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The Equity and Fairness of Employee Compensation Systems

Introduction

This aim of this assignment is to determine the equity and fairness of employee compensation systems. Having chosen the research topic the next step was to set out objectives on which to base the research. These included:

To assemble an accurate profile of the concept and meaning of equity and importance compensation.

To identify the major theories of equity throughout history.

To explore employee compensation systems.

To determine the perceived equity of these systems by surveying employees and analysing the results.

The authors have provided a Literature Review discussing the concepts and theories of authors who have previously written and whose writings are relevant to the objective of the topic. The authors believe it is important to know how employees feel about the equity of the system that determines their pay, as pay and compensation have a very important impact on the morale, motivation, job satisfaction and performance and retention of staff.

Literature Review

The Meaning of Equity

Employees compare their efforts and rewards with those of others in similar work situations. Individuals, who work for rewards from the organisation, are motivated by a desire to be equitably treated at work. Equity theory ideas ‘focus on the importance people attach to perceptions of fairness in how managers deal with them relative to others’(Knights and Willmott, 2007).

Importance of Compensation

Compensation is key to organisational strategy (Mello, 2011). It has an impact on attracting and retaining employees and ensuring optimal performance in meeting the organisation’s objectives. Mello describes the economic importance of compensation and adds that it ‘should allow the organization to maintain a cost structure that enables it to compete effectively and efficiently in its markets’.

Money as a Motivator

F.W. Taylor believed that employees would only be motivated by receiving as much money as possible (Taylor, 1911). This is a limited idea. As a result of Taylor’s theories on money as motivator and ideas by other writers, the debate about financial rewards as motivational factors continues. If rewards are allocated incorrectly on non-performance factors such as seniority, status and job title employee motivation and effort could be reduced. Managers need to recognise that the perceived value of the direct and indirect compensation, depends on employees own perspective on equity.

Adam’s Equity Theory

Equity theory suggests that once an individual has chosen an action that is expected to satisfy his or her needs, the individual assesses the equity or fairness of the outcome (Adams, 1965). Three attitudes are possible; an individual may feel equitably rewarded, under rewarded, or over rewarded. When individuals feel under rewarded or over rewarded, they will do something to reduce the inequity.

Fairness Theory

A further development ‘Fairness theory’ takes into account the notion of accountability and blame. ‘When people identify an instance of unfair treatment, they are holding someone accountable for an action that threatens another person’s material or psychological well-being. If no one is to blame, there is no social injustice’(Greenberg and Cropanzo, 2001). Managers should be aware of the importance of implementing decisions in order to achieve organisational goals in a fair and equitable manner. Compensation systems consist of two components; direct and indirect and an equitable system must incorporate three types of equity: internal, external and individual (Mello, 2011).

Equity and Fairness of Direct Financial Compensation

Base pay consists of paying the employee a set wage or salary as compensation for the work they perform for the organisation. ‘These roles are known as skill or knowledge based systems. The characteristics of a particular job is determined, and pay is made comparable to what other organizations pay for jobs with similar characteristics’ (Cummings and Worley, 2009). This method of assigning a base pay to a particular role means that there is little difference in pay for the same role across organisations. ‘This also leads to a price on a particular skill but it fails to reward employees for all of the skills they have, discourages people from learning new skills and results in a view of pay as an entitlement’ (Gibson, 1995). Equity can be viewed as both favourable and unfavourable for the employee. Equity is positive for the employee when the employee is getting the same compensation as other employees performing the same task using the same set of skills. ‘Skill based pay can lead to durable employee satisfaction by reinforcing individual development and by producing an equitable wage rate’ (Lawler, 1996). The disadvantage to this is that there would be a heavy investment on training and development of new skills for the employees. A measurement system would also need to be capable of indicating when employees have learned the new skills (Lawler, 1996). A sociological research study (Temnitskii, 2007) taken on the topic shows that people’s general opinion on the fairness of base pay is in line with Adam’ s theory of equity. The study also puts forward the hypothesis that ‘the higher the worker’s sense of fairness when it comes to wages and salaries, the higher their level of job satisfaction with the various aspects of the work and, above all, the amount of their pay and the operation of the enterprise as a whole’ (Sekisova, 2002). Direct financial compensation in the form of wages and salaries can be seen as fair for employees performing the same task as it does not allow for any discrimination or favouritism in the workplace. It is not a good motivator in terms of performance as the rate of compensation does not change with respect to performance and employees have to increase their skill set in order to increase their wage rate.

Equity and Fairness of Indirect Financial Compensation

The fairness of incentive pay as an indirect form of compensation is highly important. Incentive pay consists of systems such as bonuses, commission, profit sharing, stock options and performance-related pay. It is essential that equity standards are superior as they potentially influence an employee’s behaviour and attitudes. Research has shown that high performing organisations create relational exchanges within the work place that are based on trust care and respect (Rousseau, 1995). These companies are considered to be of a high standard. Bonus schemes and commission are two of the most common forms of incentive based pay. Bonuses are awarded when certain standards of performance are met, however if employees fail to meet these standards of performance then usually bonus will not be granted. Commission can be considered a fair form of incentive pay as the employee is paid purely based on their performance and abilities. However, it can be unfair if the employee is not working during the busiest periods, therefore said employee will miss out on compensation. In order to be equitable employers should make allowances for circumstances such as this. Profit sharing has multiple advantages including greater financial success, high levels of productivity and positive employee attitudes. Perceived pay equity is considered a psychological impact of profit sharing and demonstrates the effectiveness of a profit sharing plan. Feelings of pay inequity should develop if plan related earnings do not correspond to personal changes in work inputs (Florkowski, 1987). Stock options that are distributed differentially in proportion to performance may be perceived as more equitable than profit sharing, particularly by employees seeking some sense of control or ownership in the company. Alternatively stock options may generate weaker levels of work motivation and performance than merit pay as their ultimate value is determined, at least in part, by market forces over which the employee has no control. Consequently, the eventual value of stock options may turn out to be less proportionate to employee contribution or performance than expected, thereby again leading to a perception of inequity (Kraizberg et al. 2002).

Performance-based rewards allow employees to see a stronger connection between their performance and organisational performance. However, this form of compensation will not work for every organisation (Mello, 2006). Conflicts of interest concerning the fairness of these compensation systems can also cause problems in the work place.

Internal Equity

Employers need to establish a pay structure that meets employees’ equity expectancies. One way is through internal equity, whereby the system aims to achieve a fair pay differential among all the employees aligned to each position within the organisation. Managing and implementing an internally equitable pay structure can be delicate and difficult to achieve. Research has proved that ‘seventy eight percent of employees would be most angered if they found themselves paid less than others doing the same job in their own organization’ (Nash, 1972). As it is often easy for an employee to know their colleagues' salaries, fairness is essential when a system is chosen. Good communication needs to be present in the organisation and employers have to make sure that their employees fully understand the paying decisions in order to keep good morale and low turnover of staff. To have a successfully established compensation system and to correctly evaluate the different jobs within an organisation, four techniques are available; ‘job ranking, job classification, point systems and factor comparison’ (Mello, 2011). These techniques are adjustable to different kinds of organisation. Job ranking can be the simplest and the most suitable for small organisations, as it consists of a hierarchical ranking of the positions. Scientific organisation of the jobs, with the points systems or factor comparison focuses in a more or less quantitative way on the different factors that make a job more important on a compensation level. Once the pay system is designed and implemented, high executives and CEO pay needs to be carefully considered in order that all employees perceive their pay as equitable. Salary compression ‘happens when new hires earn higher salaries than employees who have more experience’ (Mello, 2011). If salaries are not adjusted to the new hires, a fall in morale and loyalty is to be expected.

External Equity

A simple definition of external equity is employee’s perception of the conditions and rewards of their employment, compared with employees from other firms. External equity is the term used to describe fair and competitive compensation with respect to the market value of a job.  Considering external equity involves researching alignment to what competing employers pay to attract and retain employees who have similar skills and responsibilities as the prospective new hire. Compensation is a tool used by management for a variety of purposes to further the existence of the company. Compensation may be adjusted according to business needs, goals and available resources. External equity is the situation that exists when an organisation's pay rates are at least equal to market rates. It is also known as matching strategy. An employer's goal should be to pay what is necessary to attract, retain and motivate a sufficient number of qualified employees. This requires a base pay program that pays competitively. Data as turnover rates and exit interviews can be helpful in determining the competitiveness and fairness of pay rates. There is however no single labour market for a particular job. Supply and demand differ across markets resulting in wage gaps in the labour market. This is due to a number of factors including geographic location, industry sector, organisation size, product competition, education and experience level. Most organisations set the pay for jobs to about the same as what other organisations pay for the same job. If an organisation increases costs of pay, they will attract a higher standard of applicants for the job resulting in lower turnover rates and more experienced and qualified applicants getting the job. Some organisations set the pay below that of other organisations which results in higher turnover rates and less qualified applicants applying for the position. An applicant might apply for this organisation as they see a chance of promotion and growth within the company.

Individual Equity

Mello defines individual equity as ‘pay differentials among individuals who hold identical jobs in the same organization’ (Mello, 2011). Seniority based pay in which employee compensation is determined by their longevity in the company is widely used. Research has found both examples that support and criticize this theory. In most public schools in Michigan teachers are paid according to this system. It is argued that under this scheme teachers are less inclined to ‘innovate or excel in the classroom’ (Munk, 1998). However, a recent French study found that senior members of staff were generally less exposed to stress and thought the environment of their company was agreeable (Baggio and Sutter, 2010). Merit based pay compensates employees according to their performance on the job and ‘ideally provide an incentive for employees to work harder and accomplish more’. This has however being questioned, as it depends on the feedback system, which can be quite subjective (Mello, 2010). Merit pay was condemned by Deming who states that ‘apparent differences between people arise almost entirely from the system that they work in, not from the people themselves’. He argues that the system factors are out of control for employees and that thus individual performance rating is unfair (Karwowski and Salvendy, 1994). Furthermore, Deming stresses that this kind of pay system discourages teamwork by putting too much emphasis on the individual (Deming, 2000). Companies pay by incentive plans which are also based on performance. Incentive pay is punctual, through the form of stock ownership for instance, as opposed to an addition to a base salary. As a consequence, ‘it must be re-earned in subsequent time periods and can have a greater motivational impact’ (Mello, 2010). Skill based pay systems determines employee compensation according to ‘the acquisition and mastery of skills used on the job’ (Mello, 2010). The main benefit is that it can encourage employees to get involved in training programs and then share the knowledge with the company. However the system has flaws. In a rapidly changing environment, some skills are outdated quickly, however most employees would consider it unfair their compensation was to be reduced on the basis that their skills are no longer of value to the organisation (Mello, 2010). Team based pay plans consist of rewarding a team of employees who have accomplished performance goals. It works well in companies that already have a culture of cooperation among employees and the main advantages include a climate of duty and commitment to the group, cooperation as opposed to competition and a spirit of camaraderie (Jackson, 2009). It needs to be implemented efficiently through good communication, employee implication and team members feeling that the system is ‘fair and equitable’ (Mello, 2010).

Equity of Executive Compensation

Many argue that the pay of the CEO should be a reflection of the performance of an organisation. There are negative responses which criticise CEO compensation pay. Criticism has often been from shareholders, employees, the media and the public in general. However, there is always a demand for successful CEOs, who can achieve profits for shareholders. The compensation packages are therefore justified in certain cases. High profile scandals in the media, exposing CEOs who have earned millions while their firms were in serious financial difficulties, have brought negative attention to executive compensation packages. The stock options approach to compensation packages allow the employees of a firm to purchase shares. The negative aspect of stock options is the opportunity for executives to become involved in activities which artificially drive up the value of the stock. Due to the negative publicity associated with executive compensation packages there is a shift towards offering employees and executives stock grants as opposed to stock options. Problems with unethical CEOs have resulted in companies suffering from financial difficulties while the executives have been in receipt of large payouts. The challenges associated with executive compensation packages remain key strategic issues for organisations. The balance between optimising performance and the equity of executive compensation systems are essential for the success of an organisation. This can be very difficult to achieve. The right CEO will only be attracted to an organisation with a lucrative compensation package on offer. However, it must be acknowledged, employees and shareholders require the CEO to perform competently to achieve profits. According to Steve Kaplan ‘evidence indicates that CEOs typically are not overpaid, in fact, good CEOs may be underpaid. Boards are well aware that they need to pay the going rate in order to attract and keep top executives. On the whole, they respond rationally to the inexorable force of the talent market’ (Mackey, 2009)

Research Findings, Analysis and Interpretation

In the construction of the survey the authors used a specific strategy to formulate the statements. Each statement was developed with equity of compensation or effect on employee behaviour as the central issue. By this method the authors can directly correlate the perceived equity with employee behaviour. There were sixty responses. Six questions focus directly on whether employees believe their pay is equitable.

Direct base pay for my work is fair and equitable (e.g. salaries, wages, commissions, bonuses, stock options, profit sharing)

75% of employees agreed or strongly agreed, 7% were undecided and 18% disagreed or strongly disagreed.

Indirect reward for my work is fair and equitable (e.g. holiday pay, time off, work hours, pension plans, insurance schemes)

48% of employees agreed or strongly agreed, 11% were undecided and 35% disagreed or strongly disagreed.

I am rewarded fairly and equitably relative to colleagues of the same level doing the same work in my organisation

55% of employees agreed or strongly agreed, 15% were undecided and 30% disagreed or strongly disagreed.

I am rewarded fairly and equitably relative to colleagues of a different level doing different work in my organisation

37% of employees agreed or strongly agreed, 35% were undecided and 28% disagreed or strongly disagreed.

I am rewarded fairly and equitably relative to workers outside my own organisation

45% of employees agreed or strongly agreed, 35% were undecided and 18% disagreed or strongly disagreed.

The pay and rewards of executives in my organisation is fair and equitable

37% of employees agreed or strongly agreed, 37% were undecided and 26% disagreed or strongly disagreed.

The results indicate that most employees perceive their pay as equitable and fair. With an interesting outcome regarding internal/ external and executive pay equity. High ‘undecided’ percentages for these factors pose interesting questions that may reflect the current economic crisis and the uncertainty employees are facing for their futures. The results reveal that perhaps employees don’t really know what their colleagues, managers and CEOs are being paid and so can’t determine their feelings of inequity as is reflected in the debate we see in the media regard these issues at the present time.

The next set of statements reveal data about how equity in compensation systems impact on employees feelings, behaviours and motivation

Conditions of work, perks and benefits influence my feelings regarding whether reward for my job is equitable and fair

72% of employees agreed or strongly agreed, 12% were undecided and 26% disagreed or strongly disagreed. These results quite clearly highlight the importance the influence of factors such as work conditions have on how employees perceive the equity of their pay. Perhaps management could use this information in the design of compensation systems to focus not only on direct and indirect compensation alone.

I increase/ decrease my performance according to whether I believe my pay is fair and equitable

38% of employees agreed or strongly agreed, 12% were undecided and 50% disagreed or strongly disagreed. The split result to this statement poses some interesting questions. Management should be relieved that for 50% of employees, perceived pay equity doesn’t alter their performance. However should managers focus their attention on the fact that the other 50% do alter their performance or potentially do? What implications dies this have for organisations?

My pay and reward affects my motivation

55% of employees agreed or strongly agreed, 8% were undecided and 37% disagreed or strongly disagreed. This result highlights the importance of money and compensation as a motivational factor and the need for the compensation system to be equitable.

Please rate the importance of factors you feel the fairest and most equitable reward systems should be based on (1 being most important, 5 being least important)

Employees responded as follows:

Individual Performance 1

Skills and Ability 2

Seniority/ Experience 3

Job Ranking/ Grade or Level 4

Organisation Performance 5

This result could give organisations valuable information regarding how to design compensation systems. The survey data shows the affect of perceived fairness on behaviour, performance and motivation. Management should be aware of the ability of a properly designed pay package to influence and aid the achievement of reaching organisational objectives.

Conclusions

The implication of the thinking behind the theories and concepts of equity is important for organisations to understand when considering staff compensation systems. If they are to be successful, assessing the fairness of organisational decisions about the allocation of pay is imperative. Employees take into account not only what those decisions are, but also the manner in which those decisions are made and if there is a perceived inequity the implications for the organisation could be very costly. At the same time a well planned and implemented, strategic form of employee compensation can be an effective motivator and contributor to employee performance and job satisfaction which would ultimately benefit the organisation.

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