By Awie HW Foong and Mak Yuen Teen
IN A recent panel discussion involving several Singapore bank chief
executive officers (CEOs), one was quoted as saying that remuneration
in financial services is 'inherently unfair', as those who get more
rewards sometimes did not earn as much for the bank. Another CEO added
that 'the incentive structure has to change'.
So what is wrong with the current reward management system, and why does it matter?
Recent
debates on the issue of executive compensation in some financial
institutions in the US provide more dramatic stories. Several financial
institutions were reported to have paid large amounts of compensation
to their CEOs, despite poor performance, while laying off a significant
number of employees. However, by compensating millions of dollars to a
CEO who has failed to perform, and at the same time laying off the
employees en masse, these companies are effectively sending a negative
signal about organisational fairness.
The ramification of perceived unfairness is likely to be a long term
one. Past studies have shown that the feelings of unfairness would lead
to poor employee loyalty and engagement, and consequently poor work
performance.
Based on data from the Watson Wyatt's employee opinion surveys in
2004 and 2007, we found that it is the employees' perception of the
fairness of the reward system, not how satisfied they are with the
rewards, that has the stronger effect on their loyalty to the
organisation. The findings suggest that employees want to be treated
fairly. That includes a salary and reward package that is equitable to
the industry norms as well as a fair process in determining those
rewards. Employees also expect that the performance and reward
management process is consistent and clearly communicated to them. The
study also found that employees who believe that they are being treated
fairly are in turn more willing to stay with the company and to make
sacrifices for the company during difficult times.
At the heart of organisational fairness is the system of
pay-for-performance. Corporate governance codes generally advocate pay
for performance for senior executives. If properly implemented, pay for
performance can result in improved corporate performance and fair pay
practices. Who can argue against paying better performers more? We
believe that, generally, employees - and shareholders - do support 'pay
for performance' and see it to be inherently fair in determining pay.
However, although most companies now claim that they practise pay for
performance, the real question lies in whether their implementation
really does cultivate positive perceptions of organisational fairness.
Given the intense war for talent, how companies manage their
performance management and reward systems will have a great impact on
their ability to engage and retain talent.
Two forms of fairness or perceived justice are especially important.
The first is called distributive justice, which is concerned with the
perceived equity of reward distribution. Generally, the perception
about distributive justice is positive when people believe that their
levels of pay are similar or comparable to others.
The second is called procedural justice, which is concerned with the
perception about the process that is in place for evaluating and
deciding who gets what and how much each person receives. Employees who
clearly understand how performance is being evaluated, at all levels of
the organisation, and the links between rewards and performance, would
feel more positive about procedural justice.
The importance of distributive justice should not be taken to mean
that reward distribution should not change. For example, while the
popular press often uses the increasing ratio of average CEO pay to
average employee pay over time as an indicator of excesses in executive
compensation, there may be good economic reasons for the increase in
this ratio. However, if this ratio increases considerably, it may
create a perception of lack of distributive justice within the
organisation.
A recent study by Charles O'Reilly, the Frank E Buck Professor of
Human Resources Management at the Stanford Graduate School of Business,
together with James Wade of Rutgers University and Timothy Pollock of
Pennsylvania State University found that the effects of unfair
executive compensation flow down to lower level managers and employees.
Managers who perceive that the CEO is unfairly paid are more likely to
leave the company.
To mitigate such perceived unfairness, the process by which pay is
determined becomes important. From a corporate governance perspective,
there should be strong governance surrounding the determination of pay
as, without it, employees and other stakeholders are likely to perceive
the lack of procedural justice.
Procedural justice
Concerns about the independence of compensation committees approving
senior executive pay or compensation consultants advising compensation
committees about senior executive pay are essentially concerns about
procedural justice. That is, is the process used to determine senior
executive pay 'a fair game'? In our view, pay for performance and good
corporate governance are two sides of the same coin. Implementing pay
for performance without good corporate governance increases the risk of
excessive pay and perceptions of unfair pay practices. Pay for
performance can do more harm than good if it adversely affects
perceptions of distributive and procedural justice.
The two forms of perceived justice are also highly correlated. Where
distributive justice is a concern because of significant discrepancies
or changes in reward distribution, attention to procedural justice
becomes more important. Companies need to tackle both forms of
perceived justice in a holistic manner. Although comparison is a key
step to address distributive justice, and most companies do benchmark
against other companies, such benchmarks alone are insufficient because
they do not address the issue of procedural justice. 'You should
receive X times lower than me because the external benchmarks say so'
is hardly a convincing statement for employees.
In his new book The Speed of Trust, author Stephen Covey talks about
the leadership style of John Mackey, founder and CEO of Whole Foods, a
US grocer which had outperformed Wal-Mart in both overall and
comparable-store sales growth for four years in a row. Mr Mackey
publicly posts everyone's pay. In contrast, most companies try to keep
everyone's pay under wraps. This may reflect concerns with perceptions
of lack of distributive justice if pay becomes widely known, which can
create particularly serious morale problems if there is a perception of
lack of procedural justice.
Senior management may wish to ask themselves this question: how
would employees feel about fairness in pay if everyone's pay is known?
Employees may know more about each other's pay than organisations would
like to believe. Company really don't want to have many employees who
think that they are being treated unfairly lurking around the office or
going out to meet the customers, and eventually leading the customers
out of the door too.
Clearly, the management of employee loyalty requires a commitment to
people management. The good news is, most people are reasonably fair.
The other good news is, a fair pay for performance system doesn't
necessarily cost companies more.
Open communication
Although there is no single best practice that elicits fairness and
loyalty, we believe that open communication plays a vital role in
ensuring that the employees understand how performance and rewards are
linked. When employees are well informed, they are more likely to
endorse the reward system and be more engaged. According to a separate
study by Watson Wyatt on strategic rewards in 2007, close to 70 per
cent of employees who say that their company succeeds at communicating
the reward system and delivering the promise are highly engaged,
compared to just 25 per cent overall.
We believe that the decision making process for the reward system at
all levels should be carefully reviewed in order to identify key
factors relevant to the determination of pay packages. Communication
about the reward system should focus on these key factors. Ultimately,
the secret to a win-win pay for performance is not about paying
everyone the same, nor is it about simply paying people at the going
rate. It is all about the fairness and legitimacy of the process,
coupled with a clear understanding that is shared among all employees.
While business cycles and economic situations may change, the human
desire for fairness would remain stable. If this is what the employees
want, this is what companies should strive to achieve. Companies should
continue to practise pay for performance, but they should review how it
is implemented to ensure that it does not undermine loyalty because of
perceived unfairness, thereby causing top talent and good performers to
leave the organisation or to be unwilling to make sacrifices during
tough times.
Awie Foong is senior research associate and Mak Yuen Teen is
director of the Asia-Pacific Research and Innovation Centre at Watson
Wyatt Worldwide.
This article was first published in The Business Times on July 24, 2008.
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