How to Reward Top Performers

For the first time since 1980, U.S. salary budgets are trailing the inflation rate. But that isn’t stopping employers from heaping rewards on their best performers. Top performers’ base salary raises are now typically 1.5 to 2 times those of average performers, according to Hay Group. It reports that for companies on Fortune’s most admired list there’s a 2+ times differential.

Mercer says the gap is widening “significantly” and more than two thirds of businesses are working to further increase the differential. Though employers are concerned about compensation costs “they are more worried about losing their best employees to their competitors,” says Mercer’s Catherine Hartmann.

That’s because competition for critical skills employees is now fierce. Some 59% of U.S. companies report problems recruiting them, an increase from 52% last year and 28% in 2009, according to Towers Watson.

Businesses are using a kinder, gentler form of performance ranking today than the model pioneered by Jack Welch at GE in the 1980s, where managers in the bottom 10 percent each year were shown the door. Called “rank and yank” by its detractors, the system was picked up elsewhere, sometimes with a lofty name like Individual Dignity Entitlement, as at Motorola.

Its results were not always felicitous, though. There was litigation at Ford, where within a year CEO Jacques Nasser announced the policy would be modified and the bottom 10 percent were given reprieves. The practice was softened at GE as well, which now is putting more emphasis on teamwork. Most large companies rank their employees but most don’t automatically jettison the lowest tier.

Some companies use a rank and yank system for only two or three years, according to Kerry Chou of WorldatWork, which provides education, research and conferences on employment issues. “They pick off the low hanging fruit during the first year and perhaps the system’s retained for a second year but they soon stop using it to avoid cutting into muscle.”

“Businesses have to be careful not to tilt too far, says John Challenger, CEO of Challenger, Gray & Christmas. “They have to value the employees who are not the stars, those who have been loyal for years and those who are holders of the corporate memory. There has to be the right mix between employees who challenge the status quo and others.”

Even in its gentler form today, though, ranking stirs controversy. The competition it creates among employees runs counter to the collaborative environment businesses want to create. When rewards go only to top performers and not those in the middle, “it’s difficult to tell someone they don’t get a salary increase for doing an average job,” says Ed Rataj, who heads compensation consulting at CBIZ Human Capital Services. Employees dissatisfied with their rankings question the system’s fairness and might be prompted to leave. Some authorities interviewed for this article say the system’s much better suited for cultures that are metrics-focused than for others.

Given the mixed feelings about ranking, some businesses are reluctant to talk about using it. Some go so far as not publicly identifying the employees who reside in their top tiers.

Royal Bank of Canada has just created a set of new tools to help identify the employees who are its high potentials. Earlier this year Booz Allen Hamilton selected 38 high-potential managers who will take its six-month leadership development program. Neither company has publicly identified these employees, though. Only 60% of companies formally name their high potentials and only 28% tell those employees they’ve been labeled as such, according to Towers Watson.

Among the reasons for this is fear of having these employees recruited by competitors. The strategy may be counterproductive, though, because employees who know they’re valued are less likely to leave. Research at Cornell University found that 33% of high potential managers who didn’t know their status were looking for another job, while of those who did know only 14% were looking.

There are many benefits to making it known who the company’s top performers are, says Mark A. Szypko of Kenexa: The business helps create a performance culture. It identifies benchmarks against which all of employees can aspire. And it provides “psychic income” its top performers. “Recognition is one of the most important elements for encouraging retention, says James A. Hatch, who heads the human capital practice at the EisnerAmper accounting firm. “Knowing their status motivates high-performing managers to perform even better,” he says.

Jeff Kaye, co-CEO of the Kaye/Bassman search firm, strongly encourages openness about employees’ rankings. Transparency is always best, he comments, but the information must be explained. “Secrecy hurts but telling all without context is worse than secrecy.” At his firm, he says, “We have 100% of numbers open for everyone to see.”

Whether a business encourages transparency or not, the increasing use of metrics is making it clearer than ever who’s producing and who’s not. With the focus on productivity growing ever tighter, a greater reliance on ranking is inevitable. “Organizations are quite willing to pay for performance — but only if they get that performance,” says Tom McMullen, Hay Group’s U.S. practice reward leader. “This philosophy should continue to result in widening pay differentials between top and average performers.” Adds Ed Rataj of CBIZ, “Gone are the days when simply breathing for year will result in an increase in salary.”

How to Rank Your Employees

There are high performers, there are high potentials and there’s a third group that’s both. Some authorities on performance evaluation and compensation advise that the three groups be put on separate tracks.

“High performers often are not good leaders,” says James A. Hatch, who heads the human capital practice of EisnerAmper. “Companies often make the mistake of promoting individuals who have high performance but inadequate leadership potential.” This, he adds, destroys these employees’ careers and the performance of their subordinates. They should be managed to perform and not be developed to lead.

Mr. Hatch believes that businesses pay insufficient attention to their management stars. “The needs and retention of high performers are usually ignored by most HR teams,” he says. “Most HR structures are directed to managing satisfactory performers — those who encompass the vast majority of the workforce. Most of HR’s time is devoted to issues regarding their bottom-most performers.”

Other authorities point to weaknesses in the ways employees are evaluated for the purpose of ranking. “Far too often I have seen companies rely solely on the input of one or two people to ‘anoint’ a high performer — people who may not always have the right tools or perspective to make the correct judgment,” says Gary Hourihan of Farient Advisors, the compensation consulting firm. Businesses have to establish clear guidelines on how employees should be evaluated for ranking, he says. The company should “reevaluate the employee’s ranking annually, as people do change and improve.”

The process used at Russell Reynolds’s Executive Assessment Practice can serve as a guide for determining employees’ tiers. Dean Stamoulis, global leader of the unit, describes its three-step process. It begins with interviews of the manager by an industry specialist and a behavioral psychologist, concurrently. That’s followed by the use of a set of assessment questionnaires, both standardized and proprietary. Then come 360° phone interviews.

Too many businesses evaluate managers on factors that don’t really contribute to success, authorities report. “Good performance metrics must capture the employee’s impact on the company’s profitability,” says Fred Faltin of The Faltin Group, the quantitative management consultancy.

“This might mean rating salespeople on the profitability of the deals they generate rather than the too-long-standing practice of commissioning them on revenue produced,” he states. “Technology teams might be evaluated on the market potential of new ideas or developments. Clerical and back office staff might be evaluated on how well they are doing their current job as well as how effectively they are redefining their processes to drive future results.” The evaluation process will vary greatly, he adds, depending on whether the company is focusing on long-term or short-term profitability.

Businesses also must make certain that the metrics to be used for evaluations purposes are valid. Joseph A. De Feo and John Early provide guidance on this. They are the CEO and EVP of Juran Institute, which consults on improvement solutions and provides technical training on quality improvement.

They say a metric must be understandable to the people using it. It must be repeatable and reproducible, meaning if one person measures it twice the answer is the same both times and if two people measure it the answer is the same again. It must be free from bias, which can be measured with sophisticated devices. And it must be understandable to the people using it.

They recommend using both effectiveness measures, an example of which is how well the needs of external and internal customers are met, and efficiency measures, meaning how much time and resources are consumed relative to what’s achieved.

When setting up their ranking systems, businesses sometimes make them more complicated than necessary, authorities say. Towers Perrin reports that companies establish up to seven tiers, with four and five being most common. Jack Welch used only three. “The simpler the better,” recommends Ed Rataj of CBIZ. “Too many companies split hairs to a minimal degree, for no reason at all.”