The 3% Merit Fallacy

It’s performance review season at many companies right now.  Managers are sitting with their direct report and, hopefully, having thoughtful discussions about areas of strength and opportunities for improvement.  Employees, hopefully, are sharing their thoughts on past performance and goals for the future.

How one’s performance is rated – and companies use various tools from numerical scales to vanilla euphemisms such as “Meets Expectations” to do this – determines how an employee is rewarded financially.

The message from management is generally the same everywhere:  your success is tied to both how you perform as an individual and how the company overall performs.  The implication is when the company profits, so does the employee.

That all sounds great.  But here’s the fallacy:  the merit pool, the amount of money set aside for base salary increases, is almost always 3%.  That means the baseline recommended raise is 3%.  It’s 3% when the company has a bad year.  It’s 3% when the company has a record year.   I know this from my experience in management positions for more than 20 years. But it’s not just the case at places I’ve worked.  I’ve talked to numerous people over the years at a variety of companies and industries and practically without exception 3% is the rule.

If the merit pool never deviates from 3%, regardless of company performance, does the employee really have skin in the game?

From a management standpoint, this can be especially challenging for supervisors trying to retain top performers.  Managers are told to “feed the eagles and starve the turkeys,” meaning stack the financial rewards for the top performers.

Let’s look at this in practice.  A marketing director has two coordinators to evaluate – one outstanding and the other average.  Both are making $75k.  With a 3% average merit, that typically means the top performer gets a 4% raise ($3,000) while the average receives 3% ($2,250).

Was the difference in their performances only worth $750 to the company?  And for employee was the outstanding effort really worth the extra $28, before taxes, per paycheck (assuming 26 pay periods in a year)?

The merit pool is not an issue for executives, generally VP and above, because most companies provide long term equity incentives (restricted stock units, options, etc).  Unlike the merit pool, stock incentives are highly attuned to company performance and therefore can be quite lucrative if the company does well.  It’s true there’s more risk if the company goes backward, but generally companies offer a mix of stock and options to mitigate the potential downside.

And my friends in HR will remind me that the bonus pool is variable, offering the segment of employees I’m talking about more rewards based on performance.  There’s some truth in that but again more often than not the ability of supervisors to meaningfully distinguish rewards with bonuses is limited.

So what’s the answer?

First, companies should develop alternative or supplemental bonus pools open to all employees tied directly to company financial performance that offer meaningful financial rewards.  My last company did this to great success.  It gives everyone real skin in the game.

Second, stock incentives should extend deeper in the ranks.  Manager level employees should receive stock and ideally supervisors would have the ability to vary the amount by performance.  Shortened vesting cycles for more junior employees would make this idea even more compelling for young workers.

Finally, in an era when companies are spending billions buying back stock to benefit investors, why not forego some of those purchases and raise the merit pool?  If the merit pool is raised to 5%, with the understanding that the baseline raise for average performance remains at 3%, it makes it much easier for supervisors to truly reward great performance.

Making larger, smarter investments in employees is good business for many reasons – not the least of which is it usually leads to happier, more profitable customers.

At the risk of drifting into politics, it’s no secret that among large segments of our population, including young people entering the workforce, there’s a high degree of cynicism about corporate America.  They believe the rich are getting richer at the expense of the worker.  The 3% merit fallacy unintentionally feeds this narrative by creating the perception that all the rewards are going to senior management.  It’s high time we retire it.

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