Successful Elements of Pay Differentiation

1. Successful Elements of Pay Differentiation Dr. Bashker “Bob” Biswas Associate Professor Keller School of Management DeVry University Total Rewards Conference NCHRA June 12, 2014

2. The thesis for this presentation as provided by NCHRA • Nearly every company ascribes to the belief of paying for performance. • In practice, nearly two-thirds are falling short in providing differentiated rewards. • The pressures of attracting and retaining high-performing talent in a global marketplace that is experiencing extreme sensitivity to costs, shrinking margins and an intensified need for productivity, make it more critical than ever to focus our limited compensation resources on the strongest contributors. • Experience says we should change our ways, and academic evidence will build the case of economic benefits coming from a differentiated approach to pay for performance.

3. Our goal in this presentation Take an in-depth look at the difference between compensation management and performance management Our hope is to provide information to you so that you can think about integrating the results of your performance management system into your compensation system We also hope to providesome new thinking on financial value enhancement as a key performance measure for differentiated compensation decision making Ultimately our goal is to provoke rationale thinking on how to develop pay-for-performance systems that add organizational value

4. Some words about contextual poverty The circumstances that form the setting for an event, statement, or idea, and in terms of which it can be fully understood So one is out of context, if one tries to understand or explain any phenomena without the surrounding words or circumstances that have not been fully understood Being in this state of an absence of context is being in a state of contextual poverty It is my contention that in “Human Resources” we quite often live in a state of contextual poverty. This is most evident in the area of performance management Getting out of this poverty state requires study, analysis and an understanding of all the dimensions of the context And therefore, this requires thinking, contemplation and study

5. Context • All the work that we do in HR should be based on solid theory and principles - This way we have a clear foundation for all the work we do • A common foundation on which all dialogues can be based, irrespective of our backgrounds, our experiences, our knowledge base, our individual orientations • Without this foundation, it will be difficult to build a real working system • So in the next few slides I introduce some context and some new thinking on the performance management and compensation management discussion • So, forgive me if this presentation focuses on the big picture and not the mechanics

6. \roles of IPM • Organizations develop performance management systems for a number of reasons, but primarily for: • Evaluation– the evaluation goals of performance appraisals in the work environment include: • To provide feedback to employees so they will know where they stand • To develop valid data for pay, promotion, and job assignment decisions, and to provide a means of communicating these decisions • To help management in making discharge and retention decisions, and to provide a means of warning employees about unsatisfactory performance • Development- the development goals of performance appraisals in the work environment include: • To help managers improve their performance and develop future potential • To develop commitment to the company through a discussion of career opportunities and career planning with the manager • To motivate employees via recognition of their efforts • To diagnose individual and organizational problems • To identify individual training and development needs

7. In this presentation we focus on Performance Management within the context of Rewards Management only

8. WE INTRODUCE SOME NEW THINKING IN PERFORMANCE AND REWARDS MANAGEMENT So this presentation is a mixed bag of academic thinking and it’s practical application Here we go…………..

9. The Relevance of workforce demand * 36¢ $1 “Efficiency” assesses the total amount of workforce cost “Effectiveness” assesses the linkage between cost and impact – the VALUE Companies that optimize compensation look to drive the 36¢ down and/or drive the $1 up * Based on Saratoga’s Workforce Diagnostic Data for all Companies Metric: Labor Cost Expense Percent, The % of operating expenses dedicated to Comp/Ben costs for regular employees

10. Optimizing Markets • There is a belief that the internal market for compensation is optimized • Employees Demand Compensation • Companies Supply Compensation • Most companies only look at the supply curve $ S D Quantity

11. Road to Optimizing Compensation Compensation departments need to develop tools and methodologies that assess an individual’s compensation based on both supply and demand research Phase 1 Phase 2 Phase 3 Phase 4 Compensation Supply Workforce Demand Rewards Scenario Development Apply Model to Individuals • Grade • Age • Tenure • Business Unit • Preferences • Fairness • Appropriateness • Market • Competitiveness • Internal Equity • Individual • Contribution • Ability to Pay • Program Cost Data • Turnover Metrics • Productivity • Measures

12. Let us now consider the specific Motivational Theories that form the foundation for Performance Management and Rewards Management

13. But, What is Motivation? Motivation The processes that account for an individual’s intensity, direction, and persistence of effort toward attaining a goal. • Key Elements • Intensity: how hard a person tries • Direction: toward a beneficial goal • Persistence: how long a person tries

14. The Motivation Equation

15. Skinner’s Theory “All we need to know in order to describe and explain behavior is this: actions followed by good outcomes are likely to recur, and actions followed by bad outcomes are less likely to recur.” (Skinner, 1953)

16. Central Human Motive in Skinner’s Theory Environmental consequences shape behavior

17. Hertzberg’s Two Factor Theory Bottom Line: Satisfaction and Dissatisfaction are not Opposite Ends of the Same Thing! • Hygiene Factors: • Salary • Work Conditions • Company Policies • Motivators: • Achievement • Responsibility • Growth Separate constructs • Hygiene Factors---Extrinsic & Related to Dissatisfaction • Motivation Factors---Intrinsic and Related to Satisfaction

18. Contrasting Views of Satisfaction and Dissatisfaction

19. Cognitive Evaluation Theory Cognitive Evaluation Theory Providing an extrinsic reward for behavior that had been previously only intrinsically rewarding tends to decrease the overall level of motivation. The theory may only be relevant to jobs that are neither extremely dull nor extremely interesting. Hint: For this theory, think about how fun it is to read in the summer, but once reading is assigned to you for a grade, you don’t want to do it!

21. Goal-Setting Theory (Edwin Locke) Basic Premise: That specific and difficult goals, with self-generated feedback, lead to higher performance. • But, the relationship between goals and performance will depend on • goal commitment • “I want to do it & I can do it” • task characteristics (simple, well-learned)

22. Goal Setting in Action: MBO Programs • Management By Objectives Programs • Company wide goals & objectives • Goals aligned at all levels • Based on Goal Setting Theory

23. What is MBO? Management by Objectives (MBO) A program that encompasses specific goals, participativelyset, for an explicit time period, with feedback on goal progress. • Key Elements • Goal specificity • Participative decision making • An explicit time period • Performance feedback

24. Why MBOs Fail Unrealistic expectations about MBO results Lack of commitment by top management Failure to allocate reward properly Cultural incompatibilities

25. Equity Theory Equity Theory Individuals compare their job inputs and outcomes with those of others and then respond to eliminate any inequities. Referent Comparisons: Self-inside Self-outside Other-inside Other-outside

26. Equity Theory (cont’d) • Choices for dealing with inequity: • Change inputs (slack off) • Change outcomes (increase output) • Distort/change perceptions of self • Distort/change perceptions of others • Choose a different referent person • Leave the field (quit the job)

27. Three types of Justice – Very Important for Rewards Management Distributive Justice Perceived fairness of the outcome (the final distribution). “Who got what?” Procedural Justice The perceived fairness of the process used to determine the outcome (the final distribution). “How was who gets what decided?” Interactional Justice The degree to which one is treated with dignity and respect. “Was I treated well?”

28. Expectancy Theory • Bottom line • All three links between the boxes must be intact or motivation will not occur. Thus, • Individuals must feel that if they try, they can perform • And • If they perform, they will be rewarded • And • When they are rewarded, the reward is something they care about

29. Does compensation motivate behavior? General – Research-based conclusions • A well-designed plan linking pay to employee behaviors generally results in better individual and organizational performance (All) • Companies with formal appraisal process linked to pay increases & promotions have higher productivity per employee (Heneman) • Gain-sharing & profit-sharing plans boost individual & team performance by 18-20% (Cooke) • Companies with profit-sharing-plans have 3.5-5% higher annual performance (Kruse) • Every 10% increase in the size of a bonus leads to a 1.5% increase in return on assets (Gerhart & Milkovich) • The variable portion of pay has a stronger impact on individual performance than base pay does (Gerhart & Milkovich)

30. Does compensation motivate behavior? Do people join because of pay? Reward System Personality Job seekers look for the right ‘fit’: • Person Traits Preferred Reward Characteristics • Materialistic More concerned about pay level • Low self-esteem Want large decentralized organization with little pay for performance • Risk takers Want more pay based on performance • Risk averse Want less performance-based pay • Individualists Want pay plans based on individual, not • group performance

31. Does compensation motivate behavior? Specific Do people stay because of pay? • Dissatisfaction with pay can be a key factor in staff turnover • Changes to the way we pay can create turbulence • Don’t let the design of new reward systems rupture relationships with existing employees! • Type of reward % who think it • influences retention • Work variety & challenge 50% • Development opportunity38% • Social40% • Status recognition23% • Work importance20% • Benefits 22%

32. Does compensation motivate behavior? • Management and workers believe pay should be tied to performance • Most important factor in pay increase should be performance • Higher impact of pay for group performance on corporate performance Do people perform better because of pay? • Type of plan % companies report • effectiveness • Long-term executive incentives 82% • Annual bonus79% • Individual incentives79% • Employee stock ownership79% • Spot awards 74% • Gain sharing 73% • Lump-sum merit pay 67% • Profit sharing 64% • Suggestion box 43%

33. The case for pay-for-performance Performance Entitlement Pay given if you went to work and did well enough to avoid being fired Pay that varies with some measure of individual or organizational performance • Greater interest in variable pay today can be traced to two trends: • Increasing competition from low-cost foreign producers forces US companies to cut costs and/or increase productivity • Workers must adjust to new technologies, work processes, work relationships. Failure to adapt = loss of market share.

34. Now some insights into Rewards Strategy development with Performance Management in Mind

35. Designing a pay-for-performance plan Efficiency Strategy – Does the plan support core objectives? Structure – Is there scope to create variations of the plan? Standards – Clarity on objectives, measures, eligibility, funding Fairness Amount – Is there distributive justice? Process – Is there procedural justice? Communications – Are you managing expectations? Compliance Legal – Does the plan comply with compensation laws? Reputational – Does the plan maintain and enhance the reputation of the firm?

36. Some Practices That Do Not Work “Suit-off-the-rack” Pay Secrecy Performance Appraisals Compensation Review and Salary Review tied in together There is a difference between “come to work pay” and “performance pay” - only good and excellent performers should get “performance pay”

37. Performance managementIn relation to compensation strategy Variability in organizational performance Variability / Ease of measurement in individual performance

38. Concepts to Consider to improve the connection of Pay Systems and Organizational Success Measures

39. Basis for setting goals for MBO Plans Historical performance Current business plan Peer company comparison Fixed formula Financial Non-financial

40. Categories of performance measures Financial • Characteristics • Types • Traditional • Value-based – our research focus Non-Financial • Qualitative or quantitative

41. Normally Used Performance measuresFinancial/quantitative Type of Measure Corporate Division Earnings Earnings per Share (EPS), Net Income Operating Profit Return on Total Capital (ROTC) Return on Equity (ROE)Return on Assets (ROA) Return on Net Assets (RONA) Return on Assets (ROA) Return on Investment Economic Cash Flow Return on Investment (CFROI) Total Shareholder Return (TSR) Economic Value Added (EVA) Revenue, Growth, Cashflow, Market Share, Total Shareholder Return Other Unit Sales, Expense Budget

42. Traditional financial performance measures • Return-based measures • Return on equity (ROE) • Return on assets (ROA) • Return on capital (ROC) • Income-statement based measures • Net income • Operating income • Earnings per share (EPS) • Revenue

43. The Big Question • How does HR programs and activities enhance sustainable financial value? • From the point of view of the shareholder the ultimate value indicator is intrinsic value – discounted FCF at the firm’s WACC.

44. Free Cash Flow • Free Cash Flow is an integral part of the value measurement for a firm. • Normally defined as after-tax operating profit minus the amount of new working capital and fixed assets, necessary for sustaining and maintaining the growth of the business.

45. Intrinsic Value • To state the FCF measure in value-creation terms one needs to calculate the present value of the FCF over a fixed time period by applying a discounting factor using the firm’s WACC. • Intrinsic value is a key factor in value investing.

46. Continued…. • Thus, it can be concluded that an appropriate measure of managerial and employee performance is the contributions they make directly or indirectly to increasing FCF and intrinsic value. • Managers make the business sustainable by increasing free cash flow. • The year to year change to this measure can be a key incentive compensation metric. • C&B personnel should understand the intrinsic value calculations so effective incentive programs can be developed.

47. EVA • Another key value measure that can be used to link incentive compensation programs is economic value add – EVA. • Much has already been written and discussed about this link.

48. Furthermore… • Managers are the agents of the owners – the agency model. • The challenge for the board of directors is to align the managers’ interests with those of the shareholders. • It helps both parties to align their interests. • This can be achieved by tying management compensation directly to a EVA measure because EVA directly measures the value creation by a company.

49. More On EVA • Basic Equation: EVA = Net Income + Interest charges – Capital Charge* Where, Capital Charge = (Notes Payable + Current Maturities of Long-term Debt + Stockholders’ Equity) XCost of Capital (The weighted average return sought by stock investors and lenders). • Another common method: • Net Sales – Operating Expenses = Operating Profit (or EBIT); • EBIT – Taxes = Net Operating Profit after Tax (NOPAT); • NOPAT – Capital Charge (Invested Capital X WACC) = EVA * Other EVA calculation methods are also available.

50. EVA And Incentive Compensation • After calculating the EVA for incentive compensation purposes, a formula can be set up to capture the inter-period change in the EVA measure. • An incentive compensation formula can then be set up: * Current year incentive = Target bonus + y% (change in EVA less expected EVA improvement)