3 Rules for Linking Pay and Performance Management

Businesses in virtually all industries have initiated significant renovations of their performance management systems in recent years. Gone are the rigid employee appraisals at year end. In their place are flexible, future-facing tutoring and coaching methodologies. The focus now is on helping employees develop and succeed in the hyper-change environment all companies are experiencing.

These changes have not come without growing pains, however. And one of the biggest sources of pain is compensation. Companies are trying to figure out how to align their pay strategies with the highly-fluid employee assessment and development processes they are now using.

Part of the problem is that this is a nuanced issue. Every organization is unique and there is not a “one size fits” all approach to developing rewards programs that are compatible with how employee are being managed. There are , however, principles that all companies must respect if they want to build compensation plans that synchronize effectively with their performance management approach.

The 3 Rules

Here, I’ve organized those principles into three “rules.” These are standards I observe being followed by organizations that are having success aligning rewards with performance management. By giving them a “rules” label, I’m suggesting that each really must be followed. In other words, you can’t just pick one or two; at least not if you expect to effectively link pay to your system for managing employee performance.

1. Establish and Communicate a Clear Value-Sharing Philosophy

Although your company may be dealing with a fluid priority environment, your people still need a clear understanding of the outcomes for which they are responsible. You must be able to tell them how success will be defined for their roles and the performance standards they will be expected to meet. And the results expectations you communicate to employees must comport with the results that are most important to shareholders.

Owners are focused on profit, because it is the growth engine of the business. Consequently, business leaders need to identify the profit threshold that must be achieved before value creation will be deemed attributable to employee performance. We call that threshold productivity profit. Until that target is hit, no value should be attributed to the efforts and contributions of employees; therefore, no value should be shared.

However, once the productivity profit standard has been met, you must determine how that added value will be shared with those who created it. That’s what is meant by having a clear value-sharing philosophy. This will require you to determine such things as:

How you will balance salaries and value-sharing.
How you will balance rewards for short versus long-term performance.
How you will balance rewards for company versus team versus individual performance.
What form the value-sharing will take (stock, profit pool, phantom equity, performance units, etc.).
Who will participate in each type of value-sharing.
This rule is too often ignored by organizations, regardless of the performance management process they follow. The lack of a value-sharing philosophy is what creates discord in discussions between owners and employees on compensation issues. If you want your people to perform to a certain standard, make sure both you and they have a clear understanding of how they will be rewarded if they succeed.

2. Focus on Line of Sight

Performance management is not an end unto itself. It is simply a mechanism for ensuring that strategic priorities are being met, that the roles associated with the business plan are being properly executed and that budgeted revenue and profit targets are being consistently achieved. But for any of that to happen, there must be widespread clarity about, and a unified understanding of, the relationship between the following elements of the business:

The Company’s Mission and Vision—why the business exists and what it intends to become in the future.
The Company’s Business Model and Strategy—how the company drives revenue and profit and how it competes (and wins) in the marketplace with that model.
Roles and Expectations—the strategic purpose each employee is there to fulfill and the outcomes for which they are responsible.
Rewards—how employees will be compensated for fulfilling the expectations associated with their roles.
Personal Contribution Ambitions—how the previous four elements help employees fulfill the purposes they wish to serve (in life) and gain the economic wherewithal to do so.
When employees see the connection between these five elements as they approach their roles in the business, you have achieved line of sight. Once this occurs, many other things naturally fall into place and performance management becomes more of a “steering” exercise than an evaluation or appraisal process. When line of sight exists, senior leadership can focus on guiding their people to the resources and methodologies that accelerate performance, rather correcting, disciplining and assessing them. They begin to view and treat employees as growth partners and want to facilitate their success, not micromanage their behavior.

3. Make Your Pay Strategy Both Agile and Enduring

Organizations create compensation chaos for themselves by either being too flexible or too rigid in their approach to rewards. Some view pay as a necessary “evil” (cost) that needs to be contained as much as possible. As a result, they have strict standards for setting salary levels (and increases) and pay little attention to variable forms of compensation such as short and long-term incentive plans. Others approach compensation in an almost ad hoc fashion, constructing pay offers on the fly to secure one key person after another. Sooner or later, these leaders wake up to the realization they’ve created a monster. There is no rhyme or reason to the way their people are being paid and every new hire wants a better deal than the last.

At VisionLink, we advise our clients to look at compensation as an investment, not an expense, and, therefore, to manage it like they would an investment portfolio. Wise asset managers help their clients determine the purpose of the portfolio they are creating. They establish an investment policy statement that guides the kinds of assets that are chosen and what proportion they will have to the overall “whole.” Various asset classes are chosen based on their alignment with the investment philosophy and accumulation goal of the client. As economic conditions change, wise investment advisors don’t counsel their clients to pull current assets out of the portfolio and replace them with new ones. Instead, they recommend re-balancing them. The goal is to avoid downside risk and maximize growth.

Compensation should be viewed the same way. You are building a “pay portfolio” based on the value-sharing philosophy you have established and the line of sight you are trying to achieve. Here, your “asset classes” are various compensation and benefits components—salaries, commissions, bonuses, LTIPs, medical insurance, retirement plans, executive benefits, etc. Your focus should be on determining which of those “asset classes” should be included in your “portfolio” and how much “weight” (proportion) each should be given. Then, as business or economic changes occur, you don’t pull out the plans you have and replace them with new ones. Instead, you “re-balance” your compensation portfolio just as you would in an investment portfolio. This allows you to be agile in the management of your compensation “assets” without having to reinvent your pay strategy every time the company has a new focus or revises its performance targets.

These three rules will help you transition to a more flexible system for managing employee performance without creating an untenable pay strategy in the process. Adopt and adapt specific rewards plans as you deem suitable, but make sure you do so within the framework of these standards.