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Designing anEffective Pay forPerformanceCompensation SystemA Report to the President and theCongress of the United States by theU.S. Merit Systems Protection Board

THE CHAIRMANU.S. MERIT SYSTEMS PROTECTION BOARD1615 M Street, NWWashington, DC 20419-0001January 2006The PresidentPresident of the SenateSpeaker of the House of RepresentativesDear Sirs:In accordance with the requirements of 5 U.S.C. 1204(a)(3), it is my honor to submit thisMerit Systems Protection Board report, “Designing an Effective Pay for Performance CompensationSystem.”Federal Government agencies are moving to better align pay with performance and createorganizational cultures that emphasize performance rather than tenure. From our research, we havelearned that agencies must invest time, money, and effort in the design and implementation of theirpay for performance compensation systems in order to succeed. A credible and fair pay forperformance system will require an effective performance evaluation system and supervisors who areable and willing to use it properly. Agencies will also need mechanisms such as training andsystematic monitoring of pay decisions and outcomes to ensure that pay for performance systemsoperate as intended.Although the requirements listed above are universal, we believe the long-standing principlesof providing “equal pay for work of equal value” and “appropriate incentives and recognition forexcellence in performance” are best met by agencies designing pay for performance systems to suittheir individual missions, workforces, and circumstances with respect to uniform guidelines andprinciples. Accordingly, this report discusses the critical choices that agency leaders will makeduring the design and implementation of a pay for performance compensation system. Thisdiscussion is intended to help agency leaders better understand how they can adapt pay forperformance systems to their organizations and to help them choose wisely among alternatives formeasuring and rewarding performance.I believe you will find this report useful as you consider the implementation of pay forperformance across the Federal Government.Respectfully,Neil A. G. McPhie

Designing anEffective Pay forPerformanceCompensation SystemA Report to the President andthe Congress of the United Statesby the U.S. Merit Systems Protection Board

U.S. Merit SystemsProtection BoardNeil A.G. McPhie, ChairmanBarbara J. Sapin, MemberOffice of Policy and EvaluationDirectorSteve NelsonDeputy DirectorJohn Crum, Ph.D.Project ManagerCynthia H. Ferentinos, Ph.D.Project AnalystJames J. Tsugawa

Table of ContentsExecutive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ixBackground . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .ixPurpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xConclusions and recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xiIntroduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1A summary of pay for performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1Benefits and risks associated with pay for performance . . . . . . . . . . . . . . . . . . . 2Pay for Performance Decision Points . . . . . . . . . . . . . . . . . . . . . . . . . . . 3Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3Is the agency ready for pay for performance? . . . . . . . . . . . . . . . . . . . . . . . . . . 3What are the goals of pay for performance? . . . . . . . . . . . . . . . . . . . . . . . . . . . 7Who should be paid for performance? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7What should be the timing for implementing pay for performance? . . . . . . . . . 8What should be rewarded? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8How should employees be rewarded? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14How much pay should be contingent upon performance? . . . . . . . . . . . . . . . 18How should performance-based pay be funded? . . . . . . . . . . . . . . . . . . . . . . . 20How can costs be managed? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21Who makes performance rating and pay decisions? . . . . . . . . . . . . . . . . . . . . 25Who provides input to performance ratings? . . . . . . . . . . . . . . . . . . . . . . . . . 26How can agencies facilitate pay system integrity? . . . . . . . . . . . . . . . . . . . . . . 28Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34Conclusions and Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . 37Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41A Report by the U.S. Merit Systems Protection Boardvii

Executive SummaryDecisions that are made during the design and implementation of a pay forperformance system are crucial. Therefore, agency decision makers shouldcarefully consider their design options with full awareness of potential advantagesand disadvantages. To assist agency leaders with these crucial decisions, we haveprepared this report to address topics such as who should be covered, what shouldbe rewarded, how to reward employees, and suggestions for preserving the integrityof the pay system. We hope that this discussion will assist agencies in anticipatingimportant issues and tailoring their pay systems to their unique needs, which willfacilitate their success.BackgroundIn the past, individual Federal Government agencies have obtained approvalto introduce pay for performance systems in limited demonstration projectsor in a few cases on an agency by agency basis. However, the transition of theFederal Government from the traditional General Schedule accelerated when theDepartment of Defense and the Department of Homeland Security obtainedapproval to implement performance-based pay systems. To further facilitate this shiftfrom recognizing tenure to focusing on performance, legislation has been proposedto implement pay for performance across the Federal Government.1However, moving from a pay system that rewards tenure to a pay systemthat emphasizes and rewards performance, will require more than legislation.Performance-based pay systems present unique opportunities and challenges, and thetransition from tenure-based pay systems will be neither quick nor easy. With thatin mind, we have prepared this report to support agencies who are planning to use(or are already using) pay for performance. Specifically, we discuss how agencies candesign, implement, and operate a pay for performance compensation strategy.Past experience with the General Schedule suggests that in pay systems, “one sizedoes not fit all.” Agencies need to customize compensation systems to their ownunique circumstances. Based on this premise, readers should understand thatalthough this report is presented as a “how to” guide, it is not our intent to prescribea single solution. Instead, our goal is to help agency leaders anticipate and betterunderstand some of the most critical decision points they are likely to face.1Working for America Act (draft proposal) as of February 2006.A Report by the U.S. Merit Systems Protection Boardix

Executive SummaryPurposeAs the guardian of the Federal merit systems, the U.S. Merit Systems ProtectionBoard (MSPB) hears employee appeals of covered personnel actions and conductsstudies to ensure that these systems adhere to the merit system principles and arefree of prohibited personnel practices. In this report, we provide an overview of theoptions inherent in the design, implementation, and operation of an effective pay forperformance system. For a summary of the primary questions that agencies shouldask themselves and a sample of the possible answers, see Table 1. This table servesas a roadmap to preview the decision points that we discuss in further depth laterin the report. We urge agencies to carefully consider each of these decision pointsbecause effective operation of the pay system requires agency leaders to make designchoices that best suit their organizations.Table 1. Key Decision Points When Considering Pay for Performance(Including a sample of issues and/or options)1. Is the agency ready for pay for performance?nnThe organizational culture supports pay for performanceManagement is committed to changing the culture2. What are the goals of pay for performance?nnnImproved recruitment and/or retentionIncreased individual and/or organizational performanceGreater fairness in pay3. Who should be paid for performance?nnnAll employeesFront-line employeesTop-level managers4. What should be the timing for implementing pay for performance?nnWholesaleStages5. What should be rewarded?nnnIndividual, team, and/or organizational achievementsShort-term and/or long-term goalsEfforts vs. outcomes when external constraints exist6. How should employees be rewarded?nnnOne-time cash bonusIncrease to base payCombination, such as control points7. How much pay should be contingent upon performance?nn Less than 5 percentApproximately 30 percentDesigning an Effective Pay for Performance Compensation System

Executive SummaryTable 1. Key Decision Points When Considering Pay for Performance (Continued)(Including a sample of issues and/or options)8. How should performance-based pay be funded?nnExisting funding (e.g., general increases, within-grade increases)Additional funding9. How can costs be managed?nnForced distributionReward only top performers (as a percentage of the workforce)10. Who makes pay decisions?nnFirst-level supervisorSecond-level supervisor11. Who provides input on the performance ratings?nnFirst-level supervisorSecond- or higher-level managers12. How can agencies facilitate pay system integrity?nnImproved performance evaluation processSupervisor and employee trainingConclusions and RecommendationsAgencies must tailor pay for performance systems to their mission andenvironment. Agencies have many options when designing a pay for performancesystem. These options include the coverage of a pay for performance system, thetypes of performance to be rewarded, how performance will be measured, the formthat pay for performance will take, and the delegation and review of pay decisions.However, there is no universally correct choice for any of these options. A choicethat is appropriate in one organization may be ineffective or counterproductivein another. For example, rewarding individuals who generate the greatest amountof output may be appropriate in some organizations that are very productionoriented. However, this approach could be problematic in an organization whosework demands close attention to how results are achieved, particularly in regardto matters such as quality, safety, or teamwork. Thus, an agency designing a payfor performance system must think carefully about its goals and how they are tobe achieved to create measures and incentives that can orient its workforce towardmeeting those goals.For pay for performance to be effective, agencies need to meet severalrequirements. Although agencies have options to tailor their pay practices,successful pay for performance systems do have some features in common. A pay forperformance system can only be effective if employees: value the pay or recognitionthat the organization offers in return for high performance; understand what isrequired of them; believe that they can achieve the desired level of performance; andA Report by the U.S. Merit Systems Protection Boardxi

Executive Summarybelieve that the organization will actually recognize and reward that performance.Those conditions are not likely to be achieved unless an agency meets certainrequirements. These requirements include:1. A culture that supports pay for performance;2. Effective and fair supervisors;3. A rigorous performance evaluation system;4. Adequate funding;5. A system of checks and balances to ensure fairness;6. Appropriate training for supervisors and employees; and7. Ongoing system evaluation.Research and experience indicate that agencies need to attempt to meet all ofthese requirements. For example, well-designed performance measures are not asatisfactory substitute for trained, conscientious supervisors; similarly, a high level offunding does not compensate for a lack of checks and balances.To make pay for performance successful, agencies need to makea substantial investment of time, money, and effort. To meet therequirements listed above, agencies will need to make investments that extendfar beyond the money needed to fund bonuses and pay increases. For example,supervisors will need: training in designing performance measures and providingperformance feedback; a performance evaluation system that enables themto accurately distinguish among levels of performance; and guidelines fordetermining pay increases or performance bonuses. The introduction of a pay forperformance system can also identify weaknesses in other areas—such as training,communications, and employee relations—that should be addressed.Performance evaluation serves as the foundation of a pay forperformance system. A pay for performance system links an employee’s payto some measure of individual and/or pay organizational performance, usuallythrough a formal performance appraisal. Consequently, performance standardsand measures—and the application of those standards and measures—mattergreatly to both the agency and the employee. Agencies should therefore ensurethat (1) performance goals and measures are relevant, reasonable, and usable; (2)employees understand and participate in the performance evaluation process; and(3) performance is evaluated fairly and rigorously. Agencies considering a pay forperformance system should be prepared to devote considerable effort to performanceevaluation. One frequently cited challenge is that performance is often difficult todefine and measure in public sector organizations. Even so, it is critical that thiseffort be made.xiiDesigning an Effective Pay for Performance Compensation System

Executive SummaryAgencies should select supervisors based on their supervisorypotential, develop and manage them to function as supervisors ratherthan technicians or staff experts, and evaluate and pay them basedon their performance as supervisors. Performance evaluation systems do notevaluate performance; supervisors do. Although agencies should take steps to defineand measure performance as precisely and reliably as possible, they should recognizethat it is not possible to predetermine or quantify every important aspect ofemployee performance. Therefore, agencies need to allow some room for supervisorsto use discretion and judgment when evaluating employee performance—whichis to say, some element of subjectivity. But they should also provide guidelines andtraining to equip supervisors to exercise that judgment responsibly because trustbetween supervisors and employees is critical to success.Supervisors also perform other tasks that directly affect employee performanceand how employees will fare under a pay for performance system. For example,supervisors assign work; they translate organizational goals into work unit andindividual performance goals; they identify training needs and provide access totraining opportunities; and they provide coaching and feedback. Consequently,any agency considering pay for performance needs to ensure that its supervisors arewilling and able to perform supervisory duties and should hold them accountable forhow they discharge their responsibilities.Communication, training, and transparency are essential elementsof a good pay for performance system. Pay for performance systems aremost effective when they encourage employees to manage and improve their ownperformance—when they help employees to understand what is expected of them,to choose wisely among various courses of action, and to identify, seek, and obtainthe resources (such as training and equipment) that they need to succeed.A pay for performance system cannot have these desirable effects unless employeesunderstand the organization’s goals, their role in achieving those goals, andhow the pay system works. Agencies should not assume that these matters areself-explanatory, but agencies should make a conscious effort to create thisunderstanding. That includes describing how the pay for performance systemoperates; informing employees what behaviors and accomplishments will berewarded; providing regular, constructive performance feedback; training employeeson how they should present their efforts and accomplishments; and tellingemployees how they have fared under the pay for performance system and thereasons for the outcome.Checks and balances are necessary. As discussed above, a pay forperformance system requires that agencies allow supervisors to exercise some degreeof discretion and judgment in evaluating and rewarding employee performance.However, a pay for performance system also requires fairness—both actual andperceived—for it to have any credibility or motivating power.A Report by the U.S. Merit Systems Protection Boardxiii

Executive SummaryConsequently, agencies must also ensure that supervisory decisions concerningemployee performance and pay are fair and reasonable. Training and guidance arenecessary but not entirely sufficient. Agencies should establish internal checks andbalances—such as limited delegations of authority, review panels, and internalappeals processes—to ensure that supervisors are, in fact, using their judgment anddiscretion appropriately.A pay for performance system needs sufficient funding to provide highperforming employees with meaningful pay increases and bonuses. Payfor performance represents a commitment from the agency to recognize and rewardexcellence. A pay for performance system will lose all credibility if high performancegoes unrewarded. Therefore, agencies should ensure that adequate funds areearmarked for performance awards.Pay for performance systems should be evaluated regularly andmodified when necessary. The General Schedule classification and pay systemhas remained in place, with relatively few changes, for more than 50 years. Althoughwe expect that the practice of pay for performance will endure, the useful life of eventhe best-designed pay for performance system will most likely be measured in years,not decades.Pay for performance systems need ongoing attention to keep them functioningproperly. Organizational goals will change; performance goals and measures willbecome obsolete; performance may improve or decline; managers may makeerrors in evaluating performance or allocating rewards. For all these reasons andmore, agencies need to monitor the operation and effectiveness of their pay forperformance systems and modify them accordingly. Only by giving the pay systemsand related organizational requirements the ongoing attention that they warrant willagencies be able to obtain optimal results from their pay for performance systems.xivDesigning an Effective Pay for Performance Compensation System

IntroductionA summary of pay for performanceThe term “pay for performance” refers to a pay strategy where evaluations ofindividual and/or organizational performance have significant influence on theamount of pay increases or bonuses given to each employee.When a pay for performance system functions properly:Pay forperformance– a paystrategy whereevaluationsof fluence theamount ofpay increasesor bonusesgiven to eachemployee1. Outstanding performers will receive the greatest rewards, to acknowledge theirsuperior contributions and to motivate them to continue high performance.2. Average performers will receive substantially smaller raises, which may encouragethem to work harder to achieve larger raises in the future.3. Poor performers will receive no increase, which is intended to persuade them toimprove their performance or leave.However, agencies should not rely only upon the motivational ability of moneyto improve individual or organizational performance because more employeesare motivated by factors, such as “personal pride or satisfaction in my work”or a “personal desire to make a contribution” rather than a “monetary award.”2Additionally, conditions in the Federal work environment (e.g., limited funding tosupport performance-based increases or awards, skepticism about whether or notsupervisors will reward high performance) have created a rather tenuous link frompay to performance.In fact, focusing on pay in “pay for performance” may be misleading. Rather, it maybe the associated emphasis on the performance evaluation process that producesthe most significant gains. For example, the initial clarifying of organizationalgoals and translating them into individual expectations, the emphasis on ongoingcommunication and progress checks, and the careful assessment of individualaccomplishments, which are used to justify the variation in rewards, may prove to bemore critical than the rewards themselves in improving organizational performance.Similarly, rather than concentrating entirely on the monetary benefits, individualsmay be more likely to join and stay with organizations where they witness effective2U.S. Merit Systems Protection Board, “The Federal Workforce for the 21st Century: Results of theMerit Principles Survey 2000,” Washington, DC, September 2003, p. 25.A Report by the U.S. Merit Systems Protection Board1

Introductionsupervisory practices because this creates an environment where employees are morelikely to have a sense of accomplishment and satisfaction.Benefits and risks associated with pay for performanceAgencies often have many objectives for pay for performance. For example, theymay aim to improve the organization’s ability to attract and retain high performers.They may hope to improve individual effort and consequently, organizationalperformance. They may also be searching for a fairer way to pay since those whocontribute more to the organization should receive a larger salary in return.Unfortunately, researchers have found that pay for performance has not achievedthese objectives in all instances.3 This should not be surprising: pay for performanceis a complex process that demands a large investment from those who seek to useit. The effectiveness of a pay for performance system can be undermined by flawsin the design, implementation, and operational phases. For example, an adequatebudget must be available to fund performance-based increases that are large enoughto be meaningful. Additionally, for agencies to fairly determine who receives theseincreases, the performance evaluation system must be accurate and supervisorsmust be well-versed in its use. Checks and balances should be built in to help holdsupervisors accountable for their decisions. Finally, the pay for performance systemmust be evaluated on an ongoing basis to detect when changes are needed as theorganization and the pay system evolve. We discuss these requirements and more inthe following section.3For example, the National Research Council’s 1991 report, “Pay for Performance: EvaluatingPerformance Appraisal and Merit Pay,” discusses problems encountered with pay for performanceduring the operation of the Merit Pay System and the Performance Management and RecognitionSystem.2Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision PointsOverviewUnderstanding the theory behind pay for performance and its potential impact iscritical to understanding the role performance-based pay can play in an organization.Nevertheless, agencies also need to pay attention to technical design points toensure that the mechanics of the system are sound. The effectiveness of pay forperformance in facilitating recruitment, retention, and motivation (and the resultingimprovements in individual and organizational performance) depends heavily uponmatching the approach to the situation. Thus, agencies need to carefully considernumerous decision points, such as those discussed below. To make it even morechallenging, the various choices often have both advantages and disadvantages.Although it is tempting to simply transplant compensation systems from otherorganizations where they appear to be functioning well, agencies need to tailor paysystems to fit their unique circumstances and needs. Fortunately, agencies can learnfrom the dilemmas others have faced and base their decisions on experience gainedelsewhere combined with information they glean from within.Questions agencies need to ask themselves range from the most basic—“Is theagency ready for pay for performance?”—to the more specific, questions such aswho should be covered, what behaviors should be rewarded, and how bonusesshould be distributed. Obtaining adequate funding and ensuring fairness can alsochallenge agencies, so these goals need to be pursued early in the planning process.Anticipating the substantial decision points and understanding the available optionscan help agencies make the best possible decisions. While exploring these issuesrequires some time and effort, it is worth the investment to avoid potential negativeconsequences in the long term.Is the agency ready for pay for performance?Given the appeal of paying for performance instead of tenure, many agencies havealready moved past deciding whether to adopt a performance-based pay systemand are rapidly moving towards implementation. Some of these organizations mayalready have in place an organizational culture conducive to pay for performance.However, many do not. Fortunately, these agencies do not have to passively waitfor the conditions to improve. They can use pay for performance as a tool fororganizational change to move the agency in the desired direction. For example,A Report by the U.S. Merit Systems Protection Board3

Pay for Performance Decision Pointsagency leaders can drive major organizational change by demonstrating commitmentto a performance-based pay strategy through their words and actions. As timeprogresses, the emphasis on performance perpetuates itself as the componentsof an effective pay for performance system facilitate further evolution towards aperformance-based culture. Figure 1 depicts the cyclical nature of this process.Figure 1. Changing Organizational Culture With Pay for PerformanceSince organizational culture may influence the ease with which pay for performancecan be implemented, agencies may find it useful to do a self-assessment beforedeciding how to design and implement a new pay system. Table 2 displays relevantdimensions of organizational readiness and selected indicators to help agencies gaugewhere they currently are. Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision PointsTable 2. Assessing Organizational Readiness for Pay for PerformanceDimensionOrganizational CultureIndicatornnnSupervisorsnnnPerformance EvaluationnnFundingnnFairnessnnTrainingnnSystem EvaluationnnOpen, two-way communication is valued and pursued.Trust exists between employees and supervisors/managers.Human resources management (HRM) systems such as selection, training,and performance evaluation have clear and consistent objectives and support payfor performance.Employee efforts support organizational goals.Work assignment, evaluation of performance, and distribution of awards are fair.Discretion and accountability go hand-in-hand.Assessment of employees is fair and accurate.Employees receive timely, accurate, and meaningful feedback.Appropriate pay increases and bonuses are given.Top leadership is willing to make difficult choices when allocating funds and awards.Checks and balances are in place.Transparency is valued and ensured.Training is provided to both supervisors and employees.Training covers both pay system philosophy and mechanics.The organization evaluates how the pay for performance system is being administeredand whether the pay for performance system is accomplishing its goals.Employee attitudes are tracked.Agencies may use the results of their self-assessment on the dimensions aboveto determine what areas they need to improve. As we discuss in the followingparagraphs, many of the indicators listed above will serve readily as tools forfacilitating organizational change or for monitoring the progress of organizationalchange as pay for performance is implemented.Organizational Culture. The concept of organizational culture covers numerous“values and ways of behaving that are common in a community.”4 Alignment amonghuman resources management (HRM) practices is one aspect of culture that cangreatly affect the success of pay for performance in an organization. Aligning thepay system with other HRM practices, such as selection, training, and especiallyperformance evaluation, serves to focus employees on shared goals and values anddelivers a consistent message regarding the value of performance. It also providessupervisors with the tools to move the workforce towards the desired performancebased culture. If agencies devote the proper attention to the supporting HRMsystems, they can optimize the effectiveness of their pay for performance system andstrengthen or create a performance-based organizational culture.4John P. Kotter and James L. Heskett, “Corporate Culture and Performance,” The Free Press,New York, NY, 1992, p. 141.A Report by the U.S. Merit Systems Protection Board

Pay for Performance Decision PointsAnother important indicator of an organization

Agencies have many options when designing a pay for performance system. These options include the coverage of a pay for performance system, the types of performance to be rewarded, how performance will be measured, the form that pay for performance w