Our senior leadership team wants to focus on compensation this quarter. Currently, our raises and bonuses are tied to performance. Can you help me to understand the HR best practices for raises based on performance vs. raises based on market factors?
It sounds like your senior leadership team prefers to place an emphasis on performance when it comes to making decisions regarding compensation increases. This is the most common strategy used by employers as it rewards desired outcomes and motivates employees.
However, there are some downsides to basing compensation increases solely on performance. One of those is referred to as “wage compression”. This happens when new employees (whose pay will necessarily be based on the going market rate) come in at a starting salary close to or higher than your employees with tenure.
It’s very common for the market value of certain jobs to increase over time. Often this increase occurs at a higher rate than annual performance-based compensation increases, which are generally in the range of 1% – 4% of salary. As a result, new employees may end up earning close to or even more than high performing senior employees, unless of course you make a habit of taking the market value of a position into account when doing regular salary reviews.
Because of this, we recommend against taking market data completely out of compensation planning. It’s certainly okay to make performance your primary focus, but if a top performer can finagle a big raise with your competitor because the value of their position has increased at a quicker pace than their salary, they may be tempted to do so.