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Part 4 Compensating and Managing Human Resources

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Chapter

10 Compensation: Base Pay and Fringe Benefits *

The Tribune Company developed a new performance management system, closely fol-

lowing the prescriptions provided in Chapter 7. At an orientation session in which the

new system was introduced to management, the first several questions had to do with the

relationship between the new system and pay. Pay is very important to people and very

important to organizations. Research on high-performance work systems indicates that

characteristics of a firm’s compensation system are strongly related to corporate financial

performance. 1

In December 2010, private employers in the United States spent an average of $27.75 per

hour worked on total employee compensation. Cash compensation averaged $19.64 per hour

(70.8 percent of total compensation) while per hour benefits costs were $8.11 (29.2 percent

of total compensation). 2 Figure 10-1 depicts these average per hour compensation costs

and the percent each component bears to overall compensation. But the general perspective

about pay programs looks bleak. A February 2011 survey identified salary as the leading

cause of employee dissatisfaction among U.S. workers (47 percent), followed by workload

(24 percent), lack of advancement opportunity, and the individual’s manager or supervisor

(both at 21 percent). 3 In his book, The Big Squeeze, New York Times reporter Steven Green- house asserts, “A profound shift has left a broad swath of the American workforce on a lower

plane than in decades past, with health coverage, pension benefits, job security, workloads,

OVERVIEW

O B J E C T I V E S

After reading this chapter, you should be able to

1. Understand the traditional model for base pay programs.

2. Describe the basic approaches to job evaluation.

3. Describe the contemporary trends in compensation.

4. Explain the role of government in compensation.

5. Understand the various forms of fringe compensation, including

government-mandated programs.

6. Define the different types of retirement plans.

7. Understand the complexities of international compensation.

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*Contributed by Christine M. Hagan.

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4 / Compensating and Managing Human Resources

stress levels, and often wages growing worse for millions of workers” (p. 4). While the

productivity of the U.S. workforce rose more than 15 percent between 2001 and 2008, the

average wage for the typical American worker increased by 1 percent. 4 Between January

and July 2009, pay was frozen in half of U.S. companies. (Most of these freezes were lifted

by late 2010. 5 ) A 2009 survey reported that only 30 percent of organizations believe that

supervisors and line managers communicate and manage pay programs effectively. 6

The term compensation refers to all forms of financial returns and tangible benefits that employees receive in exchange for their time, talents, efforts, performance and results. 7 As the business environment becomes increasingly complex and global, the chal- lenge to create and maintain effective compensation programs, given cost constraints, also

requires greater professional expertise, organizational understanding, creativity, and vision

than ever before.

Over the last decade, several compensation trends are noteworthy. First, there has been

a dramatic increase in the diversity of pay strategies and practices. Not too long ago, em-

ployees received a base salary (which the organization probably described as being “com-

petitive”) and a set of preestablished benefits (which the organization probably described

as being “comprehensive”). Today firms are providing variable pay, special recognition

bonuses, individual and group incentive plans, and broad-based success-sharing programs

at all levels in the organization, and flexible benefits are becoming the norm.

The second trend has been the soaring cost of employee benefits. There is general

consensus that our traditional approach to health care is “unsustainable,” but there is little

consensus about how to effectively revise the system. In the private sector, traditional pen-

sion plans have been replaced with less costly programs, which will provide considerably

lower retirement benefits. In the public sector, pension plans and other benefits are under

siege in many places because of their high price tags and because taxpayers bitterly resent

funding benefits for public workers that exceed those to which most taxpayers are entitled

as private sector workers. The future of Social Security and Medicare are in question.

Third, there continues to be significant pay inequity when comparing pay at the “top” of

the firm with pay at the “bottom.” In 1980, CEOs earned 42 times the average worker; by

1990 that figure had increased to 120 times; and in 1997 the ratio was 280 to 1. The dispar-

ity peaked in 2000 when CEOs earned 531 times the average worker in the firm. In 2009,

it was estimated to have fallen back to 263 to 1. 8 According to experts, “U.S. CEOs are far

and away the highest paid CEOs in the world. Yet, from a long-term perspective, and com-

pared to CEOs in other countries, they cannot be considered the very best performers.” 9

In a 2010 study, for every additional 10 percent increase in revenues in the private sector,

3 percent of those revenues went straight to CEO compensation. 10 The 2008 collapse of

major U.S. financial institutions, which were managed by extremely well-paid executives,

only added fuel to the fire. While Merrill Lynch’s 2008 losses soared to $27.6 billion, its

Figure 10-1 Average Employer Costs per Hour Worked

  Cost Percent

Total compensation $27.75 100 Wages and salaries 19.64 70.8 Total benefits 8.11 29.2 Paid leave 1.89 6.8 Vacation .96 3.5 Holiday .60 2.1 Sick .24 .9 Personal .09 .3 Supplemental pay .75 2.7 Insurance 2.22 8.0 Retirement and savings .97 3.5 Legally required benefits 2.28 8.2 Social Security and Medicare 1.64 5.9 Unemployment insurance .21 .8 Workers’ compensation .42 1.5

Source: Adapted from the Bureau of Labor Statistics (Private Industry Employees, December, 2010). Accessed April 19, 2011, from http://www.bls.gov/news-release/pdf/ecac.pdf

Four trends

Diversity in strategies

Soaring benefits costs

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10 / Compensation: Base Pay and Fringe Benefits

45-year-old top investment officer’s 2008 pay was $33.8 million in cash and stock, a bit

less than he was awarded in 2007. In fact, while Merrill’s very survival was in question, 11

of its executives were paid more than $10 million each, and an additional 149 employees

earned more than $3 million. The issue of such rewards in the face of record losses created

public outcry, particularly when the federal government stepped in with taxpayer dollars

to cover Merrill’s losses. 11

The fourth key trend is that pay programs are increasingly being used to communicate ma-

jor change in organizations, particularly during and after major downsizing and reengineering

efforts. As IBM began to rebuild itself in the late 1990s, one of the key tools for change was

a complete redesign of the pay system. IBM scrapped its traditional approach to evaluating

work and its pay grade structure. It reduced the number of different jobs from 5,000 to fewer

than 1,200. It significantly increased the percentage of an individual’s pay that was directly

related to performance and created pay-at-risk programs at all levels in the organization (a big

first for IBM!). 12 Although HR and compensation experts continued to design and develop

the framework of the pay program, significant day-to-day administration of the program was

transferred to line managers, making compensation more of a management tool than an HR

program. Compensation experts have traditionally argued the importance of directly align-

ing business strategies and compensation programs. This past decade, however, has seen a

rethinking of the role that compensation programs play in supporting, communicating, and

even leading the way to new organizational values and performance norms.

As a result, compensation programs are in a state of transition. Organizations are

experimenting with different types of structures; they are allocating money differently

to programs; they are questioning the traditional (rather rigid) “job-based” approach to

compensation program design; they are looking for innovative ways to get more for their

investment in compensation; and they are putting more of a focus on long-term success

criteria.

Does pay matter? Research suggests that reward systems can influence a company’s

success (or failure) in three ways. 13 First, the amount of pay and the way it is packaged

and delivered to employees can motivate, energize, and direct behavior. IBM’s compen-

sation program redesign (described previously) was directly targeted at changing the way

IBMers thought about their work, focused their energies, and directed their performance.

Second, compensation plays an important role in an organization’s ability to attract and

retain qualified, high-performance workers. Unless applicants find job offers to be ap-

propriate in terms of the amount and type of compensation, they may not consider em-

ployment with a particular firm. Compensation strategies and practices can clearly shape

the composition of a workforce. This is especially important for firms operating in tight,

high-expertise labor markets. Microsoft, for example, sets out to hire a certain percent-

age of the top technical talent that graduates each year. In addition to investing heavily

in recruiting and selection activities, Microsoft offers job candidates a generous sign-on

bonus, a competitive base salary, stock options, and a flexible benefits program, which

allows individuals to select the benefits and coverage that they both need and value most.

Finally, the cost of compensation can influence firm success. On average, the over-

all cost of labor is estimated to be 65–70 percent of total costs in the U.S. economy

and is similarly substantial elsewhere. 14 Within the United States, firms that wish

to pursue a strategy based on cost leadership must find ways to reduce those costs

without sacrificing quality. Organizations that compete in global marketplaces have

greater cost-competitive pressures. In 2009, average hourly total compensation costs

(cash compensation plus benefit costs in U.S. dollars) for a U.S. manufacturing worker

was $33.53, which was lower than costs in 12 European countries and Australia, but

higher than the costs of 20 other countries tracked by the U.S. Bureau of Labor Sta-

tistics (BLS). Norway reported the highest per hour manufacturing compensation

costs ($53.89), while the Philippines posted the lowest ($1.50). Mexico’s average

hourly compensation cost $5.38. Across Europe, the average hourly cost was $31.95

(21  countries tracked). Figure 10-2 presents an international comparison of hourly

compensation costs in manufacturing. The U.S. Bureau of Labor Statistics also reports

that average compensation costs (U.S. dollars) in manufacturing for China have in-

creased from $0.62 per hour (in 2003) to $1.36 per hour (2008). In India, those costs

A state of transition

Does pay matter?

Pay programs to communicate change

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Greece

Israel

Singapore

New Zealand

Korea, Republic of

Portugal

Slovakia

Czech Republic

Argentina

Hungary

Brazil

Taiwan

Poland

Mexico

Philippines

Estonia

Spain

0 20 40 600 20 40 60

53.89

49.56

49.40

48.04

46.52

44.29

43.77

43.50

40.08

39.87

39.02

34.97

34.62

33.53

30.78

30.36

27.74

19.23

18.39

17.50

17.44

14.20

11.95

11.24

11.21

10.14

9.83

8.62

8.32

7.76

7.50

5.38

1.50

Norway

Denmark

Belgium

Austria

Germany

Finland

Netherlands

France

Ireland

Australia

United States

Canada

Japan

United Kingdom

Italy

Sweden

Switzerland

29.60

358

4 / Compensating and Managing Human Resources

have increased from $0.81 (2003) to $1.17 (2007). 15 While the BLS reports average

hourly compensation costs for China and India, it researches and presents them sepa-

rately from European and Western Hemisphere data. This is because Chinese statistics

on manufacturing employment do not tend to conform to international standards, and

India’s employment statistics only cover “organized manufacturing” (which represents

about 20 percent of India’s manufacturing sector). However, these labor cost increases

reported for both countries suggest that competitive cost advantages enjoyed by China

and India may be showing signs of some erosion. In summary, then, the strategy and

structure of compensation programs have important implications for businesses and their

ability to create and sustain competitive advantage.

Does compensation matter to individual workers? Recent discussions suggest that

money motivates people on two basic dimensions. The instrumental meaning of money

relates directly to what money buys: better houses, better educations for children, bet-

ter vacations, clothes, and cars. The symbolic meaning of money concerns how wealth

is viewed by ourselves and within our society in general. In the United States, “rich” is

usually equated with “successful,” “intelligent,” “diligent,” and “highly motivated,” while

“poor” tends to be equated with “failure,” “unmotivated,” “uneducated,” perhaps “lazy”

and “slovenly.” One discussion of the issue pointed to all the money-oriented slang expres-

sions used in our culture as an indication of the value of material possessions: “put your

money where your mouth is,” “crime doesn’t pay,” “paying the piper,” “hitting pay dirt,”

“you get what you pay for,” and “there is no free lunch.” 16

In job situations, money motivates behavior when it rewards people in relation to their

performance or contributions, when it is perceived as being fair and equitable, and when it

provides rewards that employees value. 17 Research supports the belief that U.S. workers pre-

fer pay that is based on their own performance—not the performance of the team, group,

or company. In one study, employees reporting the strongest preference for individual-

ized rewards were also the highest-performing employees. 18 Research also indicates that

Figure 10-2 International comparison of hourly compensation costs in manufacturing (in U.S. dollars-2009)

Source: Bureau of Labor Statistics (USDL 11-0303).

U.S. workers prefer individual pay-for- performance

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10 / Compensation: Base Pay and Fringe Benefits

Five Objectives for Effective Compensation

employee satisfaction with pay is correlated with organizational commitment and trust

in management, while it is inversely related to absenteeism, seeking alternative employ-

ment opportunities, voluntary terminations, pro-union voting, and incidents of theft. 19 It

is also interesting to note that the particular components of pay have different value to

different people. Research indicates that younger people tend to focus predominantly on

cash compensation. As people age, however, their preference tends to shift to benefits and

workplace flexibility. 20 It should be no surprise that life stage, career stage, and individual

circumstances create differences in compensation preferences.

What makes an employee satisfied with pay? Research indicates that individuals differ

in the way in which they conceptualize pay satisfaction. 21 According to equity theory, pay satisfaction is a function of the comparison of an individual’s input–outcome ratio with

his or her perceptions about the input–outcome ratios of referent others. In other words,

people compare themselves to others, focusing on two variables: inputs and outcomes. In-

puts refer to individuals’ characteristics (e.g., education, previous work experience, special

licenses), effort (e.g., how long they persist in seeking a solution to a problem), and per-

formance (e.g., number of units produced). Outcomes are what people get out of their jobs

(e.g., pay, promotion, recognition). It’s important to note that these comparisons are based

on perceptions, rather than on any objective, or quantifiable, measures of actual inputs and

outcomes. Also important is that these judgments are made in terms of ratios—that is, rela-

tionships of “equal to,” “greater than,” or “less than.” Pay satisfaction occurs when people

perceive that they are paid appropriately in relation to others. When employees feel under-

paid, they are dissatisfied and may withhold effort or engage in negative or counterproduc-

tive behaviors. What happens when these comparisons suggest that a worker is overpaid?

Originally, researchers hypothesized that individuals would feel guilty and would work

harder or smarter in order to close the gap. More recent evidence suggests that employees

whose comparisons and perceptions indicate that they are overpaid tend to rethink their

comparisons in order to find (or rationalize) a more equitable balance.

Does compensation matter at the societal level? Over the course of history, societies that

produced more also enjoyed higher standards of living. This means that their citizens en-

joyed higher qualities of life, including better transportation systems, higher levels of educa-

tion, more luxuries, better health care, and more time off. 22 In addition, governments tend to

use higher standards of living as platforms for social change. Legislation such as the Fair La-

bor Standards Act (which includes the minimum wage and child labor rules), the Employee

Retirement Income Security Act (ERISA), the Equal Pay Act (EPA), the Pregnancy Dis-

crimination Act, and the Age Discrimination in Employment Act (ADEA) are aimed at

ensuring that people are treated justly and that the poorer and less powerful members of

society are protected from flagrant abuse. Former president Bill Clinton championed leg-

islation to limit the tax deductibility of excessive executive compensation. Remember that

organizations deduct the compensation they pay to employees as a business expense when

they calculate their taxes. Excessive compensation to high-level employees, then, actually

reduces the amount of taxes paid by a corporation. Who makes up the shortfall? Clinton’s

law limited an organization’s deduction to $1 million for the compensation it paid to any

individual in any year unless the pay was specifically and explicitly based on performance.

At the same time, some argue that the relatively high cost of U.S. labor, in general, is the

principal reason that the United States has trouble competing globally in certain industries.

Some assert that industry setbacks can be traced to product price increases necessitated

by the unreasonable wage and benefits demands of its workers. Two-tier pay systems

are becoming more common in some industries (e.g., automotive, airlines) where newly

hired employees are paid at a significantly lower rate (and with fewer benefits) than other

employees doing the same work.

An effective compensation system typically has the following five objectives.

1. It enables an organization to attract and retain qualified, competent workers.

2. It motivates employees’ performance, fosters a feeling of equity, and provides direc- tion to their efforts. C

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Does compensation matter at the societal level?

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4 / Compensating and Managing Human Resources

3. It supports, communicates, and reinforces an organization’s culture, values, and competitive strategy, especially long-term strategy.

4. Its cost structure reflects the organization’s ability to pay.

5. It complies with government laws and regulations.

As organizations ponder changes to their compensation systems, they should consider

all five of these objectives. The ability to attract highly qualified individuals can be deter-

mined by selection ratios and vacancy rates. The ability to retain can be ascertained by looking at voluntary termination rates, perhaps in combination with performance appraisal

data (high turnover rates among the highest performers would be a sign that compensation

system changes may be in order). Employee surveys may provide insights into motivation

levels of workers. The compatibility of pay with corporate culture and competitive strategy

can be examined by looking at employee surveys, performance appraisal data, and other

performance indicators. And the cost structure should be assessed relative to the com-

pensation packages that competitors pay for the same type of work. Employees are very

sensitive to changes in their compensation. Major changes to their compensation can have

a profound effect on these objectives, for better or for worse.

Of course, all these considerations exist in the context of the numerous laws and regula-

tions that affect compensation. This last objective is quite a challenge and perhaps more so

since 2008. Although some federal laws (e.g., the National Labor Relations Act, discussed

in Chapter 13, and the Employee Retirement Income Security Act) preempt state laws,

employers could be subject to state and local laws and regulations in addition to the major

federal laws described in this chapter. Many states increased their minimum wage in 2012

above the federal minimum wage, and 20 states (and the District of Columbia) now protect

workers against discrimination on the basis of sexual orientation and/or sexual identity.

Three states (California, Washington, and New Jersey) currently require paid family leave.

As we discussed in Chapter 3, Title VII and ADEA “disparate impact” lawsuits involving

allegations of pay discrimination are quite common.

Compensation is divided up into two parts. Cash compensation is the direct pay pro- vided by employers for work performed. Cash compensation has two elements: base pay

(e.g., hourly or weekly wages plus overtime pay, shift differential, uniform allowances)

and pay contingent on performance (e.g., merit increases, incentive pay, bonuses, gain

sharing). Fringe compensation refers to employee benefits programs. Fringe compensa- tion also has two dimensions: legally required programs (e.g., Social Security, workers’

compensation) and discretionary programs (e.g., health benefits, pension plans, paid time

off, tuition reimbursement). This chapter covers base pay programs and fringe benefits. Pay that is contingent on measures of performance is covered in Chapter 11.

As indicated earlier, compensation systems are in a state of transition. Traditional de-

signs focus primarily on attracting and retaining qualified workers and complying with

government regulations. Newer pay models balance these concerns with increased atten-

tion to motivating and directing performance and to aligning pay with achieving important

firm effectiveness goals.

The traditional model for structuring base pay programs has existed in its relatively

unchanged form for more than 50 years. 23 In the 1800s business owners knew their em-

ployees, their performance, and their financial needs, and individual pay was established

on that basis. As businesses grew, bureaucracies were created to provide structure, orga-

nization, and direction. Professional managers replaced business owners, while rapidly

growing hierarchies distanced them from most workers. Efficiency and effectiveness

became the most important business objectives. In the late 1800s, Frederick Taylor de-

signed a formal, systematic way of assigning pay to jobs while helping a steel company

identify methods for improving productivity. His methodology came to be called job evaluation.

CASH COMPENSATION: BASE PAY

Attract and retain employees

Motivate employees

Compatible with long-term strategy

Ability to pay

Numerous federal, state and local laws and regulations

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10 / Compensation: Base Pay and Fringe Benefits

Job Analysis

Will written descriptions be used?

Yes

No

Which approach will be used to develop the

job worth hierarchy?

Labor Market Data Collection and

Analysis

M ar

ke t D

at a

Job C ontent

Em phasis

Em ph

as is

Job Content Evaluation

Job Descriptions

Reconciliation of internal and external

considerations

Job Content

Evaluation

Labor Market Data Collection

and Analysis

Job Worth Hierarchy

Pay Structure

Figure 10-3 The Traditional Approach to Compensation

Source: Reprinted from “Elements of Sound Base Pay Administration,” 2nd edition © 1998, with permission from WorldatWork, 14040 N. Northsight Blvd., Scottsdale, AZ BS260; phone (877) 951-9191; fax (480) 483-8352; www.worldatwork.org © 2005 WorldatWork. Unauthorized reproduction or distribution is strictly prohibited.

In the following sections, we describe the traditional approach to base pay administra-

tion, examine some recent trends in base pay program design, and discuss the govern-

ment’s role in shaping employer practices in cash compensation. Figure 10-3 depicts and

summarizes the steps involved in creating and installing a traditional compensation plan.

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