Strategic Reward Systems I

1
Strategic Reward Systems I

• HR Management
• MBAO 6030

2
Strategic Reward Systems I Pay for Performance
Reward Systems consist of the following elements
Reward Systems consist of the following elements

• Financial Rewards Compensation
• 1. Base Salary
• 2. Pay Incentives
• 3. Employee Benefits

Non-financial Rewards 1. Intrinsic Rewards
centers on the work itself 2. Praise,
recognition, time off and other rewards given to
the employee by peers or superiors.
3
Strategic Reward Systems I Pay for Performance

• Reward Systems in most cases should be consistent
  with other HR systems.
• The Reward System is a key driver of
• HR Strategy
• Business Strategy
• Organization Culture

4
Strategic Reward Systems I Need for Consistency
with Other HR Systems
5
Strategic Reward Systems I

• Critical Thinking Question
• 1. Should pay policies lead or lag the
  development of other HR systems?

6
Theoretical Models of Pay and Performance Equity
theory (Adams, 1963)

• Assumptions
• People develop beliefs about what is a fair
  reward for ones job contribution - an exchange
• People compare their exchanges with their
  employer to exchanges with others-insiders and
  outsiders called referents
• If an employee believes his treatment is
  inequitable, compared to others, he or she will
  be motivated to do something about it -- that is,
  seek justice.

7
Theoretical Models of Pay and Performance Equity
theory (Adams, 1963)

• Is/Os versus Ir/Or
• O Outcomes the type and amount of rewards
  received
• I Inputs employees contribution to employer
• R Referent comparison person
• S Subject the employee who is judging the
  fairness of the exchange

8
Equity Theory Exchange Scenarios

• Case 1 Equity -- pay allocation is perceived to
  be to be fair - motivation is sustained
• Case 2 Inequity (Underpayment) -- Employee is
  motivated to seek justice. Work motivation is
  disrupted.
• Case 3 Inequity (Overpayment) -- Could be
  problem. Inefficient. In other cultures
  employees lose face.

9
Consequences of Inequity

• The employee is motivated to have an equitable
  exchange with the employer.
• To reduce inequity, employee may
• Reduce inputs (reduce effort)
• Try to influence manager to increase outcomes
  (complain, file grievance, etc.)
• Try to influence co-workers inputs (criticize
  others outcomes or inputs)
• Withdraw emotionally - or physically (engage in
  absenteeism, tardiness, or quit)

10
Equity Theory Implications

• There is tension between internal and external
  pay equity Decide where to place the emphasis.
  Example In and out versus lifelong
  employment system
• Let employees know who their pay referents are in
  the pay system identify pay competitors and
  internal pay comparators.
• Strive for consistent pay allocations
• Monitor internal pay structure and position in
  the labor market for consistency.

11
Agency Theory

• Agency theory is a theory of governance in the
  workplace.
• It tries to solve the problem of separation of
  ownership (atomistic shareholders) and control
  (professional executives and non-owners)
• It also tries to solve conflicts of interest
  between managers and employees with delegated
  responsibilities.

12
Agency Theory

• 1. Principals owners or managers who delegate
  responsibilities
• 2. Agents managers or employees who manage firm
  assets for owners or other principals.
• 3. Information asymmetry managers or other
  agents have greater access to strategic
  information than principals, who are not willing
  to bear the cost of directly monitoring the
  agents due to steep agency costs.

13
Agency Theory

• 4. Risk Preferences principals are risk neutral
  and willing to bear greater risks than agents
  because their asset wealth is more likely to be
  diversified between corporate assets and other
  equities/investments. Agents are more risk
  averse than principals, because most of their
  wealth is concentrated in the firm and received
  in the form of pay and opportunities for
  promotion.

14
Agency Theory

• 5. Moral Hazard agent is tempted (and some
  cases succeeds) in taking advantage of
  information asymmetry with principal and act
  opportunistically (defined as making decisions
  not aligned with principals interests) and use
  the firm resources to maximize wealth of the
  agent (often at the expense of the principal).

15
Agency Theory

• 6. Agency Contract provides solution to moral
  hazard/agency problem, by establishing rules of
  the game to control agent opportunism agents
  performance will be judged by outcomes (often
  financial benchmarks) not behaviors (which
  require direct supervision of agents actions).
  These outcomes will reflect principals goals and
  risk preferences.

16
Agency Theory

• 7. Incentive alignment the agency contract will
  specify a compensation plan that aligns the
  interests of the principal and agent. This
  agency contract will be a type of pay for
  performance plan. Meeting or exceeding
  pre-agreed upon financial or non-financial
  outcomes triggers various forms of compensation
  (individual or group-based) for the agent. Some
  agency costs are borne by the principal in the
  form of financial incentives for the agent.

17
Tournament Theory

• 1. Tournaments are competitions between peers to
  achieve a promotion to a higher rank along with
  the pay and perks that go with it.
• 2. Tournaments are likely to result in a winner
  take all outcome.
• 3. Managers who enter the tournament must forego
  other alternatives (such as jobs with other
  firms, start own business, receive more pay with
  an alternative opportunity) to compete in the
  tournament.

18
Tournament Theory

• 4. A high pay differential (such as the CEO
  receiving much greater pay than any subordinates)
  attracts more players to the tournament.
• 5. Players must invest (work long hours,
  accept less pay, show loyalty to their boss) to
  enter the tournament firm captures value from
  these players, more than what it gives up to the
  winner for the prize.

19
Controversies that Surround Pay for Performance
Plans

• 1. Single Mindedness you get what you pay for
  no more, no less. The activities that are
  rewarded get done, to the exclusion of other
  activities that are not rewarded. Example The
  dysfunctional behaviors that are observed when a
  sales representative is put on straight
  commission.

20
Controversies that Surround Pay for Performance
Plans

• 2. Control externalities can control the
  outcomes, positive or negative. There can be
  windfall affects (the bull market improving the
  stock value of all stock options) or negative
  externalities (a bear market or recession that
  lowers the value of all stocks). Employee
  performance results may be magnified or diluted
  by these effects.

21
Controversies that Surround Pay for Performance
Plans

• 3. Measurement error some measures can be
  gamed or manipulated and may not reflect true
  performance. Sales reps can withhold sales and
  report it in a different period so they are not
  penalized by a cap on sales commissions.
  Managers can use creative accounting measures
  to report greater profits than were actually
  experienced by the firm.

22
Controversies that Surround Pay for Performance
Plans

• 4. Inflexibility managers or employees may
  resist change of the basis of compensation
  because they are comfortable with current basis
  for pay and want to avoid risk of taking
  reduction in earnings in new system.

23
Controversies that Surround Pay for Performance
Plans

• 5. Misalignment of incentives if pay emphasis
  is on a goal that is no longer relevant, that
  goal will continue to be emphasized until the pay
  system places emphasis on a different objective.
• For example, managers may emphasize short-term
  goals, even if long-term goals are more relevant,
  until the pay system recognizes long-term goals
  to a greater extent than short-term goals. The
  reward mix for complex jobs with several goals
  must reflect the relative value of attaining the
  mix of goals.

24
Controversies that Surround Pay for Performance
Plans

• 6. Line of Sight problem - division performance
  and corporate performance should be reflected in
  the pay system. If division performance and
  corporate performance are closely linked than
  both division and corporate performance should
  contribute incentives to the managers pay for
  performance plan. If division performance is
  independent of corporate performance, then the
  emphasis should be on rewards for meeting
  division goals.

25
Some Suggestions for More Effective Pay For
Performance Plans

• Pay and Performance should be Loosely Coupled
  this gives managers more flexibility to make
  changes when new situations arise. Example a
  formula with a bonus based on a moving average of
  a 3-year historical performance period. A 3-year
  period smoothes out performance over a longer
  cycle.

26
Some Suggestions for More Effective Pay For
Performance Plans

• It is Necessary to Nurture the Belief that
  Performance Makes a Difference there are
  important cultural values that are supported with
  pay for performance even if the accuracy of the
  performance metrics and the fairness of the pay
  allocations fall short of an ideal situation.
  Abandoning pay for performance may be more
  problematic than having an imperfect pay system.

27
Some Suggestions for More Effective Pay For
Performance Plans

• Pay for Performance systems should be designed to
  fit each firms unique situation imitation of
  other firms plans should be avoided

28
Six Myths about Pay (Pfeffer, 1998)

• 1. Labor rates and labor costs are the same
  thing.
• 2. Labor costs can be reduced by lowering labor
  rates.
• 3. Labor costs are a significant portion of total
  costs.
• 4. Low labor costs are a potent source of
  competitive advantage.
• 5. The most effective way to work productively is
  through individual incentive compensation.
• 6. People work primarily for money.

29
Critical Thinking Questions

• 1. Sears Roebuck Auto Center paid its auto
  mechanics a commission based on the volume of
  services sold to each customer. This basis of
  pay resulted in law suits filed against Sears by
  angry customers who claimed they were
  over-charged for services they did not need.
  Sears was forced to pay millions of dollars of
  penalties to these customers which hurt its
  reputation. Pfeffer believes that Sears mistake
  was that it should have realized that individual
  pay incentives are dysfunctional. Do you agree
  with this conclusion?

30
Critical Thinking Questions

• 2. Charles Schwab, the discount broker, does not
  use commissions as pay incentives for its
  brokers, bucking financial services industry pay
  practices. Why do you think Schwab did this?
• 3. Do you think that the point of view of the
  author (of the 6 Myths of Pay) would work at a
  Wall Street investment bank such as Morgan
  Stanley?
• 4. The author of the 6 Myths of Pay article
  prefers group-based pay for performance rather
  than individual pay for performance plans. What
  is the reason behind this? Do you agree?