Pay for performance: keep compensation and performance reviews apart

Looking to understand pay for performance? In recent years, the way employee performance is managed and evaluated has changed clearly. Not long ago, we knew exactly what motivated people at work:

• perks;
• benefits;
• salary.

We assumed compensation would bring the engagement, behavior and performance we expected. That no longer holds. A recent WTW survey found that only 39% of organizations consider their performance management process effectiveopens in a new tab at delivering what employees expect.

Today, the workplace tends to be driven by:

• growth opportunities;
• development;
• learning;
• meaning;
• purposeful work.

Practices that used to be tightly linked (goals, pay for performance and performance management) now work as complements. They no longer depend on each other as directly as before, so compensation and performance initiatives, like the corporate world itself, have become more flexible.

In this post, we look at how pay for performance works and how it connects to performance reviews.

What is pay for performance?

Pay for performance is a form of variable compensation in which the company takes into account the results an employee delivers. When those results meet or exceed levels defined in advance, the employee’s pay increases.

It is important to be clear that this model does not replace fixed pay, meaning the salary. Variable compensation works as a bonus tied to the employee’s results, measured through their performance indicators.

This type of compensation helps attract and retain talent, as long as the compensation policy is easy to understand and applied correctly.

Managing performance and pay for performance

If compensation does not improve performance, what does?

• First, give your team meaning and purpose in their work.
• Second, hold frequent conversations with the team to keep people engaged and on track. Feedback has a positive impact on employee engagement.

In practice, this means linking each employee’s work to the company’s bigger picture, listening to what people have to say and helping them grow.

Money and pay for performance still matter. They simply belong in a different conversation from the one about how employees can challenge themselves day to day and grow as professionals.

Tying goals only to financial compensation can lead to several problems.

For example: paying a percentage of the bonus based on the percentage of goals achieved can lead an employee to set a weak goal to be sure of hitting 100%, without really working to improve.

It can also penalize the person who sets bold goals and reaches only 90% of them. That person probably achieves more than the colleague, since working toward ambitious goals is what drives better performance.

That is why an individual development plan should also be part of the effort to improve employee performance.

We made a video (in Portuguese) that explains variable compensation. Watch it now and visit the Siteware YouTube channelopens in a new tab:

The Google example

As Laszlo Bockopens in a new tab, Google’s former VP of Human Resources, puts it: if you want people to grow, do not talk about development and compensation in the same meeting.

Development needs to be discussed with team members all the time, while compensation comes up once or twice a year. Performance development should be a two-way street between leaders and teams and should happen as often as possible.

This builds a culture of transparency and openness. It also makes sure individual goals align with company initiatives and keeps feedback, mentoring and training frequent.

When employees know the company’s priorities and understand how their work relates to the strategy, they are more likely to feel their work has meaning. That can strengthen their sense of connection with the organization and their engagement.

3 pay for performance methods

You can set a fair, market-based salary and still hold high expectations for the work.

That way, goals are less tightly tied to pay. They remain inputs for performance reviews and merit promotions, but they serve a larger purpose: continuous performance improvement.

Here are some ways to manage compensation.

1. Management by Objectives (MBO)

In this process, managers and employees set specific, measurable goals to be achieved within a given period, and those goals define pay for performance. When employees meet or exceed their goals, they receive a bonus.

MBOs usually cover only one goal, because splitting an incentive across every goal would make each payout too small to matter. As a result, achievements and incentives fail to reflect the employee’s full effort and work.

The method also misses people who perform above or below the goal. If the goal is to deliver 3 tasks and someone delivers 2 or 4, what happens? When beating a goal earns nothing extra, employees learn to commit to less than expected.

Likewise, when an employee misses the goal, it becomes hard to hold them accountable, since the method does not plan for different scenarios.

2. Variable compensation

Variable compensation, or pay for performance, is traditional in some areas, such as Sales, where part of the pay can be tied to performance. Even if it makes sense in some cases, it is best to tie pay to performance only where results can be clearly measured.

When a significant share of pay depends on qualitative results, it is hard to measure whether the goal was met. That can create problems, especially for the people management team, and can even affect recruiting and hiring.

3. Team performance bonus

Merit bonuses can be tied to team performance. Teams and individuals face similar problems, especially the question of what to do when the goal is not reached.

The leader becomes unpopular if the bonus is not paid. But if they pay it regardless of results (as 25% of companies do, paying bonuses even when expectations are not met), the team learns that goals, objectives and rules do not matter.

There are also cases where employees do not even know how the bonus is calculated. They simply receive extra pay at the end of the year, which does nothing to encourage better performance.

The goal is to understand who your employees are and agree with your team on the forms of compensation and performance review that fit them. For that, feedback must be frequent and processes must be transparent.

Here are objective ways to evaluate employee performance and apply pay for performance (video in Portuguese):

Key takeaways for your compensation policy

Pay for performance works best when it complements salary and relies on results that can be clearly measured. Where the work is qualitative, tying a large share of pay to the goal tends to create more dispute than performance.

Development and compensation call for separate conversations. Development happens all the time, through feedback, mentoring and the individual plan. Compensation is discussed once or twice a year, with rules everyone understands before the cycle starts.

Whatever method you choose (MBO, variable compensation or team bonus), decide in advance what happens when the goal is exceeded or falls short. That predictability discourages conservative goals and keeps the team’s trust in the process.

To keep exploring the topic, browse the other articles on the Siteware blogopens in a new tab, with analysis, articles and market opinion from our specialists on performance management, strategy and compensation.

Frequently asked questions

1. What is pay for performance?+−

It is a form of variable compensation in which the employee earns extra pay when they meet or exceed results defined in advance through performance indicators. It complements the fixed salary.

2. What problems come from tying money directly to goals?+−

Goals may be lowered to guarantee 100%, or the person pursuing bolder goals may earn less while delivering more. That is why continuous feedback and individual development plans matter.

3. How does Stratws help manage pay for performance?+−

Stratws aligns individual goals with company objectives, records performance agreements, tracks indicators in real time and connects performance to variable compensation with history and reports.