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.
