CIPD - Performance-related pay

Performance management

January 2008

This factsheet gives introductory guidance. It:

explains what is meant by performance-related pay (PRP)
looks at how performance is measured and linked to pay
examines the coverage of PRP and current trends in awards
assesses key issues in the implementation of PRP schemes
includes the CIPD viewpoint.

Defining performance-related pay

Performance-related pay (PRP) is a method of remuneration that links pay progression to an assessment of individual performance, usually measured against pre-agreed objectives (‘classic’ PRP also known as individual PRP or merit pay). Pay increases awarded through PRP are normally consolidated into basic pay although sometimes they involve the payment of non-consolidated cash lump sums.

While the focus of this factsheet is individual, consolidated PRP as a means of pay progression, PRP can be defined more broadly to include many differing systems that link individual and group performance to pay, for example bonus schemes. CIPD members can use our tool on developing bonus and incentive plans.

Go to our tool Bonus and incentive plans

How PRP has developed

PRP was the ‘big idea’ of the1980s, embraced enthusiastically by many employers as the holy grail of driving high performance. Increasingly, there was a desire to move away from service-related pay progression increments (for ‘just being there’) towards an ethos where individual or group employee performance goals, often linked to pay, were used to support business performance objectives.

However, PRP has proved in some circumstances a rather crude instrument and the 1990s and beyond witnessed a number of challenges to the theory. As some of the earlier schemes failed to deliver the promised results, some employers brought in new or revised PRP schemes or moved to new approaches altogether (for example, skills-based pay) while others have developed hybrid schemes.

Today, the notion of linking pay to a wider definition of employees’ ‘contribution’ rather than simple ‘performance’ is gaining ground. This emphasises not only performance in the sense of the output (the end result that is achieved) but also the input (what the employee has contributed in a more holistic sense).

Under a new merit pay scheme at Kent County Council, for example, the review process assesses four elements including behaviours (inputs) as well as the delivery of personal objectives linked to business requirements (output)¹.

PRP rationale

The objectives of PRP systems may be grouped under three main headings:

1. Encouraging high performance levels by linking performance to pay

Arguably, however, PRP is not actually a good motivator – although it may be that even where the direct incentivisation impact is limited, the use of PRP can act as an important lever for wider organisational change. It is often the underlying improvements in performance management that have the greatest impact on bringing about positive developments, rather than the associated pay enhancement. For more information on performance management generally, see our factsheet on that topic.

Go to our performance management factsheet

2. Embedding an entrepreneurial or high-performance culture across an organisation

While PRP can help to send out a message in this respect, there are other (non-monetary) ways of communicating the need for high performance.

3. The notion of equity or fairness

There is more widespread acceptance of the effectiveness of PRP in this respect – that it is right and proper that employees who perform better at work should be rewarded more highly.

Measuring performance

PRP typically uses a system based on consolidated pay progression within pay brackets attached to each grade, level or zone in a structure.

However, in order for performance to be rewarded, it is first necessary to have an effective means of measuring that performance – most commonly via a performance appraisal or review system. See our factsheet on this topic for more information.

Go to our performance appraisal factsheet

Using this approach, each employee’s performance is ranked on a scale – typically incorporating three to six categories – ranging, for example, from ‘unsatisfactory’ to ‘superior’. Some systems allow for management discretion in translating these scores into levels of pay rise. However, it is more usual for the performance element of the pay rise to be determined by the use of a formula or a matrix system linking each grade, level or zone to each of the performance categories. This may involve the use of a comparison ratio, or ‘compa ratio’ – the term given to the relationship between each employee’s current salary and the mid-point of their grade. Thus for an employee at the mid-point of their pay range, the compa ratio would be 100%.

It is often felt appropriate for the pay rises associated with each performance category to be higher for employees at lower points within the pay brackets, given the presumed existence of a learning curve for new entrants to a grade. However, more senior employees who are performing very highly may resent the award of comparatively low percentage pay rises.

Who gets PRP?

Various estimates exist of the coverage of PRP, partly as a result of differing definitions of PRP adopted by researchers. However, some broad themes and trends may be identified:

Across the whole UK economy in 2006/07, 35.5% of pay reviews were based either wholly or partly on an assessment of individual merit, according to the latest annual review of pay trends from IRS².
This represented the first significant increase in the incidence of merit pay in recent years – up from levels hovering around the 30% to 31% mark in each of the previous four years.
Individual PRP is far more prevalent in the private than in other sectors – and indeed is virtually 'the norm’ in some parts of the sector such as financial services.
In the public sector, by contrast, the vast majority (60 out of 67 pay awards monitored during 2006/07) provided for a basic percentage increase, with just seven including a performance-based element³.
The use of PRP also remains relatively rare in the voluntary sector.
Merit pay most commonly covers managerial and other white-collar staff – and despite a growing interest in the idea of extending coverage to manual workers, few schemes do so.
There are of course major differences in coverage of PRP internationally – for example, employers in France make greater use of merit pay than occurs in Great Britain⁴. Ironically, this is partly attributable to the much more highly regulated employment background in France that leaves individual managers keen to exert some control over the improvement of performance via pay.

PRP in the public sector

Despite considerable interest in linking pay to performance in the public sector dating back many years, this has proved harder to translate into practice. Where performance pay does occur, it often takes the form of non-consolidated bonuses and/or team-based incentives – an approach recommended by the 2000 Makinson report on performance pay in central government⁵ – rather than ‘classic’ individual merit pay.

Nevertheless, there have in recent years been a number of high-profile initiatives such as the introduction of a PRP scheme for teachers, which some researchers argue has resulted in some discernible performance improvements⁶.

A number of distinct issues arise when introducing PRP into a public sector setting, including the potential difficulty of measuring individual effort in certain roles. Moreover, public sector workers such as nurses are arguably motivated by a public service ethos which could actually be undermined by some forms of PRP. One theory though is that PRP in a public service setting can help employees to work more effectively rather than to work harder, by encouraging employees to focus on key objectives.

As concluded by a recent study⁷ covering various forms of incentive pay and bonuses in the public sector:

Public sector workers do respond to financial incentives – and, while responses are sometimes small, this reflects the fact that the incentives are also small.
There is, however, also evidence of ‘gaming’ – defined as ‘manipulation of behaviour that uses resources and does not increase productivity’ in response to schemes.
Any overall benefits to society in respect of higher levels of public service are harder to assess.

Current trends in merit awards

Under PRP arrangements, the pay review process may provide for either:

pay progression entirely on the basis of individual performance appraisal ratings (known as ‘all-merit’ awards), or
a general pay rise for employees in addition to an element that is linked to individual performance (‘basic-plus-merit’ awards).

Trends in performance pay are commonly measured via the paybill budget allocated for the merit element of awards. Key developments in the most recent pay round as monitored by IRS include:

One quarter of pay awards in 2006/07 were based entirely on merit, with the paybill budget increase set at 3.5% at the median (or mid-point) – up from 3.3% in the previous year’s analysis.
Individual merit pay increases ranged from nil to 36.36%.
The maximum merit payment was 8% at the median – up from 7.4% the previous year.
A further one in eight pay reviews combined a basic pay rise with a supplementary payment linked to performance – with a median basic increase of 3% and merit paybill budget of 2%.

Implementing PRP schemes

For PRP to be effective, employees need to perceive a clear and prompt link between the effort expended and the reward that will be obtained, and also to feel that the level of reward on offer is worth the effort.

The key issues for employers implementing PRP include the following.

Objectivity/consistency of line managers

The role of the line manager is key to the effective implementation of PRP, and steps should be taken to involve this group at an early stage in designing systems, and to ensure consistency and transparency when assessing performance. Some schemes insist that all managers band a certain proportion of staff in each performance pay grouping (for example, 10% ‘poor’ and 10% ‘superior’). Ensuring objectivity is also important to avoid the ‘blue-eyed boy’ syndrome. Particularly serious is the potential for unlawful discrimination such as sex or race discrimination. It is important for appraising managers to have training/awareness of these issues and for monitoring of merit pay awards to take place (for example by gender, ethnicity and so on).

Distribution of pay awards

As noted by many HR commentators, pay may not be the only motivating factor – or even the most important one – for some employees. Moreover, the performance element of pay is often relatively small, particularly for those relatively middling performers who will by definition form the bulk of the workforce. The problem is accentuated during times of low inflation when the paybill increase is usually limited to relatively small percentage figures. Even where PRP may have a motivational impact for high performers, the unfortunate corollary can be the demotivation of the bottom performers. As well as careful consideration of pay distribution, the use of performance management techniques in support of PRP can help to tackle such issues.

Identification of development needs

A major concern for HR practitioners is that the linking of pay awards to the performance review process may inhibit an open and honest discussion of an individual’s training and development needs. One solution is to separate the pay review aspect of performance measurement from the broader performance/development review, for instance by holding separate meetings some weeks or months apart.

Time-consuming nature

The processes associated with PRP can be very time-consuming. In general, it is important to allow sufficient time away from day-to-day duties for managers and employees to be able to engage in the PRP process effectively.

Undesired impacts on employee behaviour

Poor objective setting can lead to undesired behaviour changes – for example a focus on short-termism or unwillingness to engage in teamworking – as employees try to achieve their individual PRP awards for the year. The aim should be to design objectives carefully to avoid such effects, for example by ensuring that they encourage high performance in the long term.

CIPD viewpoint

PRP is not a silver bullet – for this approach to succeed, effective arrangements must be in place to define, measure, appraise and manage performance. The focus should be on encouraging high performance first – underpinned by effective performance management and appraisal systems – and only then on pay as an incentive to help achieve that goal. To create a sustainable high-performing workplace, the whole range of financial and non-financial rewards must be carefully designed to ensure that they support and are supported by PRP.

References

CHARTERED INSTITUTE OF PERSONNEL AND DEVELOPMENT. (2007) Reward: summary of the CIPD Research into Practice event. London: CIPD. Available at: http://www.cipd.co.uk/subjects/pay/general/_rwrdres07.htm
CARTY, M. (2007) Merit-based budgets increase to 3.5% over 2006/07 pay round. IRS Employment Review. No 882, 19 October.
SUFF, R. (2007) Public sector pay 2007/08. IRS Employment Review. No 887, 14 December.
BELFIELD, R., BENHAMOU, S. and MARSDEN, D. (2007) Incentive pay systems and the management of human resources in France and Great Britain. CEP Discussion paper 0796. London: London School of Economics, Centre for Economic Performance. Available at: http://cep.lse.ac.uk
MAKINSON J. (2000) Incentives for change: rewarding performance in national government networks. London: HM Treasury. Available at: http://www.hm-treasury.gov.uk
ATKINSON, A. et al. (2004) Evaluating the impact of performance-related pay for teachers in England. CMPO Working paper, No 04/113. Bristol: University of Bristol, Centre for Market and Public Organisation. Available at: http://www.bristol.ac.uk/cmpo/workingpapers/wp113.pdf
PRENTICE G., BURGESS S., and PROPPER C. (2007) Performance pay in the public sector: a review of the issues and evidence. London: Office of Manpower Economics. Available at: http://www.ome.uk.com

Performance-related pay