Compensation

Theory, Evidence, and Strategic Implications

Barry Gerhart, Sara Rynes

• Publisher: SAGE Publications, Inc
• Year: 2003
• Print ISBN: 9780761921080, 9780761921073
• eBook ISBN: 9781506320847
• Edition: 1
• Topic: Business
• Subtopic: Human Resource Management
• Index: Business

"The authors artfully synthesize complex scholarly articles from economics, psychology, and sociology. The organization of the book is exceptionally transparent... Compensation should be accessible to a wide range of readers who appreciate a multidisciplinary perspective on organizational issues... I cannot emphasize enough how effectively Gerhart and Rynes discuss compensation thoughout this book. As an experienced academic researcher, I have already benefited tremendously from my first reading of the book . It is a must-read, and I recommend it without reservation to instructors, researchers, and students."
--Industrial and Labor Relations Review

"Gerhart and Rynes provide a thorough, comprehensive review of the vast literatures relevant to compensation. Their insights regarding the integration of economic, psychological, and management perspectives are particularly enlightening. This text provides an invaluable tool for those interested in advancing our understanding of compensation practices."
--Alison Barber, Eli Broad College of Business, Michigan State University

Compensation: Theory, Evidence, and Strategic Implications provides a comprehensive, research-based review of both the determinants and effects of compensation. Combining theory and research from a variety of disciplines, authors Barry Gerhart and Sara L. Rynes examine the three major compensation decisions–pay level, pay structure, and pay delivery systems.

Revealing the impact of different compensation policies, this interdisciplinary volume examines

• The relationship between performance-based pay and intrinsic motivation
• Implications of individual pay differentials for team or unit performance
• The consequences of pay for performance policies
• Effect sizes and practical significance of compensation findings
• Directions for future research

Compensation: Theory, Evidence, and Strategic Implications considers why organizations pay people the way they do and how various pay strategies influence the success of organizations. Critically evaluating areas where research is inconsistent with common beliefs, Gerhart and Rynes explore the motivational effects of compensation.

Primarily intended for graduate students in human resource management, psychology, and organizational behavior courses, this book is also an invaluable reference for compensation management consultants and organizational development specialists.

	1	Introduction
		THE ENIGMAS OF COMPENSATION

Little evidence demonstrates the efficacy of rewards, although much evidence indicates that rewards and their design loom large in management attention.

—Pfeffer (1998a)

I’ve gone to seminars where you’re told that people want to be told how good a worker they are. And yeah, that’s true. It does feel good. But the bottom line is money. It boils down to money. To get that big chunk at the end of the year.

—Assembly line worker at Lincoln Electric (as quoted in Jasinowski & Hamrin, 1995)

Compensation is a complex and often confusing topic. Although compensation costs comprise, on average, 65% to 70% of total costs in the U. S. economy (Blinder, 1990; U. S. Bureau of Labor Statistics, 2001a) and are likewise substantial elsewhere (e. g., European Parliament, 1999), most managers are not sure of the likely consequences of spending either more, or less, on employees or of paying employees in different ways. Consider, for example, the plight of a manager trying to distill general “best practices” from the following set of highly successful companies.

Workers at Lincoln Electric are 3 times more productive than workers at comparable companies. Lincoln workers are paid on the basis of individual piecework plus an end-of-the-year individual bonus based on ideas and cooperation, output, dependability, and quality. Size of the bonus pool is based on overall company performance for the year. Lincoln has no paid holidays, no paid sick days, no paid health insurance, no coffee breaks, and no factory air conditioning. Yet in addition to the company’s financial success, Lincoln has absenteeism of less than 1.5% and employee turnover of less than 3% after the first 3 months of employment.

SAS Institute, a software company, has an explicit strategy of deemphasizing monetary rewards and stock options, which are typically the basis on which most companies in their industry compete for workers. SAS also deemphasizes hierarchy and opportunities for salary growth through promotion, focusing instead on broad benefits for everyone that have an equalizing effect on compensation. Despite this lack of emphasis on pay for performance, SAS has experienced strong financial success and is frequently found on “100 Best Companies to Work For” lists. Employee turnover is 4% in a very high-turnover industry.

Microsoft typically pays below-market salaries and often hires people away from other companies for less than they are currently earning. In return, employees receive stock options that vary by position level and performance and, in Bill Gates’s words, “a chance to change the world” (Rebello, 1992). Microsoft also makes extensive use of contract and subcontract workers, who do not receive the same compensation or benefits.

General Electric (GE) evaluates employees on a forced curve and terminates the bottom 10% each year. The GE 2000 Annual Report says that the “top 20% must be loved, nurtured and rewarded in the soul and wallet because they are the ones who make magic happen” (p. 4). However, the lowest 10% are removed each year,

Always raising the bar of performance and increasing the quality of leadership. Not removing that bottom 10% early in their careers is not only a management failure, but false kindness as well—a form of cruelty—because inevitably a new leader will come into a business and take out that bottom 10% right away. (p. 4)

GE makes heavy use of performance bonuses and stock options for its top performers.

Egon Zehnder International, a global executive search firm, has no individual merit component in its compensation system. In contrast to most professional service firms (which pay on the basis of billable hours and clients generated), each Zehnder partner has an equal number of shares in the firm’s equity, regardless of tenure. Shares rise in value each year because the firm reinvests 10% to 20% of its profits back into the firm. The remaining 80% to 90% is distributed across partners, with 60% being distributed across the board and the rest based on years as partner. Consultant turnover is 2% (as opposed to 30% in the industry on average), and the profit pool has grown every year for 37 years.

Based on the preceding examples, what seem to be the most effective pay practices? High emphasis on individual productivity, or no such emphasis? Emphasis on stock or stock options, or not? Rewards for seniority, or constant culling of the workforce to eliminate the lowest-performing individuals?

To add to managers’ confusion, researchers often disagree on many of the most central questions surrounding pay, depending on their disciplinary training, ideological beliefs, or other factors. For example, different schools of researchers disagree over the following issues:

• Whether or not pay is a strong motivator of performance
• Whether it is better to have high pay differentials both across and within job categories, or egalitarian pay throughout
• Whether or not paying high wages and salaries will induce loyalty and hard work
• Whether it is more effective to reward on the basis of group productivity, individual productivity, or some combination of the two
• Whether executive pay is too high or too low
• Whether there are general best practices in compensation or whether appropriate compensation practices depend on a variety of contextual conditions

Like others before us (e.g., Bartol & Locke, 2000; Gerhart & Milkovich, 1992; Lawler, 1971; Pfeffer, 1998a, 1998b), we believe that some general principles can be discerned with respect to determinants and effects of compensation practices but also that there are many unanswered questions. In addition, it appears that many different permutations of the general principles can be effective, as well as some pay systems that seem to confound many (if not most) of the general principles. Finally, there are questions about the extent to which effective compensation systems are reproducible across organizations, given that the effectiveness of compensation systems may be interdependent with a variety of other factors, such as an organization’s history, business strategy, culture, and other human resource practices.

Objectives

In writing this book, we have consciously worked to accomplish a number of objectives. One is to integrate theory with empirical evidence for each of the three major compensation decisions considered in this book: pay level, pay structure, and pay delivery systems. This is very important, because theories in some areas come into direct opposition with one another. For example, some theories (such as tournament theory) emphasize the potential advantages of hierarchical pay differentials, whereas other theories (based on social cohesion) emphasize the potential dangers. Still other theories (contingency theories and the resource-based view of the firm) argue that the most effective size of pay differentials depends on other organizational characteristics. In such cases, only empirical evidence can help us to choose among theories or modify them to more closely reflect reality.

A second goal is to review theories and research about both the determinants and outcomes of these three aspects of pay (with somewhat greater emphasis given to outcomes).

Third, we incorporate theory and evidence from multiple disciplines, primarily economics, psychology, and management, but also sociology. This is an advantage because the determinants and effects of compensation are very complex and have multiple facets. Thus, a complete understanding of compensation is not possible without interdisciplinary integration. For example, economics tends to focus on average or general effects, while psychology focuses more on individual differences and variations in outcomes. Similarly, economics and psychology tend to be founded on theories of individual choice and motivation, while sociology (and “blended” fields such as social psychology and organizational economics) tend to focus on social and group relationships, motivations, and outcomes.

Fourth, wherever possible, we discuss effect sizes and practical significance of compensation findings rather than merely their statistical significance. Numerous treatises have now been written about the limitations of statistical significance testing, such as the failure of the vast majority of empirical studies to meet their underlying assumptions, the dependence of statistical significance on sample size, and the arbitrariness and lack of precision in merely reporting cutoffs between statistical significance and nonsignificance (e.g., Schmidt, 1996). Thus, wherever possible, we supplement reports of statistical significance with estimates of variance explained, or percentage change in dependent or endogenous variables as a function of meaningful changes in independent or exogenous ones.

Fifth, we reinterpret or take a broader outlook in areas where previous research has either been misinterpreted or found to have serious shortcomings. We believe that at least two such areas merit such treatment in this book: research on within-group pay differentials and research on merit pay. The reader will see, for example, that previous studies that have reported negative outcomes from within-group pay differentials have sometimes completely ignored other aspects of their findings that point to positive effects of such differentials. As such, we place entirely different interpretations than the original authors on some reported findings.

Finally, we seek to understand not only what has been learned from previous research but also the most important issues for future research. Although some areas of compensation have been widely studied, other very important issues have remained almost entirely unresolved. Specific suggestions for future research can be found in each of the chapters, and more general research needs are summarized in the last chapter.

Outline of the Book

The complexity of pay systems makes it difficult to organize theories and research about pay in a comprehensive yet comprehensible manner. Thus, we begin with relatively simple issues and then build complexity as we go along. For example, Chapters 2 and 3 discuss the most general pay decision made by an organization, that of pay level (roughly, whether to pay more, or less, than what other organizations do). In Chapter 4, we add complexity by considering the fact that organizations may have the same average pay levels but very different pay structures (e.g., differences in compensation across high-versus low-level jobs). Chapters 5 and 6 focus on changes in pay (rather than initial or starting pay) and on differences in the bases on which such changes are determined (e.g., organizational performance versus individual performance, or individual performance versus seniority). Then, in Chapter 7, we consider the most complex possibility of all: that the effects of pay are deeply embedded in circumstances unique to each organization and thus perhaps impossible to accurately describe as main or independent effects.

In Chapter 2, we address theories of pay level. Such theories seek to explain why, for example, Lincoln Electric and Microsoft offer lower base pay levels than their competitors, while other companies, such as Mars Candy or A. G. Edwards, offer above-market base pay. We begin the chapter with a discussion of why early theorists and researchers paid curiously little attention to this question. For many years, economists did not consider this to be an important issue because their basic models of wage determination predicted that organizations would always be tending toward the same “market wage” as other employers. However, investigations of actual labor markets by applied economists after World War II showed that pay varied widely for the same type of work across employers, even in the same geographical area. For example, Dunlop (1957) observed a differential of nearly 100% between Boston truckers in the magazine industry versus those working in scrap iron and metal, despite the fact that they were performing almost identical work and were represented by the same union.

Over time, the discrepancies between theory and reality became too large to ignore, and a variety of enhancements to neoclassical theory emerged to explain the existence of these differences (e.g., efficiency wage, rent sharing, resource dependence, and ability-to-pay theories). We close Chapter 2 with a summary of the very limited empirical evidence on how pay level decisions are made, as well as a discussion of the complexities of studying pay level decisions (and outcomes) as distinct from other aspects of pay determination.

Chapter 3 discusses theories and research on the effects, rather than the determinants, of pay level. We begin by reviewing general theories of pay importance, which are rather different in economics (which tends to assign a predominant role to pay in work behaviors) than in psychology (which tends to assume that pay is only one of several factors influencing work attitudes and behaviors). From these general theories, we move to contingency theories suggesting that pay importance depends on the characteristics of both markets (e.g., variability in pay across employers) and individuals (e.g., values or personality). Next, we review evidence regarding the effects of pay level on various outcomes, such as pay satisfaction, applicant attraction, employee retention, employee quality, and overall utility. Finally, we note the surprising paucity of field research concerning the effects of pay level on objective outcomes (e.g., employee attraction, quality and retention, overall utility) and call for additional research in these areas.

In Chapter 4, we introduce greater complexity by moving our discussion from differences in average pay levels across employers to differences in the structure of pay inside organizations. By structure, we mean differences in pay between the top of the organizational hierarchy and the bottom (e.g., chief executive officer, or CEO, versus entry level positions) and between one job family and another (e.g., professional versus technical). For example, we explore issues such as why SAS and Southwest Airlines deliberately restrict the number of job levels and the size of pay differentials between them, while other organizations (such as GE) pay very large differentials as employees move up the career ladder (at least when stock grants and options are taken into account).

Whereas prior to Chapter 4, we talk about jobs as an abstract concept, discussion of pay structures requires a more explicit description of how jobs are described, evaluated, and compared both within and across employers. After discussing job evaluation and other possible bases for determining pay structures (e. g., individual differences in knowledge, skills, and abilities), we turn to various theories of why employers might choose to have steeper-than-average pay structures (e. g., tournament or winner-take-all theories), flatter-than-average structures (egalitarian or cooperative theories), or structures that pay special attention to a few key strategic positions (resource dependence theory). Limited evidence on the existence and effects of alternative structures is reviewed, and suggestions are made for future research.

In Chapter 5, we introduce theories about the incentive and motivational effects of alternative pay delivery systems. Common pay delivery systems include across-the-board increases, merit pay, seniority-based pay, stock grants and options, gainsharing and other group incentives, and profit sharing.

Given the rather amazing variety of pay delivery systems or bases for pay increases (or decreases), surprisingly little is known empirically about how such choices are made in the first place. We suspect that these differences often begin with ...

Table of contents

• Cover page
• Title
• Copyright
• Contents
• Introduction to the Series
• Acknowledgments
• 1. Introduction: The Enigmas of Compensation
• 2. Differences in Pay Level: Why Do Some Companies Pay More Than Others?
• 3. Effects of Pay Level: What Do Employers Get in Return for Higher Pay?
• 4. Pay Structure: Relative Pay Within Organizations
• 5. Pay Basis: Theories of Motivation and Pay for Performance
• 6. Pay-for-Performance Programs: Empirical Evidence
• 7. Pay Strategy
• 8. Toward the Future
• References
• Index
• About the Authors