Variable Pay: A Viable Alternative Pay Strategy?

By: Lindsay Coobs

Merit increases have been the go-to method for pay-for-performance for the past several decades. However, 80% of employers say merit pay is ineffective at driving higher levels of performance and 26% of employers admit to paying bonuses to employees who fail to meet expectations, according to WillisTowersWatson. That being said, many employees are seeking variable pay options to encourage more engagement and to drive higher business results.


Merit Increases

The intent of merit increase programs is to differentiate performance among employees and reward top performers. This seems like a great pay-for-performance strategy; however, many companies now are moving away from merit programs. They have found that merit increases have become more expected and fail to motivate and retain their employees. Dow Scott, Ph.D.’s article “Blending General Increases With a Pay-for-Performance Policy”, says that merit increases “have marginal motivational value” and contribute “little to the retention of talented employees.”


Stephen Miller explains in his article, Make Way for Variable Pay, “(merit) increases, once given, never go away—they compound exponentially, rewarding employees for past contributions for as long as they remain at the company. This is why your mediocre employees—those who are comfortable with a small but guaranteed salary increase every year—love merit-based pay.”


Think about it this way: an average worker earning $50,000 per year who receives a 3% merit increase, will see his/her salary rise by $1,500, which amounts to $28.85 per week. Initially, the employee will feel happy about their pay increase, but the happiness will likely fade or be forgotten about over the next year. The extra $28.85 per week will likely not be a driver for sustained engagement and performance.  


Lump Sum Bonuses

Employers are replacing their merit programs with lump sum payments in order to better motivate, engage and retain employees. A lump sum payment is a single payment made to employees based on individual, team and organizational goal achievement. Employers may choose to give monthly, quarterly or annual lump sum payments. The percentage of organizations using variable pay vehicles, such as lump sum payments, rose to 84 percent in 2016, reports WorldatWork, in its 2016-2017 Salary Budget Survey.


John A. Rubino, president of Rubino Consulting Services, during his presentation at the 2012 SHRM Conference in Atlanta, stated, “Globally, companies are moving in this direction, and if your company isn’t, eventually it will be,” Rubino predicted. He also recommended quarterly payouts that are close in time to the behavior that’s being rewarded rather than year-end bonuses. While this ideal may not work for all organizations, Rubino said, he believes the optimal way to structure compensation is to have base pay reflect each position’s market value (determined by competitive position analyses) and the organization’s pay philosophy, such as whether salaries are set at the market average or a higher or lower percentile. Base pay would only adjust to changes in a position’s market value. This avoids the exponential curve of base pay compounding every year.


Consider Taxes

Lump sum payments are considered supplemental income with the IRS and may result in a higher withholding rate, often amounting to nearly 25-40% depending on the payment. That might come as an unpleasant surprise to many employees, even though much of the withholding may be refunded. It is important to note the differences in taxation with merit increases vs. lump sum payments and to communicate this to employees.


In Summary

It goes without saying that companies should select a pay-for-performance plan that fits the culture and goals of the company. However, companies are now realizing that merit increases are more closely tied to employee entitlement and guarantees than they are to individual goal achievement and company success. Lump sum payments service to excite and motivate the employees and reward the highest achievers. This is turn reaps exponential benefits for the success of the business. It is never too late to reconstruct an annual merit increase program to an annual (or more frequent) lump sum payment program to retain and reward employees and achieve higher ROI for the business.