The Pros and Cons of Tying Compensation to Performance Reviews

At Reviewsnap, we’ve seen firsthand the benefits delivered by a pay-for-performance structure that closely ties compensation to the performance review process. However, this isn’t the right approach for every employer or every company culture. Like most human capital challenges, tying compensation to performance reviews has its share of pros and cons. Here are a few of the most critical:

The Pros:

1.     It takes the “mystery” out of pay increases.—Employees often complain that raises and reviews are based on intangibles (how well their manager likes them, office politics, etc.) and not applied consistently. By tying reviews to compensation, performance clearly becomes the determining factor in compensation. The stronger the performance, the better the raise. But this approach demands that managers measure performance as accurately and objectively as possible, basing their reviews on concrete performance metrics and pre-communicated goals. If they don’t, it undermines the entire intent of pay for performance.

2.     It attracts top talent.—Research continues to show that top performers still cite pay as a main motivator. As Kerry Chou, Senior Practice Leader of Compensation at WorldatWork, noted during the company’s Total Rewards 2013 Conference and Exhibition, a recent WorldatWork survey revealed that better pay is the number one reason key people leave one employer for another.

3.     It can make administration easier.—With performance reviews tied directly to compensation, many employers find it improves the efficiency of integrating pay increase information into their payroll systems and generating follow-on reports. When compensation isn’t tied to the review process, HR or payroll staff members often have to take special steps to manually enter increases into the payroll system.

The Cons:

1.     Objective reviews aren’t easy to provide.—In order for pay for performance to work effectively, employees must be “rated” in some way but the rating must be objective and evenly applied. This simply doesn’t work for all company cultures. For these companies, pay for performance can actually be counter-productive and introduce an air of unhealthy competition among employees who need to collaborate. In short, if the review process is perceived to be unfair, highly valued qualities such as trust, cooperation and teamwork can go right out the window.

2.     If the process isn’t clear, it can be confusing to employees.—Under pay for performance, a manager needs to be crystal clear in communicating precisely what is driving compensation. Is it goals, for example, or competencies? Let’s say a company’s review process is based primarily on competencies but this isn’t clearly understood by an employee. She works hard all year to achieve specific performance goals and exceed targets. When she receives a lower-than-expected raise (because her communication with key team members has been consistently poor, for instance), it’s no wonder that she’ll go away disappointed, demotivated and confused. Bottom line, employees need to know how exactly they’ll be judged and what will drive their dollars.

3.     Compensation can overshadow the importance of reviews.—When a salary discussion comes on the heels of a performance review, it can be difficult for the employee to focus on the feedback he’s been given. Helpful critiques (both positive and negative) and guidance are eclipsed by the amount or lack of pay increase. Some employers overcome this by separating the review and the compensation discussion by several months. Others hold compensation discussions just once annually, while they hold several performance reviews throughout the year. If multiple performance reviews are held, employees must understand that compensation changes are based on the entire year’s worth of reviews—not just the most recent one.

At the end of the day, each employer must decide the compensation and performance review strategies that best fit its culture. Whatever your final choices are, remember they’ll form how your employees feel about working for you—and how dedicated they’ll be to giving you their best efforts day after day.

Communicate your strategies and expectations clearly. Give your people well-defined guidelines. And empower your managers to reward top performers appropriately. These are the keys to compensation and performance success.