Employee Compensation

1. Employee Compensation

2. Definitions (from Gerhart & Milkovich, 1992) • Compensation includes any direct or indirect payments to employees, such as wages, bonuses, stock, and benefits • Pay level is the average compensation paid by a firm relative to that paid by its competitors • How to operationally define? • Cost to employer? • Value to employees? • Only use direct pay? • Base pay? • Unit labor cost?

3. Main Determinants of Compensation Systems • Legal constraints • External labor and product markets • Industry or area wage surveys • Product market pressures • Internal labor market • Is the system attractive? Equitable? • Relies on job evaluation methods to determine relative worth of jobs to organization • Performance appraisal system

4. Laws that Impact Compensation • EEO laws • Fair Labor Standard Act (FLSA) of 1938 & the Equal Pay Act of 1963 • Provides for minimum wage, overtime, & equal pay • Old Age, Survivors, Disability, & Health Insurance Program (OASDHI) • Provides programs such as social security & unemployment insurance • Employment Retirement Income Security Act (ERISA) of 1974 • Regulates pension programs • Revenue Act of 1978 & Economic Recovery Tax Act (ERTA) of 1981 • Defines the taxable and nontaxable status of benefits

5. 3 Main Functions of Compensation Systems • Attracting employees • Retaining employees • Motivating desired behavior or performance • Typical view: • Relative pay level impacts attraction & retention • Individual differences in pay impacts motivation • Lawler (1981) adds that compensation systems impact organizational culture and structure, and are a significant cost factor

6. Attracting Employees with Compensation • Pay level has been found to increase: • the size of the applicant pool • likelihood of job acceptance • quality of job applicants • quality of employees • Importance of pay to individuals: • Applicants have a “reservation wage” below which they will not accept a job offer, regardless of other factors • The greater the variability in pay, the more important pay level is • When ambiguous, applicants make decisions about other job aspects based on relative pay level

7. External Market Surveys • Often used to determine entry level wages that can attract new employees • Product market competition provides a maximum constraint • In similar industry, have similar other constraints (e.g., cost of raw materials) • Thus, if labor costs exceed those of the competition, you will be at a competitive disadvantage • Labor market pay levels provide a minimum constraint • Competition for best labor across industries • If wages are too low, cannot attract and retain high quality labor • In combination, employers have little discretion to determine pay levels

8. Retaining Employees with Compensation • Job satisfaction is the emotional response to the congruence between what one experiences and what one values/expects/desires/seeks • Compensation is a dimension of job satisfaction • Cognitive Judgment Approach > Thibaut & Kelly (how CLalt affects retention)

9. Cognitive Judgment Approach (Thibaut & Kelley, 1967) • Satisfaction depends on an evaluation of the difference between one’s expectations and what one actually receives • comparisons with past experiences • observations of others in similar roles • Comparison Level (CL) • standard against which satisfaction with current role is evaluated • baseline indicator of what the individual feels that he or she deserves • Roles that exceed the CL will be satisfying, and roles that are judged to be lower than the CL will be dissatisfying • Comparison Level for Alternatives (CLALT) • represents the outcomes that an individual perceives to be associated with the best possible alternative to the current role • CLALT determines how committed one feels in the current role. As outcomes in the current role drop relative to the CLALT , the person will increasingly feel the desire to leave the current role • “Presumably, if similar organizations failed to match the contemporary practices of others in their organization field, then employee expectations would not be met and some dysfunctional outcomes would follow” (Gerhart & Milkovich, 1992)

10. Job Evaluation • Preventing pay dissatisfaction is linked to how pay differentials among jobs is determined • Common steps in job evaluation • Sampling key jobs for the development of the system • Identification of job clusters that are reflective of social comparison norms • Determination of criterion of equitable relationships • Identification of a set of compensable factors that can be accepted as equitable • Development of measurement and rating systems • Is job viewed holistically or as a sum of separate components? • Are jobs compared directly with each other or with a prescribed standard? • Implementation • Generalization to all jobs • Determining pay grades for each job cluster and rate ranges for pay grades

11. Common JE Approaches • Ranking method • Rank key jobs holistically • Once key jobs are ranked, they provide the basis of comparison to rank other jobs • Classification approach • Key jobs are ranked & differentiated into categories judged to be different in worth • Point approach • Specify the factors to be evaluated (e.g., responsibility, working conditions, required education and training) • Design rating scales & weighting for each factor • Apply scales to each job • Sum points across factors for each job • Factor comparison approach • Focuses on job factors one at a time, but involves direct comparison among jobs rather than with a standard set of scales and weights

12. Motivating Employees with Compensation • Equity theory/justice • Expectancy theory • Goal-setting theory/control theory

13. Overview (Review) of Equity Theory • Source of motivation is perception of social inequity (inequity tension) • People form beliefs about what constitutes a fair and equitable return for their contributions • People compare their outcome/input ratio to what they perceive as the outcome/input ratio of others • People tend to place greater emphasis on inputs that they have to offer • The strength of motivation to reduce inequity (drive reduction) varies directly with the perceived magnitude of the imbalance & choice/constraint perceptions

14. Equity Theory (cont.) • Feelings of equity are a matter of “the eye of the beholder” • Who is the referent for comparison? • Better support for underpayment rather than overpayment • Individual differences in equity sensitivity • Helps explain how the “should be” component of pay satisfaction is determined

15. Justice Theory • Distributive justice • Fairness re: the distribution of benefits and sanctions among people • Procedural justice • Fairness re: the policies and procedures by which people interact • Interactional justice • Fairness re: the nature of the interpersonal relationships during the administration of justice

16. Procedural Justice • A decision is fair to the extent that outcomes are seen as balanced and correct • Balance • An act by a manager is balanced if it is equivalent to similar actions in similar situations • Correctness • A quality which makes the decision seem right; regardless of outcome • Procedural justice may help build trust, which can offset the negative impact of distributive decisions • Procedural justice explained variance in pay raise satisfaction beyond that accounted for by the actual pay raise and distributive justice perceptions (Folger & Konovsky, 1989)

17. Interactional Justice • The quality and content of person-to-person interactions as people relate to one another • Associated with perceptions of trust • Causal accounts • Offering an explanation that is viewed as adequate or reasonable can help prevent negative feelings

18. Implications of Equity & Justice Research • Effective implementation (procedural justice) and communication (interactional justice) of a compensation policy is likely to be very important in addition to distributive justice perceptions and actual pay raise • Help individuals and teams make realistic assessments of their own input • Provide outcome information about referent others

19. Review of Expectancy Theory • People’s behavior results from conscious choices among alternatives, and these choices are related to psychological processes, particularly the perception and the formation of beliefs and attitudes • Source of motivation is beliefs that: • Behavior will lead to desired outcomes • Outcomes will be rewarded • The rewards are valued

20. Expectancy (cont.) • Force is the strength of a person’s intention to act in a certain way (Force = expectancy * (sum of valence*instrumentality)) • Expectancy • The strength of a person’s belief about the degree to which effort will lead to desired performance • Instrumentality • The subjective probability that behavior will lead to a reward • Will desired behavior lead to a reward? • Valence • Preferences among various rewards/outcome • Implications are that organizations can increase performance by closely linking promotions to performance and by making sure that the associated pay increases are sufficiently large • Skill-based pay addresses the expectancy component of the model, but what happens over time after skills are learned? • Gainsharing & profit sharing follows expectancy theory to some extent, but clear linkages between behavior and rewards is often missing

21. Goal-Setting Theory • People engage in behavior that is consistent with their intentions & goals; in other words, goals and intentions direct behavior • Intention • A person’s representation of a planned action • Goal • The object or aim of such an act • Goals affect behavior by: • Directing attention and action • Mobilizing on-task effort • Encouraging task persistence • Facilitating the development of task-related strategy

22. Goal-setting (cont.) • If goals determine human effort, higher or more difficult goals result in higher levels of performance • Specific goals result in higher levels of effort than vague goals • Specificity: • Nature of the act • Target of the act • Time in which the intended act might occur • Circumstances in which the intended act might occur • Difficult and specific goals are effective when people are committed to them • Incentives will have no effect unless they lead to the setting and/or acceptance of specific, difficult goals

23. Control Theory • Intentional behavior reflects a process of feedback control • Negative (discrepancy reducing) feedback loop: • People note the qualities they are expressing in their behavior (input) • They compare these perceptions with salient reference values • If comparisons indicate discrepancies between intended and actual quantities of behavior, people adjust (output) to more closely approximate the reference value • Discrepancies between goals & current performance results in: • Maintaining the goal & giving greater task effort • Lowering the goal & continuing current levels of effort • Withdrawing from the task • Views discrepancy as a cause of goal-directed behavior

24. Implications of Goal-Setting Theory(Bartol & Locke, 2000) • Use all-or-nothing bonuses with difficult assigned goals • Dangerous if goal is perceived as too difficult • Assign a difficult goal but reward for degrees of success in relation to the goal rather than an all-or-nothing bonus • Let employees set their own goals and let management determine rewards based on the value added that employees have created for the company

25. Organizational Theories related to Compensation • Agency theory • Prospect theory • Institutional theory

26. Agency Theory • Suggests that it is advantageous to separate ownership and control • Allows principles (e.g., owners) to freely transfer ownership without disrupting the operations of the firm because their agents (e.g., managers) have the control function • Concerned with how to establish the most efficient contract between principles and agents • The agency problem • When the principle and agent have conflicting goals & principles cannot monitor the behavior of the agent • The problem of risk sharing • When the principle and agent have different risk preferences • Agents are more at risk because they can’t diversify their investments, so they tend to be more risk averse

27. Agency Theory • Behavior-based contracts • The principle will monitor the agent’s behavior to be sure that the agent acts in the principle’s best interest • The principle will incur the cost of the monitoring systems • Outcome-oriented contracts • Seek to align the two parties’ interests and goals by basing the agent’s pay on performance outcomes • Both parties are dependent on appropriate actions of the agent • Means greater risk for agents, and thus, greater pay demands, as outcomes are not solely dependent on agent’s behavior

28. Implications of Agency Theory • Use behavior-based systems when: • Information systems are in place • Outcome uncertainty is high • The agent is highly risk averse • The principle is not risk averse • Goal conflict between agent & principle is low • Task is programmable • Outcomes are difficult to measure or require a long time to measure • Principle and agent have been in relationship for a long time • Recommends outcome-based systems for executives

29. Prospect Theory (Kahneman & Tversky, 1984) • People do not evaluate prospects by the expectation of their outcomes, but rather by the expectation of the subjective value of these outcomes • Subjective value is a concave function of money • E.g., The difference between the utilities of $200 and $100 is greater than the utility difference between $1200 and $1100

30. Prospect Theory (cont.) • The effective carriers of subjective value are changes of wealth rather than ultimate states of wealth • Risk averse • Preference for a sure outcome over a gamble that has equal or higher expectation • Risk seeking • Rejection of a sure outcome in favor of a gamble of equal or lower expectation • We are risk seeking when it comes to possible losses & risk averse when it comes to possible gains (except for unlikely gains/losses) • Loss aversion • function is steeper for losses; a loss of $X is more averse than a gain of $X is attractive

31. Classic Example • Imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows: • If program A is adopted, 200 people will be saved. • If program B is adopted, there is a 1/3 probability that 600 people will be saved & a 2/3 probability that no people will be saved. • OR • If program C is adopted, 400 people will die. • If program D is adopted, there is a 1/3 probability that nobody will die & a 2/3 probability that 600 people will die.

32. Prospect Theory (cont.) • Framing of outcomes • Violates the invariance rule • The preference order between prospects should not depend on the manner in which they are described • Thaler’s Endowment Effect • The reluctance of people to part from assets that belong to their endowment • Loss aversion favors stability over change • Losses are more aversive than costs • E.g., an uncompensated loss v. “the cost of protection”

33. Implications of Prospect Theory • Addresses how employees are likely to evaluate at-risk pay plans • Suggests that replacing a no-at-pay-risk system with an at-risk pay system will fail • Pay-at-risk systems are best in start-ups where no reference points have yet been established • People view pay system changes as “How much more or less will I make than I do now?” rather than “What will my financial condition be under this new system?” • Because “losing hurts more than a possible gain pleases,” people value what they currently have more than an equally attractive alternative

34. Institutional Theory • Organizational design is not a rational process, but one by which organizations in a field respond to external and internal pressures in such a way that organizations tend to resemble each other over time • Reasons: • Environmental forces define practices • Sameness develops due to mimicking each other • Managers receive similar professional training • Habit/tradition • Theory suggests that organizations should avoid designing compensation systems based on non-rational reasons • E.g., using merit pay because it is accepted practice rather than an effective motivator

35. Challenges in Designing Effective Reward Systems (Podsakoff et al., 1984) • 3 main difficulties: • Measuring performance • Identifying valued rewards • Linking rewards to performance

36. Difficulties in Measuring Performance • Changing nature of work • Increases in interdependencies and complexities of work • Multidimensionality of jobs • Use of single item measures of job performance • Technology • Results in new and untested methods of work • Can sometimes result in little variability in job performance • Manager’s personal value system • May not understand the value of differential rewarding • lack of ability to differentiate among employees • Lack of supervisory training • Biases • Lack of training

37. Problems in Identifying Valued Rewards • Different types of rewards • Choosing rewards that people do not value • Reward magnitude • Lack of resources • Company policy • Timing • Bureaucracy • Formalization of feedback processes

38. Problems in Linking Rewards to Performance • Failure to create contingencies • Lack of knowledge, skill, experience • Belief system • Creating inappropriate contingencies • Rewarding behavior A but hoping for behavior B • Rewarding behavior that does not increase performance • Nullifying intended contingencies • Problems with performance appraisal system • Employee opposition • Mistrust, lack of fairness, inequity • Restrictions due to fear of loss of work • unions