Step Plans and Pay for Performance

By Jim Fox and Bruce Lawson, Fox Lawson & Associates, A Division of Gallagher Benefit Services, Inc.

Question: Our board is interested in adopting a pay for performance pay system. However, we have a step plan that has been in place for years and I have heard that we would need to replace our step plan with a pay plan that would work with pay for performance. I am not sure the board understands the issues and the amount of change that we would have to go through so that we can have an effective pay for performance system. Can we adopt pay for performance without changing our step plans?

CompDoctorTM: Really? Of course you can do anything you want, and from our experience, some people have. But to say that they work together effectively and efficiently is another matter. And, we would assume that if you are going to put your name on it, you want it to work as best as possible. Because, after all, “good enough for government work” is really not your style.

So, what do we know about pay for performance systems and the design of a pay plan? Well, quite a bit actually. First, we need to recognize that there are two aspects of pay plans that come into play here. One is the structural design of the plan and the second are the rules and policies that guide how it is administered.

For the most part, the structure of all pay plans looks pretty much the same; there are pay grades and each grade has a range of pay from minimum to maximum. Some have steps between the minimum and maximum and some don’t. Some plans have lots of pay grades and some have few. Some have broader ranges and some have narrower ranges, and some grades are anchored at the midpoint of the market and others are not. But from a distance, one looks a lot like another.

However, the administration of the pay plan is really what makes one plan different from another. Some are managed from the perspective that for every year of experience or service, a pay increase is warranted until you reach the top of the range. Others are administered so that the only increase an employee receives is based on a general cost of living increase (an increase in the pay range), so that after 10 years or so, the employee is still at the same relative place in the range that they were when they were hired. Some plans are managed based on performance, but, how they are managed does not necessarily dictate the design of the pay plan. In fact, you can have a pay for performance system that is managed with a step plan, and you can have a seniority based pay system that is managed within a pay plan that has no steps. We have seen both.

So, perhaps the real issue here is not the design of the pay plan but the cultural issues and the management philosophy behind the reasons for pay for performance. What we are saying is that you can use your step plan with a pay for performance system of administration, but you should make sure that your strategy and cultural values are in line with that philosophy. Otherwise, you will be back here next year telling us that step plans do not work with pay for performance.

But to understand the underlying issues regarding pay for performance, you might want to consider the rest of what we have to say.

What we know today is that based upon the IPMA-HR 2007 Total Compensation Benchmarking Survey, public sector employers are moving toward the use of variable pay programs with pay for performance variations the most popular. In fact, this survey showed that almost 44 percent of the responding organizations already had a pay for performance program in place, and this included state, local and federal organizations. (So much for the cry that, “no one in the government is doing this!”)

Although the public sector has had varying degrees of success in implementing performance management and pay for performance systems, we believe that the economy will accelerate the trend toward variable pay.

The question is, again, do we have pay systems in place that will accommodate pay for performance, or, are there some structural barriers in the design of our plans that make pay for performance more difficult? We believe the answers, in many organizations, are a resounding no and yes.

For the most part, we have pay systems that are designed around the step plan concept and we believe that this can be a serious structural barrier to the adoption of an effective pay for performance system. However, before we suggest that step plans are incompatible with pay for performance, note that we have seen step plans work just fine with pay for performance. What that says is that there may also be a cultural issue that may need to be addressed as well.

The premise of a step plan is that employees deserve a pay increase based on an additional year of performing the same job (usually). Furthermore, this increase should be the same for all employees. The reason for the same increase for all employees is because we cannot or do not have the systems (i.e., management willpower) in place to distinguish different levels of performance. This system in pay is an outgrowth of the civil service system (established in the U. S. in 1872) and promoted with the growth of public sector union agreements. Civil service rules were developed in public organizations to protect employees from the “political” whims of the politicians who came and went from positions of power. After all, the argument went, if a politician was voted out and a new one came in, someone had to keep the operation moving ahead, and if pay and/or employment of the employee was tied to the results of elections, and a subsequent performance evaluation, we may have a new set of employees each time a new person came into office. This was really no way to run a government!

Step plans are more prevalent than any other system of salary structure, so the concept of a regular pay increase for additional experience is well ingrained in our thinking about pay systems—like more than 100 years, or about four or five generations of human resource managers. This means that if we move to a system that is more compatible with pay for performance, there will be considerable momentum to overcome. We have seen step plans that have worked with pay for performance; however, they are not the usual step plans which which most of us are familiar.

Here is the breakdown of step plan prevalence by broad job categories:

If step plans are so prevalent, have been around for more than a hundred years and have worked, why should we move away from step pay programs?

Let us first consider the impact of the environment in which we manage human capital. In an article we wrote for HR News Magazine called What the “New Normal” Will Look Like, we concluded that:

Pay for performance will need to become a reality. We have all heard the cry and the whine: you cannot create a fair pay for performance system in the government; it will all be based on favoritism, etc, etc. But here is the retort that will be coming from the elected officials and the citizens: We can only afford the best employees who are performing at the top levels of effectiveness. We can no longer defend the practice of across the board pay increases because the cost of living has increased. The fact of the matter is that 85 percent of the people employed in the United States (those in the private sector) do not get cost of living increases, step increases or any other regular increase. When private companies increase their salaries by 2.5 percent that means their payroll costs are going up by 2.5 percent. That includes all salary costs: cost of living, and performance. Finally, there is ample evidence that other governments have successfully applied pay for performance systems to their employees.

Next, let us consider the increasing scrutiny of public officials and appointed board members who have public fiduciary responsibilities. With electronic media and 24/7 local and national news outlets, any misstep, perceived or otherwise, in the expenditure

of public funds is exploited usually to the detriment of the individuals serving in those roles and the programs for which they provide oversight. Since in excess of 70 percent of most public agency budgets is devoted to paying staff, public officials are feeling increasing public pressure to demonstrate why increases in employee salaries are justified. Justification tied to merit system history and cost of living is less convincing than that tied directly to performance that mirrors the private sector experience of many public officials.

Let us consider the needs of public sector managers. Public sector managers are tasked today with providing higher levels of public service with less staff than ever before. As a result, recruitment and retention challenges revolve around the ability to increase pay of high performing staff. The day-to-day pressures of efficiently serving the public require less cultural attachment to issues of longevity and more to rewarding those who can not only do the job but also exceed expectations further extending the positive reach of the programs and services delivered to the public. It essentially is getting more bang for the buck when high performing employees are rewarded and lower performing employees are not encourage to stay.

Last, but not least, let us consider the needs of public sector employees. Long-term public sector employees have been accustomed to longevity (i.e., step) pay approach and may not have worked in an environment where pay for performance systems were in use. Some of these employees remain wedded to a step program as it is the only pay process with which they have experience. It is natural to want to continue what they have been used to since each year they are nearly guaranteed an increase in pay to recognize their years of service. However, we are all aware of the upcoming “brain drain” as the baby boomers retire out of government and the up and coming younger employees are looking for interesting work opportunities to optimize their ability to move among projects and employers. They are, as a group, seeking alternative pay approaches, such as performancebased pay, as well as opportunities for contracting and alternative work environments and schedules. In general, most public sector employees will acknowledge that high performing employees should be paid more as long as they see themselves falling into the high-performing group.

Regardless of the (eventual) economic recovery, there are work place efficiencies that are being forced upon us because of the budget reductions that will not go away. The need to produce work in the public sector more and more efficiently seems to be an economic if not political reality. Both the production of that work product in the public sector and the oversight of the work will become increasingly dependent upon performance-based measures incorporated into the pay systems. Although there is greater focus due to the economy’s “new normal” as well as the media scrutiny, the public sector lags behind the private sector in instituting performance management systems and incorporating them into compensation strategies and structures.

The future suggests the need for instituting performance pay components into pay systems for public sector employers currently dependent upon step-based pay programs. For those employers already using pay for performance options, dated programs should be refined based on the emerging new best practices in public sector performance management. Now is the time to take the initiative to involve public officials with fiduciary responsibilities to provide evidence of the need for employee pay increases. More than anything, that means changing the cultural and philosophical norms regarding pay for performance. But it does not necessarily mean that your step plan has to be thrown out to adopt pay for performance. In fact, we leave you with one final table from the survey noted above. This shows that pay for performance plans have been implemented with many different pay plan design structures, including open ranges, step plans and combinations.

So, if you want a pay for performance system, what you need to focus most on, in our opinion, are the cultural issues, not the design of the pay system.