Pay structure of the future – arguments in favour of a more variable salary

‘We need to set the counter to zero every year’. Xavier Baeten argues for a more variable salary.

Source: Trends (17/09/2015); Author: Goele Geeraert

“At present, wage costs are not rising any faster in Belgium than in the neighbouring countries. But that does not mean that we can declare victory. As the population ages, salary costs will become impossibly high for employers.” Xavier Baeten, Professor of Reward and Sustainability at Vlerick Business School, advocates a completely new way of looking at pay. Our pay structure is based far too heavily on fixed basic pay”, Xavier Baeten argues. “We need a new pay structure with considerably less emphasis on the basic salary.”

In what ways is the pay structure dependent on the basic salary?

XAVIER BAETEN. “First and foremost, we have pay category systems for operational white-collar workers that are often set down in collective labour agreements. In such systems, the fixed salary rises in proportion to an employee’s experience, i.e. their years of service. However, research by Hudson has shown that this method has resulted in an enormous salary gap in Belgium between older and younger employees. A 55-year-old accountant currently earns 64 per cent more than his or her 25-year-old colleague. Of course there is a difference in experience, but this argument does not explain the huge gulf. For secretaries, the salary gap can even be as much as 75 per cent.

“In light of the aging population, this system is dragging us into the abyss. Salary costs will go through the roof. Imagine the average age in a company is 40, but it rises to 45 over the next few years. Under the pay category system, this will have a serious impact on salary costs. We will not simply be able to recoup them through increased turnover or profitability. Not allowing the average age to increase is not an option. We are all fishing in the same pond.”

Pay category systems are not the only problem.

BAETEN. “That is true. There are salary components that depend on fixed pay. The pension and bonus, for example, are calculated as a percentage of fixed pay. If the fixed salary goes up, so do those rewards. That also has a serious impact on wage costs.”

How can we create a reward system that is less dependent on the basic salary?

BAETEN. “To begin with, we need alternatives to the many pay category systems in our country. For the first six to eight years, an employee’s achievements do improve as experience increases, but after that point their development is much more limited and ultimately it disappears. At that point we should shift the emphasis from a fixed to a variable salary, with the ‘counter’ being reset to zero each year. That is the approach taken in the Netherlands, for example, where they apply an ‘incremental’ system. Every job description has a pay scale consisting of a minimum and maximum salary with intermediate steps (‘increments’). The number of steps corresponds to the average time you need to reach full competence in that job. Once you have reached that point, your fixed salary stays the same and you have the right to variable pay, depending on your achievements or those of your team.

“Traditionally, variable pay is mainly linked to individual targets. If you achieve this, you get your bonus. But we are beginning to see the limits of that model. It reduces performance management to a score attached to a bonus. The relationship between evaluation and development is not given sufficient attention. This spring, the former McKinsey consultant Frederic Laloux published the book Reinventing Organisations. In it, he claims that the management paradigm of individual CPIs (critical performance indicators), management by objectives, and so on, has seen better days. He wants to get away from individual pay for performance and evolve towards pay for group performance. But that is not a model you can introduce overnight.”

Do salaries need to come down?

BAETEN. “Reducing the total salary cost of an employee – over his or her entire career – is possible under the Dutch system. Even if salary costs over an entire career remain as high as they are today, we can redistribute them. That would mean that employees earned more at the beginning of their careers and less later on. As the population ages, this system ensures that the salary costs do not rise along with the employee’s age. Hence the system would remain affordable.

“Older employees in a system with more emphasis on variable pay would earn less than at present, relatively speaking, but the government can compensate for that loss through tax measures. For example, by allowing older employees to put 40 per cent of their salaries into a pension plan with tax incentives and more flexibility. That would be a positive extra tax shift.”

Lower salaries mean less income for the government.

BAETEN. “That is true. But this measure will improve employment levels. That means that the government will not have to pay out as much in unemployment benefits. And because employees will earn more at the beginning of their careers and comparatively little at the end, the government can collect the taxes earlier. With a higher salary, young people will start investing in property more quickly again, which will benefit the economy as well. Today’s pay structure is based on constant economic growth of three per cent and a population that is not ageing. The new system is fair and provides guarantees for less strong growth and an ageing society.”

Why aren’t you in favour of a system based entirely on achievements, with no link to years of service?

BAETEN. “In fact it doesn’t make that much of a difference. Merit pay is not really a solution because it ends up being converted into a fixed reward again. Let’s say you get a positive evaluation and a three per cent raise. Your salary has increased from 100 to 103 per cent. After a positive evaluation the following year you get an extra 3.1 per cent rather than 3 (i.e. 3% of 103), and so on. What is more, unless you cap it, the fixed salary will continue to rise here as well.”

What does the pay structure of the future look like?

BAETEN. “I am in favour of a two-part system. One part consists of the basic salary, which increases until you are fully competent in the way you do your job. However you still need to stay motivated after that point. This can be done by allocating variable pay. There are various possibilities here, depending on the type of company involved. It might be a variable salary based on individual achievements or on the achievements of the team and the individual’s contribution to them. In some companies the team members would be able to decide for themselves how the budget is split, but that can also be left up to a manager. A profit-sharing system could also be added. This makes labour costs much more flexible and means that fewer heads will roll on the employment market.

“However a reward system of this kind must not become ‘orphaned’: it needs to be linked to career and performance management. If you continue to focus on individual achievements you will get nowhere.”

Will the achievements of the team – the variable salary – also form part of the salary for younger people whose basic salary can still increase? Or does it only come into play when the first part of the salary has ‘matured’?

BAETEN. “I would give employees this right from the very beginning. But if a company’s financial possibilities are limited, it might equally well only allow younger people an increase in their basic salary. They would only get the right to variable pay later on.”

If profit sharing was an option, would it apply to everyone, then?

BAETEN. “There are certain tax requirements at present that mean profit-sharing has to be collective, although this does not mean it has to apply to the whole company.”

Does the reward always have to be financial?

BAETEN. “We focus too much on the financial side of reward. Research has shown that employees attach most importance to autonomy and challenge, the way decisions are made and the company’s reputation. Compensation and benefits are considerably less important. The poorer the company is at providing non-financial rewards such as culture, vision and working atmosphere, the more attention it will have to pay to financial compensation.

“The financial reward must be fair and the costs need to stay under control. Fairness means that it should be both competitive and appropriate to the employee’s age and achievements. The rest of the reward should be composed of non-financials, from training possibilities to staff events to household help. The key thing is that the link between the nature of the reward and the activity and mission of the business should be as strong as possible.”

How can financial reward be linked more closely to the company’s activity?

BAETEN. “Firstly, for example, by focusing more on team targets if teamwork is important for your company. But it can also be done by linking reward more closely to the company’s results. If things are going well, the company should dare to be more generous and when things are more difficult, it should be stricter. This might apply to the variable pay, but also to the basic salary. If the company has no money, it cannot give pay rises either. At present we are just improvising. We always give people something; sometimes it is too much and sometimes it is not enough.

“A clearer policy is only possible, however, if the company pays sufficient attention to procedural justice. Many people are dissatisfied with their salary because they have no trust in the procedures that determine their pay – and no clear idea of what these procedures are. You can treat employees as fairly as you like in comparison to the rest of the market, but if their salary is a mystery to them, they will be unhappy. A company needs to be able to say: this is our vision, this is our reward strategy, these are the elements that constitute your pay package, and these are our choices. These may not make the company any more popular, but they do show that it is transparent and has a system.”

How can you get companies on board for a new pay policy of this kind?

BAETEN. “I advise companies to make a projection of their staff costs for the next ten years under current conditions. They should include a number of assumptions in the model: a certain salary package, their pay category system and a certain degree of ageing. They then need to look at the impact that this will have on costs. We need to arrive at an approach that offers a good balance for all stakeholders, both in the current socio-economic context and in that of the future. This should reinvigorate the business, whilst also offering security to employees. At present there is too much emphasis on fixed pay. This is a financial bomb waiting to explode.

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