Reward schemes for employees and management

http://www.accaglobal.com/en/student/acca-qual-student-journey/qual-resource/accaqualification/p5/technical-articles/reward-schemes-for-employees-and-management.html A major part of performance management involves managing employees and managers as their performance will have a major effect on the performance of the organisation as a whole. !his article loo"s at how reward schemes can be used to influence the behaviour of employees

#eaning of reward schemes A broad definition of reward schemes is provided by Bratton: Reward system refers to all the monetary, non-monetary and psychological payments that an organisation provides for its employees in exchange for the work they perform. Rewards schemes may incl!de extrinsic and intrinsic rewards. "xtrinsic rewards are items s!ch as financial payments and working conditions that the employee receives as part of the #ob. $ntrinsic rewards relate to satisfaction that is derived from act!ally performing the #ob s!ch as personal f!lfilment, and a sense of contrib!ting something to society. %any people who work for charities, for example, work for m!ch lower salaries than they might achieve if they worked for commercial organisations. $n doing so, they are exchanging extrinsic rewards for the intrinsic reward of doing something that they believe is good for society.

$bjectives of a reward scheme &hat do organisations hope to achieve from a reward scheme' (he following are among the most important ob#ectives: ). (o s!pport the goals of the organisation by aligning the goals of employees with these. *. (o ens!re that the organisation is able to recr!it and retain s!fficient n!mber of employees with the right skills. +. (o motivate employees. ,. (o align the risk preferences of managers and employees with those of the organisation. -. (o comply with legal reg!lations. .. (o be ethical. /. (o be affordable and easy to administer.

Aligning the goals of the organisation and employees (he reward scheme sho!ld s!pport the organisation s goals. At the strategic level, the reward scheme m!st be consistent with the strategy of the organisation. $f a strategy of differentiation is chosen, for

Reward schemes for employees and management

example, staff may receive more genero!s benefits, and these may be linked to achieving certain skills or achieving pre determined targets. $n an organisation that has a strategy of cost leadership, a simple reward scheme offering fairly low wages may be appropriate as less skilled staff are re0!ired, new staff are easy to recr!it and need little training, so there is less incentive to offer genero!s rewards. (he 12 s!permarket gro!p &almart competes on low cost. $t recr!its employees with low skills, and pays low wages. $t disco!rages staff from working overtime, as it wishes to avoid paying overtime rates.

!o recruit and retain sufficient employees with the right s"ills $f rewards offered are not competitive, it will be diffic!lt to recr!it staff since potential employees can obtain better rewards from competitors. "xisting staff may also be tempted to leave the organisation if they are aware that their reward system is !ncompetitive. 3igh staff t!rnover can lead to higher costs of recr!itment and training of new staff. 4osing existing employees may also mean that some of the organisation s acc!m!lated knowledge is lost forever. 5or many knowledge-based organisations, the h!man capital may be one of the most val!able assets they have. 3igh technology companies s!ch as %icrosoft are companies that trade on knowledge, so offer competitive rem!neration to key staff.

!o motivate employees %otivation of employees is clearly an important factor in the overall performance of an organisation. 6rganisations wo!ld like their employees to work harder, and be flexible. (he link between reward schemes and motivation is a complex iss!e that is hotly debated in both acco!nting and h!man reso!rce-related literat!re. A well-known theory relating to motivation is %aslow s hierarchy of needs. %aslow stated that people s wants and needs follow a hierarchy. 6nce the needs of one level of the hierarchy are met, the individ!al will then foc!s on achieving the needs of the next level in the hierarchy. (he lower levels of the hierarchy are physiological, relating to the need to s!rvive 7eg eating and being ho!sed89 once these have been met, h!mans then desire safety, followed by love, followed by esteem, and finally at the top of the hierarchy, self act!alisation, or self f!lfilment. Applying %aslow s hierarchy of needs to reward schemes s!ggests that very #!nior staff, earning very low wages will be motivated by receiving higher monetary rewards, as this will enable them to meet their physiological needs. As employees become progressively more highly paid, however, monetary rewards become relatively less important as other needs in the hierarchy, s!ch as #ob sec!rity, ability to achieve one s potential, and feeling of being needed become more important. 3er:berg arg!ed that increasing rewards only motivates employees temporarily. 6nce they become demotivated again, it is necessary to recharge their batteries with another increase. A far better way to motivate employees is to install a generator in an employee so they can recharge their own batteries9

Reward schemes for employees and management

in other words to find o!t what really motivates them. According to 3er:berg, it is the intrinsic factors in a #ob that motivate employees, s!ch as achievement, recognition for achievement, the work itself, responsibility and growth or advancement. ;iving greater responsibility to employees, for example, can increase motivation. <erhaps the concl!sion to be gained from this is that monetary rewards alone are ins!fficient to motivate employees. 6ther factors s!ch as giving greater recognition and greater responsibility may be e0!ally important, for example giving praise at company meetings, promoting staff, and involving staff more in decision making.

Aligning the ris" preferences of managers and employees with those of the organisation %anagers and senior employees make decisions on behalf of the company, acting as agents of the company. $t is desirable that the risk preferences of these employees sho!ld match the risk preferences of the organisation and its stakeholders. 6ne problem with many reward schemes is that managers are too risk averse, and will not make investments that may risk their targets not being met. (he events leading !p to the financial crisis of *==> are a good example of the opposite sit!ation, where the risk appetites of employees at investment banks did not match the risk appetites of the owners. ?!ring this period, individ!als working in the banks were paid large commissions for selling mortgage loans to c!stomers. (he problem was that the employees were selling loans to c!stomers that posed a large risk to the banks, d!e to their low credit worthiness. (he problem was confo!nded by the fact that in many cases, the employees of the banks were paid commissions on the date that the loan agreements were signed, while the loans lasted for *- years. $n sit!ations where the borrower defa!lted, however, there was no claw back, so the employee wo!ld not be re0!ired to repay the commission. %any co!ntries have p!t in place new laws and codes to change this sit!ation. $n the 1@ for example, the financial services a!thority introd!ced a code whereby rem!neration str!ct!res sho!ld be based on so!nd risk management practices, incentive payments sho!ld be deferred over a n!mber of years, and there sho!ld be claw back provisions whereby employees are re0!ired to repay bon!ses in the event that the longer term res!lts of their actions leads to similar problems experiences in the financial crisis. 2hare options may also create a miss-match between the risks faced by the organisation and the risks faced by the holders of the options, since the holders benefit if share prices increase, b!t do not bear any losses if the share price falls. 2hare options are disc!ssed in more detail later in this article.

%omplying with legal regulations Rewards sho!ld comply with legal reg!lations. (ypically, employment laws incl!de areas s!ch as minim!m pay, and e0!al pay legislation to ens!re that no gro!ps are pre#!diced against. (here have been high profile cases of female investment bankers winning legal cases against their employers

Reward schemes for employees and management

beca!se their bon!ses were far less than those paid to male colleag!es.

&thics and reward schemes $n recent decades there has been a move away from fixed rem!neration systems towards reward systems where at least part of an employee s rewards are based on performance of the individ!al and the b!siness as a whole. 2ome writers claim that this is !nethical for two reasons. 5irst, s!ch systems tend to place increased b!siness risk onto employees. 2econd, s!ch systems !ndermine collective bargaining systems, and red!ce the power of !nions. (his leads to a sit!ation where employees as a collective have less bargaining power. (he si:e of total rem!nerations paid to directors of large p!blic companies has also become a hot political iss!e, with a perception that the gap between top earners, and average earners is becoming larger. $n the 12, the average directors of 2A< -== companies earn *== times more than the average ho!sehold income in the 12. ?efenders of s!ch large differences in pay point o!t that this difference has act!ally declined in recent years9 in the year *===, directors of 2A< -== companies earned +-= times the average ho!sehold income. According to some research, s!ch high packages are #!stified as they do reflect the performance of those directors.

Affordable and easy to administer $t is an obvio!s fact that there is an inherent conflict of interest in the relationship between employer and employee. (he employee s rewards represent a cost to the employer, which the employer wants to minimise. Blearly whatever reward scheme is in place, it m!st be affordable to the employer.

!arget setting %any reward schemes are based on employees achieving pre-determined targets, so some consideration of target setting is re0!ired. $n 5it:gerald and %oon s b!ilding block s model, three principles are given when setting standards or targets: e0!ity, ownership and achievability. "0!ity in this context means fairness9 when setting targets for the vario!s managers, those targets sho!ld be e0!ally challenging. 6wnership means that the targets sho!ld be accepted and agreed by those managers for whom they are set. (his can !s!ally be achieved by participation. 5inally targets m!st be achievable9 otherwise the employees for whom they were set will become demotivated. (he b!ilding block s model then goes on to specifically cover reward schemes. $t states that there are three principles of a good reward scheme. 5irst, there sho!ld be clarity C it sho!ld be clear how the reward scheme works. $f yo!r boss tells yo! that yo! will receive a bon!s at the end of the year if yo! do a good #ob, that is not very clear, since the boss has not specified what doing a good #ob means.

Reward schemes for employees and management

Rewards sho!ld be motivational. 5inally there is the important controllability principal. "mployees sho!ld only be #!dged and rewarded based on things within their control. (his is why profit-related pay might not be relevant to a #!nior administrative assistant, for example. 3ope and 5raser warn against the !se of linking rewards to fixed performance targets, as this leads to gaming. $n partic!lar, managers whose rewards depend on fixed targets may be tempted to always negotiate lowest targets and highest rewards, which s!ggests that management plans will !nderstate the potential that the organisation can make. Always make the bon!s, whatever it takes, is another example of gaming s!ggested by 3ope and 5raser, which s!ggests that managers may ind!lge in !nethical behavio!r s!ch as fra!d!lent acco!nting in order to ens!re that targets are met. 3ope and 5raser s!ggest divorcing the planning process and the target setting process, and basing rewards on relative targets and benchmarks. A relative target might be market share, for example, where rather than setting an absol!te target for a sales manager, a market share 7D8 target is provided. $f the market rises, then more is expected in absol!te terms. (his adds to controllability, since the sales manager co!ld not be held responsible for a rise 7or fall8 in the overall market, which is o!tside of his control, b!t wo!ld be able to control whether or not he achieves the expected share of the market.

!ypes of reward scheme 'ase pay Base pay, or basic pay, is the minim!m amo!nt that an employee receives for working for an organisation. 5or example, the employee may be paid E)= per ho!r for a minim!m of ,= ho!rs per week. (he employee will therefore earn at least E,== per week. (his will be paid regardless of how many of those ,= ho!rs the employee is act!ally working. A fixed ann!al salary is another example of basic pay. Basic pay may be s!pplemented by other types of rem!neration. A bl!e collar worker may be paid overtime for example if he works more than ,= ho!rs per week, and a manager may receive some form of performance pay in addition to the base pay. Basic pay is likely to address the lower levels of %aslow s hierarchy of needs mentioned above. (erformance-related pay <erformance-related pay is a generic term for reward systems where payments are made based on the performance, either of the individ!al 7individ!al performance-related pay8 or a team of employees 7gro!p performance-related schemes8. $n recent decades there has been a move toward performance-related pay schemes in many organisations. (his has lead to a sit!ation where a higher portion of the employees pay is dependent on performance. (his rationale for performance-related pay is that it motivates employees to work harder, and rewards those who make a greater contrib!tion to the organisation s goals. (his sho!ld lead to efficiency savings. (here are many types of performance-related pay, and the most pop!lar ones are described below:

Reward schemes for employees and management

1. Piecework schemes 1nder <iecework schemes, a price is paid for each !nit of o!tp!t. <iecework schemes are the oldest form of performance pay, and were !sed for example in the textile ind!stries in ;reat Britain d!ring the ind!strial revol!tion. <iecework schemes are appropriate where o!tp!t can be meas!red easily in !nits. (hey are typically !sed for paying freelance, creative people. 5reelance writers for example are often paid based on the n!mber of words. (he benefit of piecework schemes is their inherent fairness. (he higher the o!tp!t, the more the employee 7or s!bcontractor8 receives. 5rom the employer s perspective, the employer does not have to pay for idle time or inefficiencies. 5rom the employee s perspective, s!ch schemes mean that the employee bears commercial risk if demand for their prod!ct falls. A f!rther disadvantage of piecework schemes is that the payment is not based on the 0!ality of o!tp!t. 3owever, some sort of 0!ality control is likely, and if the 0!ality is not of a re0!ired standard, the employee or s!bcontractor will not be paid. 2. Individual performance-related pay schemes $ndivid!al performance-related pay schemes are where the employee receives either a bon!s, or an increase in base pay on meeting previo!sly agreed ob#ectives or based on assessment by their manager, or both. (hey are typically !sed for middle managers in private sector organisations and for professional staff. (he advocates of individ!al performance-related pay schemes claim that their they are an obvio!s way to align to ob#ectives of middle managers with the goals of the organisation. $f performance targets set are based on the goals of the organisation, then it appears obvio!s that making part of the rewards of employees contingent on achieving those targets will mean that employees are motivated to achieve the goals of the organisation. $ndivid!al performance-related schemes also have the advantage over gro!p schemes that the employee has control over her rewards, as they do not depend on the effort 7or lack of8 of other members of the team. Britics of s!ch schemes point o!t that the link between rewards and motivation is far from clear, as disc!ssed above. $t is also arg!ed that performance-related schemes lead a sit!ation of t!nnel vision whereby if something is not meas!red, and then rewarded, it won t get done. $ndivid!al reward schemes may lead to a lack of teamwork and may lead to variances in pay among individ!als, which can lead to ill feeling. An example of an individ!al performance-related pay scheme is one that is operated by a 1@ bank. 1nder the scheme, a bon!s pool is allocated to each region based on the performance of that region. 5rom this pool, individ!al awards are made based on assessment of performance, taking into acco!nt the rating on a five-point scale. (hose with scores of ) to + 0!alify for a discretionary bon!s. (he assessment depends on how m!ch new b!siness the individ!als have bro!ght in, or how m!ch

Reward schemes for employees and management

efficiency savings they have generated. (he rewards are !s!ally paid in cash, altho!gh for senior employees receive a portion as deferred stock. 3. Group-related performance-related pay schemes ;ro!p-related performance-related schemes are similar to individ!al, in that rewards are paid based on the achievement of targets. 3owever the targets are set for a gro!p of employees, s!ch as a partic!lar department, or branch of a company, rather than for an individ!al. 2ince the rewards apply to a gro!p, they are likely to be based on a pre-determined 0!antitative form!la, rather than on assessment of staff. A bon!s pool is calc!lated based on the performance of the team, and this is shared among the members of the team. Bon!ses may be paid !p at the end of the year, or may be deferred, and paid at a later date, as this may enco!rage staff and managers to take a longer term view, rather than simply foc!sing on the c!rrent year s bon!s. (he advantage claimed for gro!p schemes is that they enco!rage teamwork. (he disadvantage is that the la:ier members of the team benefit from the hard work of the more dedicated. 3ope and 5raser give the example of a scheme operated by 2venska 3andelsbanken, where each year, a portion of the banks profits are paid to a profit sharing pool for employees, provided that certain conditions are made. (he main conditions are that the 3andelsbanken ;ro!p m!st have a higher ret!rn on shareholder s e0!ity than the average of its peer gro!p. (he !pper limit of the amo!nt paid into the scheme is *-D of the total dividends paid to shareholders. "mployees do not act!ally receive anything from the pool !ntil they reach the age of .=, at which point they receive a pay o!t based on the n!mber of years that they have worked for the bank. (he B"6 of 3andlesbanken claimed that employees are not motivated by financial targets, b!t by the challenge of beating the competition. (he reward scheme is designed to be a dividend on their intellect!al capital. 4. Knowled e contin ent pay @nowledge contingent pay is where an employee will receive a pay rise or a bon!s, or both, for workrelated learning. An ABBA candidate, for example, may receive a higher salary once he has passed all the knowledge level papers, and an even higher salary after passing all of his exams. !. "ommissions Bommissions are a form of rem!neration normally !sed for sales staff. (he staff may receive a low basic pay, b!t will then receive commission, based on a percentage of the amo!nt of their sales. (he advantages of commission are that they sho!ld motivate sales staff to achieve higher sales, as their rewards depend on it, and they mean that the large part of the salesman s salary becomes variable. $f sales are low, the organisation will have to pay less. (he disadvantage of commission is that it may lead to dysf!nctional behavio!r. 2ales staff may ind!lge in window dressing, for example to meet this years sales target, by selling on a sale and ret!rn basis in the final month of the year, with the inherent !nderstanding that the goods will be ret!rned in the following month of next year. (hey may also lead to short termism, where sales staff never p!t the c!stomer above the sales target to 0!ote 3ope and 5raser.

Reward schemes for employees and management

#. Profit-related pay <rofit-related pay is a type of gro!p performance-related pay scheme where a part of the employee s rem!neration is linked to the profits of the organisation. $f the company s profits hit a pre-determined threshold, a bon!s will be paid to all members of the scheme. (ypically the bon!s will be a percentage of the basic pay. (he bon!s may be paid d!ring the year in 0!estion9 for example, 0!arterly, or it may be deferred !ntil some later date, s!ch as the retirement of the staff. Advocates of profit-related pay arg!e that it motivates employees to become more interested in the overall profitability and therefore become more motivated to do their bit to improve it. $t may also enco!rage loyalty in cases where staff may lose their bon!s if leaving the organisation means that they lose the right to it. (he obvio!s disadvantage with profit-related pay is that it does not match the primary ob#ective of commercial organisations, which is to maximise the wealth of the shareholders. %anagers may be motivated to increase profits by taking short-term actions that will harm the b!siness in the long r!n, for example, or destroy wealth by investing in pro#ects that increase the profits of the organisation, b!t prod!ce a ret!rn that is below the cost of capital of the organisation. <rofit-related pay might not be a motivator for #!nior employees, who may fail to see the link between their effort and the overall profits of the organisation. $. %tock option plans 2tock option plans have become very pop!lar since the )FF=s, when greater emphasis started to be given to shareholder val!e. 1nder stock option plans, staff receive the right to b!y shares in their company at a certain date in the f!t!re, at a price agreed today. 5or example, Alpha Bo is listed on the stock exchange of 3omeland. (oday, shares in Alpha Bo are trading at E)== each. (he company has #!st awarded the B"6 of Alpha Bo the option to b!y ) million shares for E)== each in exactly ten years time. (hese options have no intrinsic val!e at the granting date. $f the share price rises to say E*== in )= years time, the B"6 co!ld exercise his options, b!ying ) million shares at a price of E)== each. 2ince the shares wo!ld be worth E*== each by then the B"6 wo!ld make a gain of E)== per share, or E)==m in total. 2tock option plans are most appropriate for the senior management of organisations as they are the people who have the most infl!ence over its share price. (he rational for !sing stock option plans is that they align the ob#ectives of the directors with the ob#ectives of shareholders. $f the share price rises, the senior management benefit beca!se their options increase in val!e. (h!s senior managers will start to think like investors. (he big weakness of stock option plans is that share prices may depend on external factors as m!ch as on the performance of the directors. ?!ring the b!ll markets of the )FF=s and *===s, many companies share prices rose simply beca!se the market rose. Another weakness is risk misalignment. 2hare options reward managers if the share price goes !p. $f

Reward schemes for employees and management

the share price falls, however, there is no difference in reward between the share price remaining the same 7E)==8 and falling to 7E)8 C so managers may be motivated to take extreme risks where the exercise price may not be met. &hat shareholders really want is the performance of their company to be better than the market. 6ne sol!tion to this is to !se an indexed exercise price, where the price at which the director can b!y the shares is e0!al to the c!rrent market price, pl!s the increase in the stock market index between the date that the options are iss!ed, and the exercise date. (his means that the share option reflects the controllability principle more closely, as directors wo!ld not be rewarded for rises in the stock market in general.

(ension schemes ?efined benefit pension schemes !sed to be a pop!lar form of reward. 1nder s!ch schemes, the employee pays a pension to former employees based on their final salary, and the n!mber of years that the employee worked for the organisation. A typical example is that the former employee receives )G.=ths of their final salary for every year of service. An employee who works for ,= years for the same organisation wo!ld therefore receive a pension e0!al to ,=G.=ths of their final salary from the date of retirement to the date of death. ?efined benefit schemes leave organisations with an !ncertain, often large liability, and for this reason, many organisations have now discontin!ed s!ch schemes. ?efined contrib!tion schemes are another form of pension scheme where the employer pays a certain percentage of the employee s salary into an acco!nt for the employee in a pension pot. (he employee may also have the option of making additional vol!ntary contrib!tions into this pension pot. (he pension pot is then invested, and the employee receives whatever is in their acco!nt on retirement. $n some co!ntries, employees may be re0!ired to !se what is in the pot to b!y an ann!ity, which pays them a fixed income for the rest of their lives. %any co!ntries offer tax incentives for s!ch pension schemes, s!ch as allowing employees to red!ce their taxable income by the val!e of contrib!tions made to the schemes.

'enefits in "ind Benefits in kind 7or indirect pay8 are paid to employees in addition to their base salary and performance-related pay. Benefits in kind incl!de items s!ch as health ins!rance and meal vo!chers. (hey are !s!ally provided to more #!nior staff in order to provide additional incentives at a lower cost. (hey are often !sed as a form of recognition, so the employee of the month for example will be given a benefit rather than a cash payment. (he advantage of benefits in kind is that greater flexibility can be given in designing a reward scheme for an individ!al.

Reward schemes for employees and management

Bafeteria schemes have also become pop!lar, whereby employees are told that they may select benefits from a men! !p to a certain val!e. (he advantage of this is that employees will select the benefits that they val!e most. Benefits from which the employees can choose typically incl!de s!ch items as health ins!rance, holiday vo!chers, company cars or sports vo!chers. Bafeteria schemes may be diffic!lt to administer. 2taff may also find them complex to !nderstand, as they will have to select a n!mber of benefits that have a val!e that is within the agreed limit.

&stablishing the level of benefits 3ow m!ch sho!ld employees be paid' (wo factors need to be taken into acco!nt here. 5irst, competitiveness, and second internal e0!ity. As already mentioned above, !nless the level of pay is competitive, it will be diffic!lt to recr!it and retain the right n!mber of skilled employees. $f it is too m!ch, the cost to the organisation will be too high. 3ere the organisation will compare its pay levels with competitors. 2!ch information may be available from #ob adverts in newspapers or on the $nternet, or from recr!itment cons!ltants. $nternal e0!ity relates to the pay differentials within the organisation itself. 2taff will become demotivated if they feel that the rem!neration system is !nfair and that other people are being paid more genero!sly. Hob eval!ation techni0!es are !sed that try to determine the val!e of a specific #ob to the organisation. Based on this, the level of rewards for that partic!lar position will be determined.

!he role of appraisal in reward systems %any of the performance-related reward schemes depend on the performance of the employees. As s!ch, the employees performance has to be assessed. (his !s!ally takes place d!ring the appraisal process. 2taff will be assessed on a reg!lar basis, for example twice a year. ?!ring the appraisal, targets will be set for the next period, and rewards agreed if the targets are met.

%onclusion A good reward system aims to motivate employees to work harder, and align their goals with those of the organisation they work for. (he c!rrent trend towards performance-related reward systems is designed to lead to greater rewards and motivation for those who contrib!te the most. 3owever, designing s!ch reward systems is complex, as they aim to infl!ence h!man behavio!r. As the h!man reso!rces director of 5lowpack "ngineering said 70!oted in Bratton8 (here is no s!ch thing as a good pay system9 there is only a series of bad ones. (he trick is to choose the least bad one. )ic" Ryan is a freelance lecturer and writer

Reward schemes for employees and management

References Bratton and ;old, &uman 'esource (ana ement )heory and Practice, ,th edition chapter )=, <algrave %acmillan, *==/ 3ope and 5raser, *eyond *ud etin , 3arvard B!siness 2chool <ress, *==+ 5rederick 3er:berg, I6ne %ore (ime: 3ow ?o Jo! %otivate "mployees'I &arvard *usiness 'eview, 2eptG6ct )F>/