A pay philosophy is a company's commitment to how it values employees. A consistent pay philosophy gives the company and the employee a frame of reference when discussing salary in a negotiation.

The goal of a pay philosophy is to attract, retain, and motivate employees. For companies in the private sector, this usually requires a competitive pay philosophy. For companies in the public sector, this means a well-rounded philosophy, with a focus on benefits and work life.

Companies attract, motivate, and retain through total compensation
The purpose of a good compensation philosophy is to attract, retain, and motivate good people. To accomplish these goals, companies use a mixture of the three main components of compensation: Base pay, also called salary; incentive pay, whether in the form of cash or non-cash award such as stock; and benefits, or non-financial rewards. A pay philosophy is a blend of all three, since the company must pay for whatever it delivers to employees.

For example, a company's pay philosophy might be to offer salaries that are competitive in the market, or it might favor pay that is structured to attract employees rather than pay that helps to retain them. But few companies can afford to attract, motivate, and retain via generous compensation. The challenge is to create a pay program that acknowledges all three goals without exhausting resources.

As an example, suppose a small company with moderate cash resources is establishing a pay philosophy. The philosophy might look something like this:

• Pay a competitive base salary - not an aggressive one, but a salary comparable to what an employee could get somewhere else.
• Offer equity in the company to all employees, so that they can reap the rewards of the company.
• Be aggressive in total overall compensation through the use of the incentives. If, for example, an employee is below market by $20,000 in base pay, deliver market parity via a $5,000 signing bonus; a $5,000 retention bonus; and a $10,000 incentive. Incentive programs should be designed so that high-performance people get high compensation.

Lead-lag, lag-lead establishes timing of adjustments
Most companies review salaries once or twice a year, but the market moves continuously. Therefore, a company's pay is likely to be at market value just once or twice a year, similar to the hands on a broken clock, which only tell the correct time twice a day.

As a consequence, companies must decide what time of year to offer raises, and whether to lead the market at the beginning of the year and lag behind at the end of the year; or to lag behind at the beginning of the year and lead at the end. These two approaches are called lead-lag and lag-lead.

Employee proficiency ties skills to market value
Some pay philosophies track the development of skills that lead to proficiency in a job. The more proficient an employee becomes, the closer to market value he or she gets. This is a way of paying according to a market based on the value of skills.

Paying for employee proficiency is in contrast to paying for longevity, which has fallen out of favor in many industries but prevails nevertheless. The formula for employee proficiency involves calculating a comparatio - the employee's salary over market, defined as the median or some other control point. For example, if an employee earns $45,000 and the median for that job is $50,000, the employee has a comparatio of 90 percent.

An employee who has lingered at a comparatio of 90 percent is at risk of leaving the job. If the company is interested in retaining the employee, it won't cost much to bring him or her up to market. If there is a reason the company doesn't want to pay 100 percent of market for this job, for example if the employee is not yet fully proficient in the job, it might still make sense to pay the employee98 percent of market. In the example above, the company would pay $4,000 more to their current employee, who might well merit the full $50,000 anyway, to insure against the cost of hiring a new employee.

There are several advantages of the pay-for-proficiency method. Because pay is tied to the market value of a job, employees don't get stuck with merit increases of just a few percentage points a year. Because the market value of a job is tied to skills, the conversation about compensation can begin from a level playing field: An assessment of how the employee compares on each of a number of measures of proficiency and skill.

Proficiency is not the same thing as performance. Someone who is not yet proficient at a job may still be learning some of the basic skills, especially after a promotion. Yet the employee's performance may exceed expectations. Poor performers do not deliver on the expectations of the job, and companies do not typically retain these employees for long.

As employees become proficient in their jobs, it is important to keep them moving to the next level. Otherwise their pay will stagnate and they may become unmotivated or look elsewhere for a new challenge.

Program should be carried out consistently
By law, pay practices must be consistent, must not discriminate, and must not be arbitrary. Yet a pay philosophy may include different approaches for different types of employees.

For example, a company might decide to pay a competitive rate for most jobs and an aggressive rate for jobs that are especially difficult to fill and important to the bottom line. Such a company might pay its executives and its sales personnel at the 75th percentile and the rest of its employees at the 50th percentile.

A philosophy applied inconsistently can devalue employees and lead to trouble. For example, suppose a company established a flat rate of $9.90 per hour for nonexempt employees in a customer service role. The department had 200 percent turnover. Despite the published flat rate, some employees with college degrees successfully negotiated for $10 per hour or more, while employees with 20 years of experience faithfully assumed the flat rate was non-negotiable. Soon, three women over 40, a protected class under age discrimination laws, were earning less than three men who had just graduated from college. The manager's defense when confronted with the disparity was that the women never asked for more.

Legal cases involving such discrepancies often center around the principle that it is more egregious to violate and be inconsistent with your own pay practice than it is to follow the law. In this example, correcting the discrepancy could cost the company tens of thousands of dollars. If the money isn't in the budget, the department could be forced to lay people off or freeze salaries.

Communication is part of retention
Employers benefit from communicating their pay philosophies to employees, because a sound philosophy consistently applied creates a sense of fairness. Some companies advertise their pay structure as a recruitment and retention strategy. If a company publishes its pay philosophy anywhere, it should also tell any employee who asks.

Job candidates should also be aware of a company's pay philosophy. If a company doesn't have a pay philosophy, it will be easy to tell during the salary negotiationSome companies even publish the philosophy in an employee handbook, and show employees where they are in relation to market. It makes more sense, during a salary negotiation, for an employer to say, "My final offer is $67,000, which is 100 percent of market," than it does to say, "My final offer is $67,000, and I can't pay a cent more." Can't usually means won't.

It can be to a company's benefit even to communicate a two-pronged pay philosophy where some jobs are compensated at more than the market rate. For example, one company with high turnover in its customer service department, a department critical to the company's success, decided to compensate customer service representatives above market. Customer service people got better work spaces, incentive plans, and higher-than-market base pay. In communicating this change in philosophy to all employees, the CEO spoke candidly about the business reasons for the philosophy and the value to the company. Some employees thought the change was unfair, and left the company. But others respected the CEO for his honesty and fairness, and stayed. It became easier to hire and keep personnel for customer service jobs, and the plan succeeded.

Start the dialog, involve senior management
If you have questions about the philosophy behind your compensation, ask your human resources department for a copy of the company's pay philosophy. This should show you the link between your pay and the company's overall compensation principles.

If your company does not yet have a pay philosophy, suggest that the human resources department establish one. Employees need to see the connection to understand their value. Pay philosophies are important for companies of all sizes and stages because without them entrepreneurs could end up underpaying or overpaying for employees. Both problems result in a cost for the company, either in turnover or high salaries. In most companies, a human resources person takes responsibility for compensation; in a small company, the CEO might become proficient in the principles of compensation.

When a new company is establishing a pay philosophy, senior management must be involved, and the philosophy must be strongly aligned with company objectives. The CEO and other senior management must understand the program, agree to it, and support it consistently in order for the effort to be successful and worthwhile.

- Erisa Ojimba, Certified Compensation Professional - Modified 11-15-2004