The Organizational Pay System – Principle versus Practice – A Wide Chasm

It is my contention, after spending almost forty years in the pay management business, that most organizational pay systems although fairly well intended are mostly mythical beasts that in practice suffer from implementation malaise.

In this piece I am going to lay down the framework of some of the following essays that will follow in this blog further elaborating on the primary premise that has been stated in this essay.

Internal equity is a stated core objective of any pay system. Internal equity means that within the organization the intention is to pay employees according some logic based on the work being done and the value of that work to the specific organization. Well this a valuing system. And as such it is quite subjective and is thus fraught with confusion and mistrust. Systems and structures used to achieve this internal equity principle does not necessarily reduce the subjectivity. Rather these systems are at best rational and cannot be scientific. Human judgement and biases do play a big role in the distortion process. This is one area where the chasm between theory and practice is wide. More on this in a future blog.

The stated pay system principle that is often widely adopted is pay for performance. Although well intentioned, in practice this principle rarely achieves its stated purpose. This is because here again human judgement with all its biases quite often raises its ugly head. More on this in a future blog.

The principle of market competitiveness is an important structural principle of a pay system. But suffice it to say, here again gathering and validating believable market data for their use in pay systems is always questioned in both the positive and negative directions if the data does not say what the recipient wants to hear. More on this in a future blog.

Special interest thinking dominates the pay ethos thus creating all kinds of aberrations in the pay system. Executive Pay, allowances, perks, equity plans, adders, differentials all tend to create a great deal of confusion and controversy and as such widening the chasm between principle and practice. More on this in a future blog.

Another widely sustained principle in pay systems is variable pay, as formulated through bonus and incentive arrangements. Although in principle this is very sound thinking but in practice the system wilts under the pressure of management discretion and the realities of continuing talent management challenges.

Then there is the deep chasm created between the difference between principle and practice of equity compensation. Sharing ownership with managers and employees is a noble principle of effective reward management. But that principle suffers from the vagaries involved in the actual practice and operation of these plans. More on this later also.

Finally, see my essay on structural poverty in the design of the pay systems. Here is another big reason for the huge chasm between principle and practice. A blog on this to follow.

Thus I want to end this introductory essay with a quote from one of favorite books (People Specialists – author Stan Herman – unfortunately the book is out of print). In this quote the author very appropriately explains what one can expect from pay systems after all:

“The point is that there are some things that compensation administration can be expected to do and other things that it cannot. It can help establish a limited and transient orderliness in the way people get paid. It cannot structure a sublime and everlasting order where everybody’s pay is self-evidently equitable and proper in comparison to everybody else’s pay.”

“The quest for a neat correlation between work and reward is a natural one which fits nicely with most people’s idea of the way things ought to be. But the fact that they ought to be does not mean they are. Money value determinations are not the products of fine, dispassionate measurements made in the dust-free, dehumidified atmosphere of a laboratory. Rather they are continually buffeted and rebuffeted in the turbulent environment of the messy outside world, and not merely on a supply and demand basis, either.”

But all is not lost there is very new thinking as to how to really mitigate the chasm and create greater harmony between principle and practice in pay systems. 

There is power point presentation in my website (www.biswasandassociates.com), in the reference page that  explains this new thinking. Those interested can look up the reference.

Yet another post on Wage Theories…

Here are some additional theories….

The Wages Fund Theory –

This theory was developed by Adam Smith (1723-1790). His basic assumption was that wages are paid out of a pre- determined fund of wealth, which lay surplus with wealthy persons – as a result of savings. This fund could be utilized for employing laborers for work.  If the fund were large, wages would be high; if it was small, wages would be reduced to the subsistence level. The demand for labor and the wages that could be paid them were determined by the size of the fund. 

The Surplus Value Theory of Wages – This theory owes its development to Karl Marx (1818-1883). According to this theory, the labor was an article of commerce, which could be purchased on payment of ‘subsistence price.’  The price of any product was determined by the labor time needed for producing it. The laborer was not paid in proportion to the time spent on work, but much less, and the surplus went over, to be utilized for paying other expenses. —Marx himself considered his theory of surplus-value his most important contribution to the progress of economic analysis. It is through this theory that the wide scope of his sociological and historical thought enables him simultaneously to place the capitalist mode of production in his historical context, and to find the root of its inner economic contradictions and its laws of motion in the specific relations of production on which it is based .

The Residual Claimant Theory - §Francis A. Walker (1840-1897) propounded this theory. According to him, there were four factors of production business activity, viz., land, labor, capital and entrepreneurship. Wages represent the amount of value created in the production which remains after payment has been made for all these factors of production. In other words, labor is the residual claimant.

The Marginal Product Theory of Wages- —This theory was developed by Phillips Henry Wicksteed (England) and John Bates Clark (USA). According to this theory, wages are based upon an entrepreneur’s estimate of the value that will probably be produced by the last or marginal worker. In other words, it assumes that wages depend upon the demand for, and supply of, labor. Consequently, workers are paid what they are economically worth. The result is that the employer has a larger share in profit as has not to pay to the non-marginal workers. As long as each additional worker contributes more to the total value than the cost in wages, it pays the employer to continue hiring; where this becomes uneconomic, the employer may resort to superior technology.

 The Subsistence Theory of Wages - —This theory, also known as ‘Iron Law of Wages,” was propounded by David Ricardo (1772-1823). This theory (1817) states that: “The laborers are paid to enable them to subsist and perpetuate the race without increase or diminution.”. —The theory was based on the assumption that if the workers were paid more than subsistence wage, their numbers would increase as they would procreate more; and this would bring down the rate of wages. If the wages fall below the subsistence level, the number of workers would decrease – as many would die of hunger, malnutrition, disease, cold, etc. and many would not marry, when that happened the wage rates would go up. In economics, the subsistence theory of wages states that wages in the long run will tend to the minimum value needed to keep workers alive. The justification for the theory is that when wages are higher, more workers will be produced, and when wages are lower, some workers will die, in each case bringing supply back to a subsistence-level equilibrium. —The subsistence theory of wages is generally attributed to David Ricardo, and plays a large role in Marxist economics. —Most modern economists dismiss the theory, arguing instead that wages in a market economy are determined by marginal productivity.

 The Bargaining Power Theory of Wages - —John Davidson propounded this theory. Under this theory, wages are determined by the relative bargaining power of workers or trade unions and of employers. When a trade union is involved, basic wages, fringe benefits, job differentials and individual differences tend to be determined by the relative strength of the organization and the trade union.

 The Behavioral Theory Of Wages - —Many behavioral scientists – notably industrial psychologists and sociologists like Marsh and Simon, Robert Dubin, Eliot Jacques have presented their views or wages and salaries.

 Briefly such theories are:

 The Employee’s Acceptance of a Wage Level – This type of thinking takes into consideration the factors, which may induce an employee to stay on with a company. The size and prestige of the company, the power of the union, the wages and benefits that the employee receives in proportion to the contribution made by him – all have their impact.

 The Internal Wage Structure – Social norms, traditions, customs prevalent in the organization and psychological pressures on the management, the prestige attached to certain jobs in terms of social status, the need to maintain internal consistency in wages at the higher levels, the ratio of the maximum and minimum wage differentials, and the norms of span of control, and demand for specialized labor all affect the internal wage structure of an organization.

Why do I use the word “ethos” in this blog?

Since I started writing this blog many people have asked me why I use this word “ethos” in the context of “pay”. So here is the answer.

—Ethos forms the root of ethikos (ἠθικός), meaning “moral, showing moral character”. To the Greeks ancient and modern, the meaning is simply “the state of being”, the inner source, the soul, the mind, and the original essence, that shapes and forms a person or animal (from wikipedia).

  

Ethos, according to The Oxford English Dictionary, is defined as “the characteristic spirit, prevalent tone of sentiment, of a people or community. Originally the word has its roots in the Greek word ‘etho‘ or “to be accustomed to.”  It refers to accepted standards, rather than what is more modernly thought of as character unique to a certain individual. The word also means  ‘’a habitual gathering place.” A place where one might gather often, the opportunity for developing communal or common values. These types of values are those which are established in the meaning of ethos.

Thus I find the word appropriate in the pay context. Why, because —pay in our lives is all encompassing. —It affects our economic, sociological, cultural, environmental,  psychological, familial, physiological, emotional and spiritual lives and more. Thus understanding the concept of pay and how to manage the administration of pay systems requires an understanding of the words used, the theories, the issues, the principles – the context – the ethos! — For our livelihoods we are loyal/disloyal, committed/not committed, respectful/disrespectful, dedicated/not dedicated, motivated/not motivated and on and on. Every single human emotion. —It almost touches our souls.  Thus our Ethos!  Thus the use of the word!  

 

Commonly Used Words in the Corporate Context

After having written two essays on all the words that are currently used in many different contexts in the pay ethos, I have found that the most commonly used words in the organizational context are:

• —Base, Basic, Fixed, “Come To Work” – this describes the “fixed” part of your pay. This element is mainly provided to employees to come to work and do the work by using the required skills, knowledge and abilities.
• Incentives or bonuses – given to you for achieving time bound goals and objectives. Words such as incentive targets, objectives (bonus able objectives), measurements, ratings are all contextual terms used here in most organizations
• Allowances – not ‘benefits” are used here.  Housing allowance, transportation allowance and education allowance are common. These types of allowances are widely used in various countries
• Adders to base – are common in the US. Overtime pay, call-back pay, on-call pay are common elements and are provided for work that is done beyond normal work hours
• Risk Benefits – medical, disability and life. These benefits are provided to employees in lieu of cash to mitigated the various life risks for employees and their families
• Retirement, Savings benefits are commonly found in organizational settings to assist employees with their post-employment lives
• Equity Participation – this element in the past had been mostly provided to senior executives to motivate them to increase share-holder value. This component of pay has seen the most contextual fluctuations during my many years in this business. There has come to being many versions of these plans (non-qualified stock options, incentive stock options, restricted stock options). This topic is a much discussed topic in all realms. Accounting, tax and legal implications surround these programs. More recently issues of Executive Compensation Excesses, Insider trading, Ownership Culture, Stock Option pricing, dilution, over-hang and plethora of issues, concerns, debates, and legal mumbo jumbo has almost clouded the pay ethos with total confusion. This element has spawned specialists, legal experts, associations, interest groups and what not around this one element of the pay ethos. In my opinion, the over-riding factors that surround this element is, 1) whether these programs have any value if distributed all across the whole employee population, even to the lowest employee levels and 2) the over-riding issue in my mind, is whether the organizations that distribute stock options to wide variety of employees, hoping that this distribution of stock options will make all levels of employees as if they are owners do indeed achieve an “ownership culture” (watch for an essay on this subject on this blog)
• Perquisites – here the mind will indeed be boggled for the common person. Many Fortune 500 companies provide executives a wide variety of perks. This practice is wide spread around the world. Most common are first class travel, private jets (do not forget that the automobile executives in the US showed up to Capital Hill to beg for the tax payers money in company provided private jets – what a joke!), country club memberships etc. etc. Why may I ask are these elements provided to these senior executives? What is the rationale? Is their any direct correlation between organizational performance and the granting of these perks to executives? Now is the time to question the existence of these pay elements widely in all circles of our society. Reasonableness should a key determinant.

The concept of contextual poverty in the field of pay

I contend in this essay that what we are seeing in the current debacle of unseemly Executive Bonuses in AIG and also the whole realm of Executive Compensation that we have witnessed during the last twenty years or so, is a result of a severe case of contextual poverty in the design, review and evaluation of these programs. It is my contention, that in the “Pay Ethos” we quite often live in a state of contextual poverty.

This contextual poverty state has been created and maintained by Compensation Consultants,Internal Compensation Specialists, Boards of Directors, the executives themselves and their Human Resource executives. 

So what do I mean by contextual poverty.

—The circumstances that form the setting for an event, statement, or idea, and in terms of which it can be fully understood. So one is out of context, if one tries to understand or explain any phenomena without the surrounding words or circumstances that have not been fully understood. Being in this state of an absence of context is being in a state of contextual poverty. (Wikipedia)

—

—Getting out of this poverty state requires study, analysis and a deep understanding of all the dimensions of the context

—

The field of Pay is surrounded by stated, researched and validated theories that have been passed onto us from the days of the advent of the Industrial Age. No less illuminators than Karl Marx, David Ricardo, Adam Smith all the way down to Edward Lawler have all theorized various pay related theories. Thus this field requires deep study and understanding before one can call themselves “experts” in the field. This is not the case.

Furthermore, the field of Pay is a multi-disciplinary field engulfing sociology, psychology, economics, the business disciplines of  - finance, accounting, legal, tax and social anthropology ( I may have missed some). Thus an understanding of this field requires a study and understanding of these contexts. How many people developing, advising and approving programs  in this field have this multi-disciplinary context under their belts? Not many I would say. 

Finally, the pay context covers an understanding of the macro issues of social cost, governance, comparable worth, gender equity  that affect our Pay Ethos.

Most of what you see are “suit off the rack” “copy the others” programs designed and implemented in a contextual poverty environment. No wonder we have such anger, emotions and bewilderment attached to this subject, especially in democratic societies. The US Congress and also the current President having to deal with programs where the context is not well understood.

This is the conclusion I have reached with the advantage of hindsight after having spent most of my adult life in this field. Sad isn’t it?

Its time to ponder this subject in more depth.

The two main pillars of Compensation Systems

There are two main pillars around which most Compensation Systems or Structures are based. And they are:

1) Internal equity and 2) External Competitiveness.

I will first introduce the concept of internal equity and then over the next few posts I will raise various issues and concerns about how in practice this concept is misused and distorted thus resulting in many continuing problems and challenges.

In order to achieve internal equity companies should go through a process. The components of these processes are: 1) Job analysis, 2) Job description writing, 3) Job evaluation resulting in a classification system or job rankings, 4) and finally the end product being a job structure. This resulting job structure is supposed to achieve the admirable goal of creating internal equity.

But does it?  I do not think so. 

Over the next few posts I will be discussing in detail some theory based underpinnings of the internal equity concept. But, on the other hand I will also present thoughts and opinions about the misuses of the internal equity concept.

The basics

There are only four ways to pay people.

First, we can pay for the job a business or a company hires people for.

Second, we can pay for the skill possessed by the people who are hired.

Third, one can pay people the market going rate for the job or the position they hold.

Fourth, it can a be combination of the first three.

Thus, first and foremost a company or an organization  needs to determine is which path they are going go down.

Having said this quite often managers and executives criticize the pay system without having either understood or without determining strategically how they want pay their people based on the structure of the work execution portion of their business plans,

Outside consultants come in and set about structuring pay systems without answering this first base question. I have in my consulting practice often asked CEO clients what they want to pay their people for, based the four questions stated above, and they have no clue. They just want some kind of a structure. Or they say do not implement this or that program. This feeling being based on their past experiences. But they have no clue fundamentally how they should pay their people based on the strategic organizational requirements. So quite often the “suit is borrowed off the rack” and things do not work. People put in “the Hay System” or some other system. This then results in universal angst. They cut immediately instead of measuring twice before – the carpenter’s rule.

Pay, I say is a lagging variable not a leading one. Don’t blame the pay system for all the ills in the organization. Recruit the “right” people, for the “right” job at the “right” time first and then determine the best pay package for them.

So, borrowing from Steve Covey I say, “begin with the end in mind”.