Performance-Based Compensation

Inherent limitations in the ability of traditional compensation systems to recognize outstanding employee performance have resulted in two major performance-based reform initiatives: merit pay, also referred to as pay for performance, and pay banding, also referred to as broadbanding. Of the two reforms, merit pay is perhaps the more commonly proposed and has received the most scholarly attention. The basic intent of merit pay plans is to develop pay practices that link wage rate levels or salary increases to employee performance measurement outcomes. The underlying premise is that by this linking, organizations can more effectively encourage individual performance and increase the overall level of organizational performance. Merit pay reform efforts have their roots in the US Civil Service Reform Act of 1978, which implemented merit pay reforms for senior federal employees. As a component of broader new public management reform initiatives, merit pay reforms were later adopted at the state and local government levels in the United States and internationally in such countries as Australia, Canada, and the Netherlands (Ingraham, 1993; Kellough & Lu, 1993; Cardona, 2007).

Despite their continued and widespread adoption, scholarship on the impact of merit pay reforms has consistently shown that in most circumstances, merit pay compensation practices do not achieve their goal of increasing employee or organizational performance (Cardona, 2007; Perry, Engbers, & Jun, 2009; Bowman, 2010).

As part of a jointly sponsored research effort by the Organization for Economic Cooperation and Development and the European Union (EU), Cardona (2007) found no empirical support for merit pay reforms having a positive impact on performance or motivation for managerial and nonmanagerial employees. Instead, he points out that prior reviews of merit pay implementation in EU member countries identified a number of shortcomings, including the inability to adequately measure employee performance for many occupations, “costly and time-consuming” processes, and an inability to effectively address underperformance (p. 3). Cardona posits that it may be more beneficial to maintain traditional compensation systems with strong ties to pay grades since they provide a “greater deal of predictability for employees and reduce the likelihood of arbitrariness in determining individual salaries” (p. 6).

In analyzing over fifty-seven studies of merit pay, Perry et al. (2009) find that “performance-related pay in the public sector consistently fails to deliver on its promise” of such benefits as increased individual and organizational performance (p. 43):

• Merit pay plans have typically fallen short in changing employee perceptions of the relationship between their compensation and performance.
• Merit pay plans are commonly affected by organizational factors such as the quality or effectiveness of an employee performance appraisal system and the levels of financial incentives tied to employee performance appraisals.
• Merit pay plans are likely to experience greater odds of success for positions “in which job responsibilities are fairly concrete and measurable” (p. 44).
• Differences in institutional frameworks between the public and private sectors, such as the transparency inherent in public sector compensation systems, may play a greater role in limiting the successful implementation of merit pay plans.
• Theoretical frameworks more closely aligned with public employment (e.g., public service motivation) may be better resources for seeking to improve public employee performance.

Echoing many of Perry et al.'s (2009) observation, Bowman (2010) highlights an often cited report by the US Merit Systems Protection Board (2006) asserting that the successful implementation of merit pay plans requires public organizations to possess the following characteristics: “a culture that supports pay for performance; effective and fair supervisors; a rigorous performance evaluation system; adequate funding; a system of checks and balances to ensure fairness; appropriate training for supervisors and employees; and an ongoing system evaluation” (p. xii). However, even if these requirements are met within an organization, Bowman aptly points out that the implementation of such pay plans may result in unintended consequences such as a focus on short-term outcomes or reduced performance as a result of limited expectations.

Pay banding has often been proposed by compensation reformers for its ability to provide greater managerial flexibility in setting employee wage rates. Under these plans, traditional, fixed-rate pay grades are consolidated into a smaller number of pay bands with corresponding maximum and minimum pay ranges. Managers are then granted the discretion to set the pay rate for an individual employee anywhere within the occupation's corresponding pay band. For example, if a particular occupation is placed within a pay band with a minimum annual salary of $50,000 and a maximum salary of $80,000, a manager hiring a new employee within this band would be able to set the pay rate anywhere within that range.

While pay-banding has not experienced the same level of attention as merit pay in the broader literature, its related reform initiatives have experienced a similar record of success as a result of many of the same challenges that merit pay plans face. For example, Whalen and Guy (2008) provide a comprehensive overview of pay-banding adoption across US state government and an in-depth study of implementation challenges in three states. They report adoption by only twelve states, with limited adoption by an additional four states. The states that considered pay-banding reform but chose not to move forward with implementation communicated their skepticism of the potential benefits of pay-banding reforms over traditional compensation systems. In addition, the states selected for a more detailed analysis indicated significant problems with the implementation of their reforms. Two of the primary reasons for implementation failure were insufficient funding for potential salaries within pay bands and a lack of formal discretion delegated to managers to set individual pay rates.

Comparative Compensation

Related to the challenge of using existing public compensation systems to reward high-performing employees, there has been a renewed discussion on the competitiveness of public sector wages, especially given scholarship evaluating the impact of pay on key human capital metrics. One of the primary goals of broader compensation strategies is to ensure that organizations possess the necessary human capital to fulfill their missions. Conventional wisdom has held that organizations unable to meet this goal will likely experience the harmful effects of decreased employee satisfaction and increased employee turnover or turnover intent.

Overall, there have been mixed findings concerning the relationship between compensation and turnover, one of the most common measures associated with effective human capital management. For example, research has commonly found pay to be a predictor of job satisfaction (Ellickson & Logsdon, 2001), and prior research has found evidence of an indirect relationship between job satisfaction and turnover intent (Moynihan & Pandey, 2008). Research has also found support for the indirect impact of pay satisfaction on turnover intent (Bertelli, 2007), even when controlling for organizational satisfaction (Lee & Whitford, 2008). Turnover intent, however, is not operationally equivalent to actual employee turnover. While research has found support for the indirect impact of pay levels on voluntary turnover rates (Selden & Moynihan, 2000), more recent research did not find a significant relationship between relative pay rates (public and private pay gaps) on voluntary turnover (Llorens & Stazyk, 2011). This somewhat contradictory finding is most likely explained by the role that defined-benefit compensation programs have played in retaining public sector employees. Since two of the core characteristics of defined-benefit pay plans are their nonportability and link between years of service and final benefit levels, it is not uncommon for public employees to remain with their employer despite dissatisfaction with their overall pay levels.

Although absolute pay comparability between the public and private sectors (external equity) has not traditionally been one of the goals of public sector compensation systems, given perceived public sector employment benefits like job security and the opportunity to serve the public interest, there has been a growing debate on the extent to which public sector pay is comparable to private sector pay. Much of this research has been driven by two sometimes competing perspectives. From the perspective of many public sector employers, there has been a growing acceptance that for many occupations, public sector wages are simply too low to compete for high-quality job candidates, especially in the science and technology fields (US Bureau of Labor Statistics, 2009). This drive to remain competitive in the broader labor market has been the catalyst for such pay reforms as FEPCA, which instituted differential federal pay rates by geographic location (locality pay) and set a goal of federal pay rates falling within 5 percent of comparable private sector pay rates. Overall, FEPCA has been quite successful in increasing federal pay rates in high-cost geographic regions such as northern California and the upper East Coast. However, the movement toward full pay comparability has not been as successful.

In contrast to the prevailing view of many public employers on the competitiveness of their wages, there is a competing perspective, held by many nongovernmental organizations and independent researchers, that public sector employees are in some circumstances overpaid when compared to their private sector counterparts. Miller (1996) notes that the basis for competing perspectives on the state of public sector pay lies in the fact that from a methodological standpoint, one can come to drastically different conclusions on pay comparability depending on how comparisons are made and the underlying data used to estimate wage differences. For example, if average wages are compared between the public sector and private sector, results can often be contradictory. Individual-level data provided by US Bureau of Labor Statistics (BLS, 2011) suggest that US public sector workers are overpaid compared to their private sector counterparts. However, using data from an international survey of public and private sector employees, Taylor and Taylor (2011) find that US public sector employees are underpaid compared to the private sector counterparts, while public sector employees in countries such as Canada, Spain, and Japan are considerably overpaid. Both of these results, however, mask the occupational differences in employment sectors, such that the average wage for private sector employment is driven down by low-wage, service sector occupations that generally have no equivalent in the public sector.

To address this shortcoming, researchers have commonly used one of two additional means of comparing public and private pay: occupational and individual comparisons. Given its annual mandate for providing comparisons of federal and private sector to the president, BLS routinely surveys the salaries of private sector occupations that are comparable to those in the federal service. Results using this occupation-based approach have consistently found that federal salaries for lower-graded occupations fall above comparable market rates, while salaries for high-graded occupations fall below comparable market rates (Condrey et al., 2013). These results at the federal level have also been replicated for the public sector as a whole, with prior research pointing out that on average, lower-skilled occupations in the public sector tend to experience higher relative wage rates, while higher-skilled occupations tend to experience lower relative wage rates (Donahue, 2008).

A second method of estimating wage comparability, primarily used in the labor economics literature, compares the wages of individual workers in the public and private sectors while controlling for common human capital characteristics such as age, education, and experience (the human capital approach). Results derived from this approach vary considerably, with evidence of both public sector wage premiums and penalties, dependent on such factors as level of government, geographic location, union strength, ethnicity, and gender (Center for State and Local Government Excellence, 2011). For instance, research using this methodological approach has found evidence that women and minorities in the public sector often enjoy higher wages than their private sector counterparts, arguably due in part to the wage discrimination protections inherent in traditional civil service classification and compensation systems (Llorens, Wenger, & Kellough, 2008).

Retirement Benefits

Along with the difficulty in making broad assessments concerning the overall competitiveness of public sector wage rates, the Great Recession prompted a renewed focus on nonwage compensation in the public sector, particularly postemployment retirement benefits.

Public employers face considerably different decision processes when seeking to develop an appropriate mix of wage and nonwage benefits. In practice, the public and political nature of the wage- and benefit-setting process has resulted in government wage rates that have historically been perceived as falling below comparable market rates for many occupations in the public sector. Underlying this perceived norm of modest or below-market wage rates is the common opinion that public sector employment possesses a number of unique benefits not found in private sector employment. First and foremost, public sector employment has been considered much more stable than private sector employment since public agencies are rarely eliminated and government entities can always raise additional revenue through tax increases to fund operations. Public employment has also been viewed as a form of public service by both employees and the general public. As a result of these factors, highly competitive pay rates have not been viewed as critical to staffing and maintaining a high-quality workforce.

While job security and the opportunity for public service have been viewed as significant benefits to public sector employment, generous retirement benefits have also been used as a means of increasing the attractiveness or competitiveness of public sector compensation packages in both the United States and internationally (Pew Center on the States, 2010; Ponds, Severinson, & Yermo, 2011). Retirement benefits are typically distinguished between more traditional defined-benefit plans (pensions) and more recently adopted defined-contribution plans (401k-style plans). Defined-benefit plans, once the norm for large public and private employers, promise a lifetime benefit to retired employees and commonly require employees to contribute a percentage of their annual wages into an employer-managed fund during their active employment. Contribution rates during employed years can vary at the discretion of the employer, along with aspects such as vesting requirements and final benefit levels. The defining characteristics of these plans are their nonportability and promise of lifetime benefits to retirees regardless of the performance of invested pension contributions made by employees and employers.

Newer defined-contribution plans differ substantially from their older defined-benefit counterparts. Originally developed as supplemental retirement options, these plans provide employees with the option of contributing a percentage of their wages to an employee-managed retirement fund with both employee contributions and employer matching contributions. Employees are typically granted the discretion of determining what percentage of their wages will be placed into the fund, and employers have the discretion of matching employee contributions at a rate they feel appropriate. Unlike defined-benefit plans, employees, not employers, are responsible for managing the investment of their retirement account according to their individual risk tolerance. Most important, on retirement, employees receive the invested balance of their retirement fund that can be converted into an annuity or taken as a lump-sum payment. The balance of a retirement account represents all that employees will have during their retirement years, which can potentially be exhausted if an employee has not saved enough during employment, has experienced significant investment losses, or has a longer-than-anticipated life expectancy. Employers, however, view these plans as a more favorable benefit option since they cut long-term retiree obligations. Over the past thirty years, most private sector employers have abandoned their traditional pension plans in favor of defined-contribution plans (Jaffe, 2004). Recent estimates published by BLS (2014) show that only 19 percent of private sector employees in the United States have access to defined-benefit retirement plans, while over 59 percent have access to defined-contribution plans.

Unlike their private sector counterparts, public employers have, by and large, maintained their defined-benefit plans, and for many in the public sector, they are viewed as more beneficial due to their traditionally low risk and guarantee of lifetime benefits regardless of market performance. The BLS (2014) estimates that approximately 83 percent of state and local government employees still have access to defined-benefit retirement plans, while only 32 percent have access to defined-contribution plans. Prior research has also pointed out that since the characteristics of defined-benefit plans have not received the same level of public scrutiny as wage rate levels, many public employers have historically opted for increasing the generosity of pension benefits in lieu of increased wage rates (Pew Center on the States, 2010). While increases in public pension benefits did not receive a great deal of attention during the economic boom years of the 1990s and early 2000s, there have been increasing alarms concerning the unsustainability of such plans in light of widespread losses in government pension funds since 2007.

While private-defined benefit plans in the United States are insured by the Pension Benefit Guarantee Corporation in case private employers go out of business, public plans receive no such insurance. As a result, public employers are responsible for covering retirement obligations regardless of the performance of their pension investments. The Pew Charitable Trust has been one of the leading voices calling attention to this issue in recent years. In 2010, it estimated that state and local government pension funds were underfunded by approximately $757 billion, and without significant reforms, many states and localities would be forced to cut vital services in order to meet their obligations to retirees. At the state level, Illinois stands out for its low level of pension funding and impending cutbacks due to rising pension costs. As a result of such factors as lower-than-anticipated investment returns, inadequate employer contributions, and employee benefit increases, Illinois's pension plan was underfunded by approximately $95 billion in 2013 (Pew Center on the States, 2013). As a result, an increasing percentage of taxpayer dollars has been dedicated to paying pension obligations. Recent estimates suggest that roughly 20 percent of all tax dollars go toward paying pension costs (Pew Center on the States, 2013).

The issue of unfunded pension liabilities is not confined to the United States. Given the global nature of today's economic markets, a number of countries worldwide are also facing challenges in meeting their long-term pension obligations. An analysis of pension underfunding by the OECD found that while some countries, such as Canada and Sweden, possess financial reserves that exceed their liabilities, others, including the United Kingdom and Australia, face underfunding at levels comparable to US state and local government employers (Ponds et al., 2011).

For governments, both nationally and internationally, facing the challenge of resolving unfunded pension liabilities, there has been a growing push for compensation reform rooted not in earlier performance-related goals but in the perceived inability of public employers to maintain nonwage benefit packages at levels that have historically been provided. These financially driven reforms have taken a number of approaches to driving down retirement costs, but most focus on substantially reducing benefits afforded to current and future employees through such initiatives as increasing retirement eligibility age levels, increasing employee contributions to pension funds, and, in more extreme cases, creating retirement benefit plans that incorporate aspects of defined-contribution plans. For example, facing a $13.4 billion pension liability, the State of Rhode Island enacted pension reforms in 2011 that raised the retirement eligibility age from sixty-two to sixty-seven and moved current and future state employees from a traditional defined-benefit plan to a reduced defined-retirement benefit and a newly added defined-contribution plan (Pew Center on the States, 2011). Under this new plan, guaranteed lifetime benefits were reduced by nearly 50 percent with the expectation that employees would be able to supplement their retirement earnings through managed investments in their defined-contribution plan.

The growing inability of many public employers to cover their long-term pension liabilities will inevitably add fuel to the growing calls for benefit reforms such as the type enacted by the Rhode Island.