles the money around. It makes their salary and wages line look really good, but then they’d spend more in general operating expenses.

6. Individual negotiation skill

Clearly, some people are more assertive about negotiating their pay than others. They’re not always the best performers, but they certainly know how to maximise their value in the market.

One very close colleague of mine, in particular, is a dead set genius at negotiating his CEO packages. He’s had roles where he’s negotiated a substantial sign-on bonus as well as a time-based retention bonus. It’s a sleight of hand that very few people can pull off.

As a leader, you’ll always end up paying more for people who are clever negotiators.

7. Uniformity of collective bargaining agreements

I have to say, this one really sticks in my craw. The whole purpose of collective bargaining is to eliminate differentiation between individuals.

Everyone who’s on the agreement gets paid the same regardless of their performance, their contribution, their capability, the value they create… and even their attendance. And progression is often determined by seniority.

I saw people under collective agreements who were just sitting there waiting to retire. They knew they’d get a huge pot of gold at the end of their working lives.

I almost died when one person said to me, “I don’t really want to go up any further in the company. I’m just happy to wait for retirement.” He didn’t seem particularly old to me, so I asked him when he was planning to retire. “Ah, in 11-and-a-half years,” he said.

I spent plenty of time around unionised workforces, but that one really shocked me.

8. Pay conventions in different industries and job families

Some job families in certain industries attract different pay mechanisms, and it’s rare that they’re representative of the actual value delivered.

In the technology sector, for example, salespeople get paid huge commissions. I know more than one centimillionaire who spent their life in computer software or hardware sales… but the people who worked alongside them in, say, pre-sales tech support earned only a tiny fraction of what they did.

And think of all the people behind the scenes in these companies who had to make good on the outlandish promises the salespeople made to earn their commissions.

These eight barriers are virtually unavoidable. And, even when you have total flexibility and decision making control, one or more of them will throw you off-balance. This is why it’s so important that you know precisely why your people are paid what they’re paid, and that you take the time and effort to explain it to them.

FIVE WAYS TO ALIGN PEOPLE’S PAY WITH THEIR VALUE

So, how do you get the pay-for-performance equation right?

Before you do anything, you’ve got to be comfortable that, because pay anomalies are unavoidable, aligning people’s pay with their value will never be totally right. It’s impossible to get complete consistency.

You don’t need to apologise for it, but you do need to make sure you understand it. And you also have to believe deeply in the principle of meritocracy. Simply, those who create the most value should earn the greatest share of the rewards.

There are five things you can do to better rely on your people’s pay with their value.

1. Differentiate to the greatest extent possible

You’ve got to be completely committed to doing everything humanly possible to pay the top contributors as much as you can, within the constraints of your remuneration policies. That means some people are going to get bad news… and you’ve just got to be okay with that.

You can never allow yourself to take the easy way out. Every single pay decision has to reflect the value the individual contributes.

2. Remove the secrecy

A lot of leaders rely on confidentiality and secrecy. That way, they never have to explain to their people why pay differences exist. But it’s not like the good old days… people talk!

You’ve got to start with the assumption that everyone knows what everyone else is being paid. And, although you’d never actually divulge someone’s confidential information, it’ll certainly help you to frame the conversation with each individual.

3. Be prepared to have the money conversation with your people at least once a year

You need to be able to explain to each of your direct reports why their rem is set where it is. This should be a natural part of the annual review cycle (and, of course, you also need to be able to explain clearly why they are or aren’t getting a pay increase, and what the basis for that decision is).

For example, in the case I mentioned earlier about that 35-year employee, I told him that, despite his ongoing value to the business, he was massively overpaid compared to his peers… and he was just going to have to come to terms with the fact that he wouldn’t be getting a pay rise anytime soon.

4. Help every individual to improve their potential reward

If there is anything they can do to improve their performance and increase their likelihood of promotion, they need to learn about it from you.

The one thing that’s consistent from company to company and from industry to industry is that the biggest pay increases come when you get promoted to the next level up.

Promotions generally dwarf other pay increases and they trump almost all pay anomalies. So, the best thing you can do for your people is to show them exactly, specifically what they need to do to get to the next level.

5. Be prepared to take the fight up with your boss

If you have a star performer on your team, you should be prepared to put an exception case to your boss to pay them well over the odds, to better align with their value.

And when I say “a case”, I mean a solid, well-prepared business case. Explain the multiples of value that they deliver compared to your average employee; talk about their current value in the open market; talk about what it would cost to replace them.

And, most importantly, paint the gap between this highly productive employee (who you risk losing) and the less effective, inexperienced person whom you might have to pay even more to attract.

PAY YOUR PEOPLE THE RIGHT WAY

If you do these five things, you won’t necessarily overcome all the pay anomalies you find in your team, but you will definitely improve the overall alignment between people’s pay and the value they deliver.

And just as importantly, you’ll be able to explain confidently and unapologetically what the hell you’re doing. This made a huge difference to me in my executive roles: that confidence in itself is worth a lot.

But the biggest payback is that, once your people see you working hard to pay for performance and to balance the scales of meritocracy, you’ll start to attract and retain the right people, every… single… time!

And that is the thin edge of the wedge in building a performance-driven culture in your team.