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Pay for Performance: Evaluating Performance Appraisal and Merit Pay 1 Introduction At the request of the Office of Personnel Management (OPM), the Committee on Performance Appraisal for Merit Pay was established in the National Research Council, the working arm of the National Academy of Sciences, to assist federal policy makers as they undertake a revision of the federal government's system of performance appraisal for merit pay. Specifically, the committee was asked to review current scientific knowledge about performance appraisal and the use of performance appraisal in merit pay allocations, especially for managers and professionals. We were also asked to examine performance appraisal and pay for performance practices of private-sector employers and, if possible, to recommend models that federal policy makers might consider in revising the merit pay plans currently in place. The committee's investigation, begun in January 1990, has of necessity been fast-paced; the legislative mandate for the federal government's current merit pay program, called the Performance Management and Recognition System (PMRS), is coming to an end, and widespread dissatisfaction with the system has brought about the third major examination of merit pay procedures in the federal government since 1978. There is renewed public debate over such issues as the pay gap between federal employees and their private-sector equivalents, the waning prestige of federal employment, employees' dissatisfaction over merit pay, training and development opportunities, performance appraisal, and union opposition to merit pay (Perry and Porter, 1982; Merit Systems Protection Board, 1988; Havemann, 1990). During this time, too, private-sector compensation systems have been the topic of a great deal of attention. In particular, adoption of "pay-for-performance
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Pay for Performance: Evaluating Performance Appraisal and Merit Pay plans" has been highly publicized as a means for improving U.S. labor productivity. Public policy analysts have been exploring the impact that pay for performance plans might have on labor productivity in preparation for recommendations about national tax incentives for these plans (Blinder, 1990). Their interest was sparked by theoretical arguments that certain types of pay for performance plans (particularly profit-sharing) might stabilize national employment without inflation (Weitzman, 1984). Many employers, having already trimmed their work forces, are exploring the potential of these plans for making their remaining work forces more productive while continuing labor cost control (TPF & C/Towers Perrin, 1990; Wallace, 1990). Consultants, academics, and employee advocate groups (including unions) are also beginning to seriously discuss the effects of pay for performance plans—and to explicate the potential downsides, in particular the high costs of organizational changes required for effective plan implementation, and the equity problems associated with asking employees to place a larger part of their pay at risk when they have little control over many factors influencing organizational outcomes. In other words, it is a time of reassessment in the private as well as the public sector. Amidst widespread dissatisfaction with PMRS and the current celebration of pay for performance plans in the private sector, the question presents itself: Are there things to be learned from private-sector organizations that can improve human resource management in the federal bureaucracy? The government has many sources of advice on these issues, from blue ribbon groups like the Volker Commission, to federal employee associations, to a variety of consulting firms. Our task was to supply one perspective to the coming policy deliberations—that is, to bring together the best scientific evidence and knowledge derived from practice on performance appraisal and on linking pay to performance. PAY FOR PERFORMANCE: A FIELD GUIDE The Performance Management and Recognition System, like its predecessor the Merit Pay System, is a system of merit pay. This represents one genre in a broad spectrum of pay plans that bear the label pay for performance. There is an important difference in the use of the terms merit pay and pay for performance by the government and the private sector that should be noted. In government parlance, merit pay and pay for performance tend to be used synonymously. In the private sector, it has become common in recent years to distinguish between the two. The term pay for performance is closely associated with the drive to make U.S. business more competitive; private-sector analysts use it to designate systems in which a sizable portion of a worker's annual compensation is partly or wholly dependent on the overall success of the firm, rather than on individual performance. Variable pay plans include profit-sharing and gainsharing plans of all descriptions.
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Pay for Performance: Evaluating Performance Appraisal and Merit Pay In this report, we have chosen to use pay for performance generically to denote any compensation system that links pay and performance. Subsumed under that rubric are two distinct types of compensation systems: merit pay and variable pay. Merit Pay In merit pay plans, the locus of attention is individual performance. As one element in a meritocratic personnel system, merit pay plans link pay level or annual pay increases, at least in part, to how well the incumbent has performed on the job. Just as ability or skill is intended to rule employee selection in such systems, so the quality of each employee's job performance should, according to merit principles, be recognized through the pay system. The most recent survey data indicates that 94 to 95 percent of private-sector companies have merit pay programs to provide individual pay increases to their eligible ("exempt") employees, and 71 percent of companies have merit pay programs for their nonunion hourly employees. Performance appraisal is at the heart of merit pay plans. Although there are numerous variations in systems labeled as merit plans, some sort of rating of each employee's performance precedes compensation decisions. In some firms, the rating of performance is informal, with very little committed to paper; some firms undertake detailed job analyses, which provide the underpinnings of the appraisal system; a majority of firms appear to base the performance appraisal on a set of goals established by the supervisor or negotiated by the supervisor and the employee. The committee's review of private-sector compensation surveys suggests that the dominant model of merit pay plan can be characterized roughly by the characteristics listed below. They are discussed in more detail in the chapters of the report: The plan is tied to a management-by-objectives system of performance appraisal for exempt employees and a work standards or graphic rating scale performance appraisal for salaried nonexempt employees. The typical appraisal summary format has four to five levels of performance. Pay increases are administered via a matrix (merit grid) that uses both an employee's performance level and position in the pay grade to determine a prespecified percentage increase (or increase range) in base salary. The other components of the merit grid are the organization's pay increase budget and the time between pay increases. Merit increases usually are permanent increases, which are added into an individual employee's salary and are funded from a central compensation group. These funds are allocated to divisions or units as a percentage of payroll. Because merit pay increases are added to base pay and compounded into the earning stream, they can result in significant changes in pay levels over time.
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Pay for Performance: Evaluating Performance Appraisal and Merit Pay In contrast to federal practice, most companies do not communicate their pay structure or average pay increase percentages to their employees. Many communicate all increases given to an individual employee as merit-related. (This is in contrast to communicating increases as general, seniority, and merit combined.) The merit plan tends not to be accompanied by formal "due process" mechanisms for appealing unfavorable appraisals (unless an employee is covered by a collective bargaining contract), but it may be accompanied by informal protections. It is characterized by limited training of the managers who administer the plan and virtually no training of employees covered by the plan in the performance appraisal process. It is associated with relatively modest annual increases that are added into base salary. The Hay Company reported an average increase in 1989 of approximately 5 percent with a range of 2 to 12 percent. Variable Pay Variable pay plans fall into two categories, individual incentive plans and group plans. Piece work and sales commissions are the best known of the individual incentive plans. In recent years, a variety of group incentive plans have come into vogue. These pay plans are specifically designed to influence aggregate organization measures. They typically tie a significant portion of annual pay to organization-wide productivity or financial outcomes. For example, profit-sharing plans or equity plans link individual employee's pay to the overall fortunes of the firm as measured by some indicator of its financial health. Hence, one important distinction between merit pay plans and group incentive plans is that the latter base compensation decisions in whole or in part on organizational performance rather than individual performance. In addition, the portion of pay associated with the variable plans is usually a one-time payment, not an increase to base pay. Variable pay plans have taken on an importance in our report that they would otherwise not have had, given our mandate to look at performance appraisal and merit pay, because virtually all of the research on the effectiveness of pay for performance plans deals with these compensation plans. The enormous difficulty of trying to link individual performance in most jobs to productivity (the grand exception being manufacturing piece work and sales) may have turned the attention of social scientists to system-level indicators of effectiveness, and hence to the variable pay incentive plans. Advocates of variable pay plans argue that their implementation can help to revitalize organizations and control labor costs. They believe that the link between pay and organization outcomes is likely to motivate employees to work more creatively, smarter, harder, and as teams to achieve these outcomes. If
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Pay for Performance: Evaluating Performance Appraisal and Merit Pay the outcomes are achieved, they fund sizable payouts; if they are not, employee pay in addition to base would be small or nonexistent. In either case, the ratio of labor costs to total costs stays about the same, making the organization more competitive. The actual impact these variable pay plans can have on an organization's productivity and financial competitiveness is just beginning to be seriously examined. But it is a fact that, by design, these plans either require system changes—such as redefinition of jobs, creation of teams, and changes in work methods and standards as is typical in gainsharing programs—or provide powerful monetary incentives to employees to experiment with changes in their own jobs (individual bonus and profit-sharing plans.) There is disagreement about whether it is the broader system changes (Deming, 1986; Beer et al., 1990), or the presence of the variable pay plans themselves (Schuster, 1984a) that are most critical to improvements in organizational effectiveness. No one denies, however, that broader system or context changes will influence the impact of a variable pay plan on an organization's performance. The potential of variable pay plans to control labor costs and improve an organization's effectiveness has received the most attention in the press. Since such plans pay out only when they are funded by improvements in system measures, making a larger portion of a lower-level employee's pay dependent on them shifts management risks to those who have little say in management decisions. The potential abuse of employee equity with these plans is thus high. ISSUES With this background in mind, the committee has interpreted its charge from OPM as requiring the investigation of whether and under what conditions performance appraisal and merit pay can assist the federal government in regulating labor costs, managing performance, and fostering employee equity. We interpreted the managing of performance to include improvements in organization effectiveness, thus requiring some examination of variable pay plans and comparisons of their intended effects with those of merit pay plans. We broadly defined employee equity to include, not only employee perceptions of the legitimacy and fairness of performance appraisal and merit plans, but also incentives for managers to administer these plans equitably. By defining expectations for performance appraisal and merit pay plans in this way, our investigation was of necessity expanded beyond a restricted examination of the plans themselves to include an exploration of organizational and institutional conditions under which the plans are believed to operate best. We ask the reader to keep in mind several caveats in reviewing this report. Most important is that there is no commonly accepted theory of pay for performance or performance appraisal. Therefore, we have to consider the proposition that pay for performance plans affect performance, given certain
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Pay for Performance: Evaluating Performance Appraisal and Merit Pay conditions, via the examination of research designed to answer somewhat different questions—primarily related to alternative theories of motivation, such as goal setting, expectancy, equity, and agency theories. Given the diverse and fragmentary nature of the available evidence, we rely on the convergence of interdisciplinary findings and professional expertise to offer insights—not proofs—to federal personnel managers. We also lay no claim to making a comprehensive survey of all performance appraisal, merit pay, and variable pay plan methods and designs used in the private and public sectors today. We focused on predominant private sector trends and examined only five "model" private-sector organizations more intensively. Our committee's charge did not include an examination of the "total quality" or "organization revitalization" movements often associated with the implementation of variable pay plans; consequently, we draw no conclusions about them. Our review in this area was conducted to contrast the intended effects of these plans with those of performance appraisal and merit pay. Plan Of The Report We have organized our investigation of the issues in the following way. In Chapter 2 we begin by describing the history of merit principles in the federal government, the Civil Service Reform Act of 1978, and government workers' reactions to the act and its implementation. In Chapter 3 we summarize the nature of the evidence we examined and the implications of our decision to use convergent findings to generate the report's conclusions. In Chapter 4 we turn to a review of the psychometric properties and usability of performance appraisal instruments. In Chapter 5 we review the evidence from economics, sociology, psychology, and practice in the private sector on whether performance appraisal and pay for performance plans can affect labor costs, performance, and equity and what determinants or conditions are likely to influence these effects. In Chapter 6 we summarize trends in the design, administration, and use of performance appraisal and pay for performance plans—with a focus on the practices of five organizations that have a long history of satisfactory performance appraisal and merit pay programs. Our review then moves in Chapter 7 to a brief examination of the broader organizational and institutional context in which these plans are embedded to highlight other influential factors in both private- and public-sector organizations. In the final chapter we present our findings and conclusions for federal policy makers.
Representative terms from entire chapter: