COMPONENTS OF A COMPENSATION PLAN

Introduction All organizations have a compensation plan, written or unwritten, formal or informal. For some organizations, the purpose of that plan may be merely to meet compliance requirements. For other organizations, the goal of the compensation plan may be to attract qualified employees, to retain those employees, and to motivate employees to direct their efforts towards achieving the goals of the organization. Regardless of the goal, size and complexity of a compensation plan, there are generally many easilyidentified elements to any compensation plan. his commentary reviews these elements, poses questions management can use to determine the stance it would li!e to ta!e regarding compensation, and offers some advice and recommendations on implementing these ideas. he topics that will be covered are development of a compensation philosophy, ob"ectives of a base pay program, developing rates of pay for "obs, pay rates and increases, performance appraisal, maintaining and auditing a compensation plan. Development of a Compensation Philosoph #efore an organization actually develops a compensation plan, there are several questions that need to be answered. a!ing the time to consider and answer these questions will ma!e the both the process of developing and administering a compensation plan much easier and will result in the development of a compensation plan that more closely matches the organization$s goals and ob"ectives. %hat is the goal of the organization$s compensation system& 'n addition to attracting and retaining qualified employees, is there an intent to reward employees for good performance, motivate good performance, and(or create or reinforce a particular type of organizational climate& !hat is the communication polic & )ow is the organization going to communicate the compensation plan to employees once it has been developed& 's the organization prepared to evaluate the effectiveness of any such communication& 'f so, how& )ow will decisions regarding pay be made& %ho will be involved in these decisions& %hat decision guidelines will need to be developed& %hat is the organization$s desired mar!et position relative to pay& %ill the organization choose to pay mar!et rates, above mar!et or below mar!et& )ow does the desired mar!et position fit with other strategic goals& Are there any competitive factors involved that will determine the pay strategy& %hat is the desired mix between benefits and cash& *ince benefits are an important form of compensation, how does an organization use them to maximize the effectiveness of the compensation plan& %hat does the organization pay for& +oes it pay for performance or seniority or some

combination of the two& %hat is the role of performance appraisal in the organization& )ow important is performance appraisal and why& )ow will the organization manage change to the compensation plan once it has been developed& %hat systems need to be in place to implement any changes including deciding when change is necessary and who will ma!e these decisions& )ow does the compensation philosophy and plan fit with the rest of the organization& )ow can the compensation practices reinforce other overall management philosophies and ob"ectives& O"#ectives of a $ase Pa Pro%ram #efore delving into the details of how actually to pay people, there are many factors that impact a base pay program that an organization must consider. 'n general, every organization$s base pay program has certain ob"ectives. he principal ones are as follows, - internal equity. - external equity .or competitiveness/, - individual equity, - process equity, - performance or productivity incentives, - maximum use of financial resources, - compliance with laws and regulations, and - administrative efficiency. As will be shown in the following, all of these ob"ectives must be balanced in the development of a sound base pay program. As these points are being reviewed, management should as! the following questions, 's this point important to this organization& 'f so, how important& %hat are the implications of this point to the current or desired practices& Internal E&uit - 'nternal equity deals with the perceived worth of a "ob relative to other "obs in the organization. All employees compare their "obs to other "obs within the organization. 0enerally, they consider s!ill, effort, responsibility and wor!ing conditions in this comparison in order to determine the value of their "obs relative to other "obs. 1i!ewise, management must often determine the 2worth2 or 2value2 of one "ob in relation other "obs for the purpose of pay programs. 3aintaining appropriate pay relative to value or worth is achieving internal equity. E'ternal E&uit - 4xternal equity deals with the issue of mar!et rates for "obs. An

employer$s goal should be to pay what is necessary to attract, retain and motivate a sufficient number of qualified employees. his requires a base pay program that pays competitively. Among others, internal data such as turnover rates and exit interviews can be helpful in determining the competitiveness of pay rates. 4mployees also compare their "obs and pay to the "obs and pay in other organizations. 0enerally, employees consider much more than base pay in determining external equity. +epending on the individual employee, serious consideration may be given to employee benefits, "ob security, physical wor! environment, commuting distance, opportunity for advancement and the employee relations practices of the employer in determining external equity issues. 'n the 5acific 6orthwest, a frequent consideration is also lifestyle and quality of life. An important issue to employees in determining external equity is the transferability of their s!ills. 'f an employee$s s!ills are valued more highly in a different type of "ob or industry in the area, the employee may believe that s(he is being treated inequitably. Note, An organization may choose to place the primary emphasis of its base pay program on internal equity, external equity or a blend of the two. here are important ramifications to this decision that should 2fit2 with other organizational structure issues and overall management ob"ectives. Individual E&uit - 'ndividual equity deals with how individuals perceive how they are being paid relative to other individuals within the organization and perhaps within the same position. his focus of individual equity is on the merits of the person filling a "ob, as opposed to the "ob itself. 'n simple terms, employees want to feel that the rewards they receive for how they do their wor! are comparable to the rewards received by others for the same amount of effort or output, all other factors being equal. )ow merit rewards or increases are given strongly impacts perceptions of individual equity. Process E&uit - )ow employees perceive the fairness or equity in the administration of the compensation system is process equity. 5rocess equity, in the perceptions of employees, is strongly influenced by the openness of the system, communication of the system to employees, participation in design or administration of the system and a grievance appeal procedure. Performance Incentives - A significant element of a base pay program is to encourage higher or increased levels of employee performance. 5ay systems need to be designed to improve organizational performance. Ma'imum (se of Financial )esources - *ince an organization does not have unlimited financial resources, the base pay program needs to be designed to maximize the value to the organization with minimum use of these limited resources. 'n order to accomplish this, pay programs have a variety of tools such as pay range maximums, pay increase budgets, authorization procedures, compensation committees or various internal auditing procedures available to help accomplish this ob"ective.

Compliance *ith La*s and )e%ulations - %hile not the primary ob"ective of a pay program, one of the ob"ectives of a pay program needs to be to !eep the organization in compliance with various state and federal laws and regulations. Administrative Efficienc - +ue to the limited financial resources in an organization, one of the ob"ectives of a pay program should be to have a pay program that is easy to administer, flexible, and cost-effective. +eveloping Rates of 5ay for 7obs he basis for most pay programs is a pay structure - a hierarchy of "obs with pay ranges and(or rates assigned. 5ay structures are designed so that the greater the worth of a "ob .as determined by internal or external equity/, the higher the pay grade and range. +eveloping a pay structure is a process with a series of steps, - "ob analysis, - "ob documentation, - development of a "ob worth hierarchy, - labor mar!et data collection and analysis, and - establishment of pay rates and(or ranges. +o" Anal sis - his involves collecting and evaluating relevant information about "obs. Any data collected should clarify the nature of the wor! being performed .principal or essential tas!s, duties and responsibilities/, the level of the wor! being performed, the extent and types of !nowledge, s!ill, mental and physical effort and requirements, and responsibility required for the wor! being performed. here are five primary sources of data for collection of "ob information, questionnaires, interviews, logs or diaries, direct observation and wor! plans. All of these methods have advantages and disadvantages and the organization must choose the method that will provide comprehensive data with administrative efficiency and cost-effectiveness. +o" Documentation - here needs to be a formalized way to document "ob content. 'n most organizations, a "ob description is the means used to accomplish this. 7ob documentation is used to evaluate "ob content, provide ob"ective criteria for ma!ing pay comparisons, ensure that "obs are classified according to content as opposed to individual personalities, effectively communicate the "ob duties to both supervisors and employees, and help the organization defend itself against charges of discrimination. %ho should write "ob descriptions& hat will depend on the resources available to the organization, but they should always be reviewed by line management. Development of a +o" !orth ,ierarch - A "ob worth hierarchy is the result of "ob evaluation, the overall process of comparing "obs. here are 8 ma"or methods of comparing "obs in order to develop the "ob worth hierarchy. he first three methods are 2whole-"ob2 evaluations and are non-quantitative in nature. hese include ran!ing, classification and slotting. he second three are 2factor2 evaluation and are quantitative in nature. hese include point factor, factor comparison, and scored questionnaires.

La"or Mar-et Data Collection and Anal sis - #efore an organization begins the process of collecting labor mar!et data, it must first define its relevant labor mar!et. his may include similar organizations in the same labor mar!et, all employers in the local mar!et, similar organizations in the regional or national mar!et, and(or all employers in the regional or national mar!et. he goal of labor mar!et data collection is to find data from employers with whom the organization competes for employees. For clerical employees, this may be all employers in the local labor mar!et. For high level management positions or certain specialized positions, this may be all employers in the national mar!et. 9nce the data has been collected, it must be analyzed. he simplest analysis involves comparing the going mar!et rate and approximating this rate within the organization$s own pay structure. 9ther methods involve using advanced statistics to study relationships among certain items in a specific "ob or mar!et group. An organization may find pay range information, as well as weighted average of actual pay, very helpful. Esta"lishment of Pa )an%es and.or )ates - 'n order to actually establish a pay structure, an organization needs to set rates of pay for the "obs in the "ob hierarchy. #efore doing this, an organization needs to as!, and answer, the following questions, )ow should the organization$s pay level relate to the external mar!et& *hould the organization be a pay leader, match the mar!et or pay less than mar!et& %hat is the organization willing to pay for, "ob content, seniority, performance, s!ills, cost of labor, or some combination of all of these& ,o* does the or%ani/ation pa its emplo ees0 based on a single rate structure .all employees in the same "ob receive the same pay/, based on seniority, based on merit, based on productivity .piece wor!/, based on new s!ills .s!ill-based pay/, or based on some combination of these factors& Are short term or long term incentives provided& %hat steps does the organization need to ta!e to ensure that pay is administered in a manner free of bias and discrimination& 'f an organization decides to use pay ranges .or grades/, it will have to determine how many ranges to have. his will depend on the number of different levels of relative "ob value that are recognized by the organization and the difference in pay between the highest and lowest paid "obs in the pay structure. he focal point of a pay range is the mid-point as this is generally the 2going2 rate for "obs assigned to that range. From the mid-point, an organization can determine the range minimum and maximum. he range minimum is the usually the lowest pay rate for any "ob in that range and is usually the pay rate given to people hired in that range who meet minimal qualifications only. 9ccasionally an organization will pay a 2training2 rate that is below that minimum. he maximum of a range is the highest rate an employer is willing to pay for "obs in that pay range. 9ther important range issues include the range width and the degree of overlap between ranges.

he end result of all of the above is a pay structure that should accomplish the organization$s ob"ectives with regards to a pay program, and should reflect the organization$s philosophy on how it wishes to relate its pay program to the mar!et. Also, this pay structure should demonstrate the internal "ob values of positions, and how the organization wishes to mix base pay, benefits and incentives. Pa )ates and Pa Increases :reating a pay structure is not the final step in the creation of a compensation plan. An organization must also decide how to administer this compensation plan. his means deciding how to pay new employees, how and when to give employees increases, including how to move existing employees from the minimum to the maximum of their assigned pay grades, how to determine the pay increase for an employee being promoted from one "ob to another and what influence, if any, cost of labor increases will have on the determination of pay increases for employees. 'n addition, an organization must develop policies and procedures that will implement the results of these decisions in a consistent manner. Startin% Pa for Ne* Emplo ees - 'n order to avoid paying new employees the same as more experienced employees, most employers choose to start new employees closer to the minimum of the pay range. 'n general, an employee with minimum qualifications should be paid the minimum of the range. his general rule is not true when a new hire has s!ills which are in great demand or has s!ills or other expertise substantially above the minimum. Emplo ee Increases - here are several different types of base pay increases, general .across-the-board/ increases, cost-of-living(labor increases, promotion increases, step increases .based on longevity/, and merit increases. 0eneral increases are diminishing in popularity because they are not consistent with the idea of pay for performance. %ith a general increase, employees in a certain group based on established requirements are eligible for a certain monetary or percent increase to their base pay. A cost-of-living increase is a type of general increase given to all eligible employees. his type of increase may happen as a result of union contract negotiation. *ome companies choose to trac! benchmar! positions over a period of time and modify other positions based on changes in the ranges of benchmar! positions. 5romotion increases are given when an employee is moved from one "ob to another with a higher pay grade and range. he size of the increase will be influenced by the difference between the old and new pay ranges, and the pay of the newly promoted person$s peers, superiors and subordinates, if any. *tep increases can be based solely on longevity or some combination of longevity and performance. *tep increases alone are inconsistent with pay for performance.

3erit increases are also !nown as pay for performance. o be successful, an organization must be able to measure differences in "ob performance and these differences must be significant enough to merit the time and effort required to measure them and pay accordingly. 3erit increases also affect other components of the compensation plan in that the pay range must be wide enough to allow for significant differences based on performance, supervisors and managers require training in performance planning and appraisal, and control mechanisms must be in place to successfully administer a merit increase program. Performance Appraisal 'f an organization chooses to pay for performance, the compensation plan must include a well-designed and properly administered performance appraisal system in order to be complete. Following are some questions that will help determine if an organization$s current performance appraisal system meets this criteria. 's performance appraised on the direct measurement of an employee$s output or results& +oes the performance appraisal system consider only "ob-related behavior rather than personality traits& Are supervisors and managers trained in the performance appraisal process& Are the criteria used to measure performance as ob"ective and quantitative as possible& 9r are the criteria open to sub"ective interpretation& )ave ob"ective "ob standards been developed& )ave the employees had input into the development of these standards& Are they communicated to the employees at the beginning of the appraisal period& Are "ob standards reviewed regularly to ensure relevance and importance to the department and organization& 's the employee actively involved in the performance appraisal process& 9r is a performance appraisal something that is 2done2 to the employee& Maintainin% and Auditin% a Compensation Plan :hanges in the external mar!et or internally within the organization can cause one or more parts of a compensation plan to become outdated. 5art of the challenge in creating a compensation plan is to build in mechanisms that facilitate change when necessary, yet maintain control on a regular basis. *ome actions an organization can ta!e to maintain an updated compensation plan include regular review of "ob descriptions, monitoring of compensation levels versus companies with which there is competition for employees, and regular review of the pay structure including pay ranges and pay increase budgets. An audit is an excellent means to ensure that a compensation plan is being properly administered and maintained. %hen planning to audit a compensation plan, an

organization needs to consider the following, 5rocess measures - Are procedures and practices in place to ensure the compensation plan is being administered smoothly and efficiently& 5olicy compliance - Are there procedures or other mechanisms in place to ensure that the compensation plan is being administered in accordance with policy& +ocumentation adequacy - 's there adequate documentation in place to ensure that the administration of the compensation plan and compliance issues can be audited& 9verall results - Are there measures that can assess how well the compensation plan is achieving its goals and ob"ectives& After reviewing audit results, management can ma!e recommendations on any improvements that may be necessary, allocate the necessary resources and follow-up to ma!e sure the wor! is completed. Summar *uccess of a compensation plan includes an overall pay philosophy as well as the policies and procedures that govern operation of the compensation plan. #ecause organizations have limited resources, excessive time and money should not be expended in pay program administration. he costs of administration should be balanced against achieving the other ob"ectives of the pay plan. An organization must decide how it will move employees through the pay range once a pay-range structure has been developed. An organization may utilize the following, - 'ndividual performance as a basis for movement - Automatic or step progression based on employee tenure - :ost of living increases 'f an organization chooses to implement a performance-based pay program, then compensation professionals must ensure that their merit-pay programs measure performance ob"ectively and management must carefully evaluate performance to ma!e "udgments regarding pay differentials. 9rganizations find that an audit of the compensation plan is a useful tool for educating management, thus increasing their understanding and support of the pay program. 't is recommended to conduct a comprehensive audit at least every two years in order to identify problem areas and resolve them as soon as possible. 4xplaining what the terms li!e 2rewards,2 2base pay2 and 2per!s2 mean in a pay system.

Compensation Philosoph , 'dentifies target mar!et position for competitive pay levels and articulates the company s commitment to motivating, and rewarding employee contribution and performance through the various elements of the company s total pay system. $ase Pa , 5ays for standard "ob duties, s!ills and results. *hould be designed to reflect competitive rates for comparable "obs within identified mar!etplace. Performance $ased 1aria"le Pa , +esigned to reward achievement of specific company and(or individual performance ob"ectives. 5ayouts vary based on company and(or individual achievement. ypes of variable pay plans include,;< -*!ill pay -'ncentive pay(bonus plans -:ommission -0ain sharing(results sharing 1ong erm 'ncentive :ompensation, +esigned to reward long term company performance. 'ndividual "ob level(performance may impact eligibility to participate. :an be an effective retention tool. #enefits #road range of practices including health insurance, vacation, leave policies, and retirement and savings plans. +esigned to address health and welfare needs of employees. :an send strong messages about company culture and values. 5er!s = 6on-:ash Rewards >sed to recognize exceptional contribution, performance, commitment to culture and values. ?ariety of methods including additional time off, tic!ets to events, trips, dinners, public recognition, etc. 'ntrinsic Rewards;< -5erformance Feedbac! 3anagement ;< -+evelopment 9pportunities ;< -%or! 4nvironment 5rocesses used to communicate and align employee behaviors with business priorities

and company values to achieve desired results. 5lay a significant role in successfully engaging full scope of s!ills and abilities within the wor!force.:ritical in retaining !ey talent.

@AB C plan here are two main types of employer-sponsored retirement plans, defined benefit and defined contribution. A defined benefit plan, such as a traditional pension plan, sets the amount that the employer will pay to wor!ers upon their retirement. 'n defined contribution plans, the plan sets the amount of the contributions that an employer ma!es, not the benefit it will pay at retirement. 'n BDEF, section @AB.!/of the 'nternal Revenue :ode authorized a new !ind of defined contribution plan that allows the employee to ma!e pre-tax contributions to the plan. 'n a @AB.!/ plan, the employer sets up a special savings and investment account with an investment company, a ban! trust dept, or an insurance company. he employee agrees to put part of his or her salary into the plan through automatic deductions each pay period. his money is deducted before the employeeGs paychec! is taxed, so that it remains untaxed until it is ta!en out of the plan, often years or even decades later. 4mployers frequently match employee contributions up to a certain level, sometimes by as much as BAA percent, but are not required to do so. he money in the plan is invested into one or more funds provided in the plan according to choices made by the employee. he plans usually are intended to earn money over a very long period of time, which is much less ris!y than short-term investing.. 4mployees li!e @AB.!/ plans for several reasons. he tax deferral an obvious plus. 9thers popular features include the increased portability of this plan from one employer to another, the matching contributions, and the sense of control due to the ability to choose oneGs own investments. +etermine your organization$s salary philosophy. +o you believe in raising the level of base salaries in your organization or do you appreciate the flexibility of variable pay& A growing, entrepreneurial company, with variable sales and income, may be better off controlling the levels of base salaries. %hen times are good, the company can tie bonus dollars to goals achieved. 'n lean times, when money is limited, the company is not obligated to high base salaries. A longer-term company, with fairly stable sales and earnings, may put more money in base salary. Find Comparison Factors for Salar

%hile ' believe every organization can benefit from industry comparison studies, if conducted by reputable organizations, the bigger question is whether you are competitive within your local mar!et for most of your positions. Research the salary range for similar positions and "ob descriptions. he "ob description is particularly important for comparisons but usually harder to find for comparison. +etermine whether you are competitive with similar positions with organizations of similar size, sales, and mar!ets. 'f you can find companies in the same industry, especially in your area or region, that is another good comparison source. %hat 0oals 3ust *alary )elp Hou Achieve& 5ay must relate to the accomplishment of goals, the company mission and vision. Any system that offers an employee the 2average2 increase for their industry or length of service .usually B-@ percent/ is counter-productive to goal accomplishment. 4ven an above-average increase that differentiates one staff person from another can demotivate. 9ne manager at a 03 plant offered his star staff person a seven percent increase because she had accomplished all of her goals and 2wal!ed on water.2 3otivating& *hould have been, however it was not when the staff person !new others in the organization were receiving ten percent increases and more. Additionally, your pay system must help you create the wor! culture you desire. 5aying an individual for his performance accomplishments alone, will not help you develop the team environment you want. hus, you must carefully define the wor! culture you want to create, and aim your best salary increases at those contributing to the success of that culture. 'f you want your organization to change, define the change, and pay employees commensurate with their support of and contribution to the change. Finally, your salary strategy must align with your human resources goals and strategies. 'f the )R function is charged with developing a highly s!illed, outstanding wor!force, you must pay above industry or regional averages to attract the quality employees you see!. 5aying less than comparable firms will bring you mediocre employees and fail to fulfill the desire to create an outstanding wor!force. 'f, on the other hand, the )R strategy is to get cheap labor in the door quic!ly with little regard for turnover, you can pay people less salary. Assess the Competition and La"or Mar-ets %eGre currently experiencing a period of high unemployment. 3any s!illed people are available because of "ob loss, the economic downturn, the demise of many dot com companies, and other reasons. :onsequently, the economic reality is that you may be able to hire good people for less money than in the past. his may be short-term thin!ing, however. +onGt get too far out of line with what you would have paid that employee during better times. Hou ris! losing her when the

economy improves. *he may never feel valued by your organization if her pay is out-ofline with her experience and contribution. *he may never really stop her "ob search, using your company as a resting place until the right offer arrives. Hou will also want to consider percentages of increase in salary in similar "obs in your local area. As! yourself if this is an employee you really want to !eep& 'f so, pay the employee a salary that ma!es you the employer of choice. Create Salar )an%es !ithin 2our Or%ani/ation 5eople always tal! about salary and pay issues. 6o matter how many times you as! them not to discuss their salary and other personnel issues at wor!, they do. hus, grouping similar positions with similar responsibility and authority into pay ranges, usually ma!es sense. 6othing impacts morale as much as individuals who feel they are underpaid in comparison with others based on their contribution and that of other similar "obs. Recognize Hour #enefit 5ac!age Role in *alary *atisfaction An organization that offers better than average benefits may pay less salary and still have motivated, contributing employees. 'f your health plan fees go up and you continue to pay the cost, this is the same as pay in your employeesG poc!ets. he range of benefits you offer, and their cost to the employer, is a critical component of any salary approach. he biggest mista!e organizations ma!e is failure to communicate the value of the benefits offered. Determine $onus Philosoph and Potential Hou may pay a bonus that is determined individually based on the value of the goals accomplished and the person to your organization. Hou may give all employees the same bonus, based on group goal attainment, across the board. Hou may use profit sharing in which a portion of company profits is paid out equally to every person who was employed during the time period. %ays to address bonus, as part of your overall pay system, are limited only by your imagination. ' recommend bonus structures that are fair, consistent, understandable, communicated up front, and tied to measurable, achievable goals. he better the shared picture of what constitutes eligibility for a bonus, by the organization and the employee, the more li!ely the bonus will result in employee motivation and success. :ommunicate Hour *alary 5hilosophy and Approach. 'n many organizations, who gets what and why is a cause for consternation, gossip, demotivation, and unhappiness. he more transparent you ma!e your pay and salary philosophy and determinationsI the more li!ely you are to achieve positive employee morale and motivation. +onGt !eep your salary philosophy a secret. Hes, individual compensation is confidential, but your methods for determining pay must be clear and

understandable. Conclusion 'f you ta!e these tips to heart and apply them within your organization, you increase the li!elihood that youGll have happy, motivated employees. he alternative is to use your salary system to create disgruntled, grumbling, unhappy people. %hich group do you thin! will do a better "ob of serving your customers& 'ncreasing your profitability& 3a!ing you the employer of choice& 'ncreasing your positive visibility in your community& 's there any question in your mind&