Lump Sum Payments vs. Merit Pay

Thursday, May 20, 2010

Tradition has it that each year employees are reviewed for performance and if they meet the performance requirements of their organization the employee’s base pay may be increased by a percentage or flat dollar amount. Over time, the employee progresses through their designated pay range until they reach some maximum point within either the range or the end point of the range. Therefore, what does an organization do with an employee who has max’ed out and is no longer eligible for an incremental increase to their base pay? Assuming the employee is otherwise a “standard” or above level performer, what options are available to an organization to keep the employee motivated and focused?

The organization could simply inform the employee that they have reached the range maximum and send the employee back to their desk with a hardy handshake and a big “Thank You”. That approach might work for a few employees but my personal experience is that it will not work for very many or for very long. The organization could find some way to create a new job for the employee at a higher-grade level, however, in an economy when many jobs are being consolidated, that option may not pass muster. The organization could re-evaluate the employee’s job and determine if there have been sufficient changes in the employee’s level of duties to justify an upgrade. That approach might be easier to sell to management than a superficial promotion, but that action result in grade-creep and pressure from other managers to upgrade their employees as well.

Many organizations have adopted the practice of paying a single annual lump sum dollar amount to “standard” or above level performers in lieu of a percentage or flat dollar amount added onto their prior base pay amount. This has the ability of recognizing the employee’s continued efforts without distorting the employee’s position within the range relative to other performers. It also recognizes that there is a ceiling to the value of employee’s contributions to the organization. If you prescribe to the theory that labor is a commodity, then even the most highly talented employee has a maximum value. To justify paying 10%, 20% or 30% over the going market rate would require an employee with extrordary knowledge, skills, and abilities to say the least.

Lump sums generally limit the additional increment in costs associated with certain benefits, which are often tied to base pay such as life insurance and short and long-term disability. In addition, depending on the Plan language, retirement plans may not consider lump sum payments in the calculation of finial average pay or for use in calculating employer-matching amounts in defined contribution plans. Finally, since lump sums do not add to base pay, pay out of accrued time off at termination usually does not include such amounts.

Faced with the option of no increase, lump sum payments are a viable tool used in the recognition of an employee’s additional contributions. The basis for the actual amount could be based on a number of factors, including; a multiple of pay times weeks, a flat percentage equal to the organization’s merit budget or a flat dollar amount. As with most things, how lump sums are calculated is less important than how they are communicated to the employee. Significant thought should be placed into the communications phase to ensure that there are no mis-understandings.