Strategic Compensation A Human Resource Management Approach

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N i N t h E d i t i o N

Joseph J. Martocchio University of Illinois at Urbana-Champaign

Strategic Compensation A Human Resource Management Approach

In Loving Memory of Orlando “Lundy” Martocchio

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Library of Congress Cataloging-in-Publication Data

Martocchio, Joseph J. Strategic compensation: a human resource management approach / Joseph J. Martocchio. pages cm Earlier edition: 2015. ISBN 978-0-13-432054-0 1. Compensation management. I. Title. HF5549.5.C67M284 2017 658.3'22—dc23 2015030687

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v

Part I Setting the Stage for Strategic Compensation 1

Chapter 1 Strategic Compensation: A Component of Human Resource Systems 2

Chapter 2 Contextual Influences on Compensation Practice 25

Part II Bases For Pay 51

Chapter 3 Traditional Bases for Pay: Seniority and Merit 52

Chapter 4 Incentive Pay 77

Chapter 5 Person-Focused Pay 100

Part III Designing Compensation Systems 119

Chapter 6 Building Internally Consistent Compensation Systems 120

Chapter 7 Building Market-Competitive Compensation Systems 146

Chapter 8 Building Pay Structures that Recognize Employee Contributions 171

Part IV Employee Benefits 201

Chapter 9 Discretionary Benefits 202

Chapter 10 Legally Required Benefits 227

Part V Contemporary Strategic Compensation Challenges 251

Chapter 11 Compensating Executives 252

Chapter 12 Compensating the Flexible Workforce: Contingent Employees and Flexible Work Schedules 280

Part VI Compensation Issues Around the World 305

Chapter 13 Compensating Expatriates 306

Chapter 14 Pay and Benefits Outside the United States 325

Epilogue 343

Chapter 15 Challenges Facing Compensation Professionals 344

Brief Table of Contents

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vii

Preface xvi

Part I Setting the Stage for Strategic Compensation 1

Chapter 1 Strategic Compensation: A Component of Human Resource Systems 2 Defining Strategic Compensation 3

What is Compensation? 3 What is Strategic Compensation? 3

Compensation as a Strategic Business Partner 5 Strategic Compensation Decisions 6

Competitive Business Strategy Choices 7 Compensation Decisions that Support the Firm’s Strategy 8 Employee Roles Associated with Competitive Strategies 8

Building Blocks and Structure of Strategic Compensation Systems 8

Building Blocks: Core Compensation and Employee Benefits 9 Fundamental Compensation System Design Elements 11 Alternative Pay Structure Configurations 13

Fitting the Compensation Function in an Organization’s Structure 14

How HR Professionals Fit into the Corporate Hierarchy 14 The Compensation Profession 14 How the Compensation Function Fits into HR Departments 15

Stakeholders of the Compensation System 18 Employees 18 Line Managers 18 Executives 19 Unions 19 U.S. Government 19

◼◼ COmPenSatiOn in aCtiOn 19 Summary  20  •  Key Terms  21  •  Discussion Questions  21

◼◼ CaSe: Competitive Strategy at Sportsman Shoes 21 ◼◼ CRUnCH tHe nUmBeRS! CalCUlating tHe COStS OF inCReaSing tHe tOtal COmPenSatiOn BUDget at BUtCHeR enteRPRiSeS 22

•  Endnotes 23

Chapter 2 Contextual Influences on Compensation Practice 25 interindustry Wage Differentials 26 Pay Differentials Based on Occupational Characteristics 27 geographic Pay Differentials 29 labor Unions 30

Contents

viii Contents

employment laws Pertinent to Compensation Practice 32 Income Continuity, Safety, and Work Hours 34 Pay Discrimination 38 Civil Rights Act of 1964 40 Accommodating Disabilities and Family Needs 43 Prevailing Wage Laws 44

◼◼ COmPenSatiOn in aCtiOn 45 Summary  45  •  Key Terms  46  •  Discussion Questions  46

◼◼ CaSe: exempt or nonexempt? 47 ◼◼ CRUnCH tHe nUmBeRS! WHetHeR tO WORk OveRtime OR HiRe aDDitiOnal emPlOyeeS 47

•  Endnotes 48

Part II Bases for Pay 51

Chapter 3 Traditional Bases for Pay: Seniority and Merit 52 Seniority and longevity Pay 52

Historical Overview 53 Who Participates? 53 Effectiveness of Seniority Pay Systems 54 Design of Seniority Pay and Longevity Pay Plans 54 Advantages of Seniority Pay 56 Fitting Seniority Pay with Competitive Strategies 56

merit Pay 57 Who Participates? 57 Exploring the Elements of Merit Pay 57

Performance appraisal 59 Types of Performance Appraisal Plans 60 Exploring the Performance Appraisal Process 65

Strengthening the Pay-for-Performance link 67 Link Performance Appraisals to Business Goals 68 Analyze Jobs 68 Communicate 68 Establish Effective Appraisals 68 Empower Employees 68 Differentiate among Performers 68

Possible limitations of merit Pay Programs 69 Failure to Differentiate among Performers 69 Poor Performance Measures 70 Supervisors’ Biased Ratings of Employee Job Performance 70 Lack of Open Communication between Management and Employees 70 Undesirable Social Structures 70 Mounting Costs 71 Factors Other than Merit 71 Undesirable Competition 71 Little Motivational Value 71

◼◼ COmPenSatiOn in aCtiOn 71

Contents ix

Summary  72  •  Key Terms  72  •  Discussion Questions  73

◼◼ CaSe: appraising Performance at Precision 73 ◼◼ CRUnCH tHe nUmBeRS! COStS OF lOngevity anD meRit Pay 74

•  Endnotes 75

Chapter 4 Incentive Pay 77 exploring incentive Pay 77 Contrasting incentive Pay with traditional Pay 78 individual incentives 79

Defining Individual Incentives 80 Types of Individual Incentive Plans 81 Advantages of Individual Incentive Pay Programs 83 Disadvantages of Individual Incentive Pay Programs 83

group incentives 84 Defining Group Incentives 85 Types of Group Incentive Plans 85 Advantages of Group Incentives 89 Disadvantages of Group Incentives 90

Company-wide incentives 91 Defining Company-wide Incentives 91 Types of Company-wide Incentive Plans 91

Designing incentive Pay Programs 93 Group versus Individual Incentives 93 Level of Risk 94 Complementing or Replacing Base Pay 94 Performance Criteria 94 Time Horizon: Short Term versus Long Term 95

◼◼ COmPenSatiOn in aCtiOn 95 Summary  96  •  Key Terms  96  •  Discussion Questions  96

◼◼ CaSe: individual or team Reward? 97 ◼◼ CRUnCH tHe nUmBeRS! CalCUlating PieCeWORk Pay aWaRDS 97

•  Endnotes 98

Chapter 5 Person-Focused Pay 100 Defining Person-Focused Pay: Competency-Based, Pay-for-knowledge, and Skill-Based Pay 100 Usage of Person-Focused Pay Programs 103 Reasons to adopt Person-Focused Pay Programs 104

Technological Innovation 104 Increased Global Competition 105

varieties of Person-Focused Pay Programs 106 Contrasting Person-Focused Pay with Job-Based Pay 110 advantages and Disadvantages of Person-Focused Pay Programs 111

Advantages 111 Disadvantages 113

◼◼ COmPenSatiOn in aCtiOn 114 Summary  114  •  Key Terms  115  •  Discussion Questions  115

◼◼ CaSe: Person-Focused Pay at mitron Computers 115 ◼◼ CRUnCH tHe nUmBeRS! tRaining BUDget COStS 116

•  Endnotes  117

x Contents

Part III Designing Compensation Systems 119

Chapter 6 Building Internally Consistent Compensation Systems 120 internal Consistency 120 Job analysis 122

Steps in the Job Analysis Process 122 Legal Considerations for Job Analysis 127 Job Analysis Techniques 128 U.S. Department of Labor’s Occupational Information Network (O*NET) 128

Job evaluation 132 Compensable Factors 133 The Job Evaluation Process 134

Job evaluation techniques 135 The Point Method 136 Alternative Job-Content Evaluation Approaches 139 Alternatives to Job Evaluation 140

internally Consistent Compensation Systems and Competitive Strategy 141

◼◼ COmPenSatiOn in aCtiOn 141 Summary  142  •  Key Terms  142  •  Discussion Questions  143

◼◼ CaSe: internal Consistency at Customers First 143 ◼◼ CRUnCH tHe nUmBeRS! mODiFying a JOB evalUatiOn WORkSHeet 144

•  Endnotes  145

Chapter 7 Building Market-Competitive Compensation Systems 146 market-Competitive Pay Systems: the Basic Building Blocks 146 Compensation Surveys 147

Preliminary Considerations 147 Using Published Compensation Survey Data 148 Compensation Surveys: Strategic Considerations 151 Compensation Survey Data 153 Updating the Survey Data 160

integrating internal Job Structures with external market Pay Rates 162 Compensation Policies and Strategic mandates 164

Pay Level Policies 164 Pay Mix Policies 165

◼◼ COmPenSatiOn in aCtiOn 166 Summary  167  •  Key Terms  167  •  Discussion Questions  168

◼◼ CaSe: nutriment’s new Hires 168 ◼◼ CRUnCH tHe nUmBeRS! UPDating SalaRy SURvey Data 169

•  Endnotes  170

Chapter 8 Building Pay Structures that Recognize Employee Contributions 171 Constructing a Pay Structure 171

Step 1: Deciding on the Number of Pay Structures 172 Step 2: Determining a Market Pay Line 172

Contents xi

Step 3: Defining Pay Grades 174 Step 4: Calculating Pay Ranges for Each Pay Grade 175 Step 5: Evaluating the Results 178

Designing merit Pay Systems 179 Merit Increase Amounts 179 Timing 180 Recurring versus Nonrecurring Merit Pay Increases 181 Present Level of Base Pay 181 Rewarding Performance: The Merit Pay Grid 181 Merit Pay Increase Budgets 183

Designing Sales incentive Compensation Plans 185 Alternative Sales Compensation Plans 186 Sales Compensation Plans and Competitive Strategy 187 Determining Fixed Pay and the Compensation Mix 188

Designing Person-Focused Programs 189 Establishing Skill Blocks 189 Transition Matters 190 Training and Certification 191 In-House or Outsourcing Training 191

Pay Structure variations 192 Broadbanding 192 Two-Tier Pay Structures 194

◼◼ COmPenSatiOn in aCtiOn 195 Summary  196  •  Key Terms  196  •  Discussion Questions  197

◼◼ CaSe: a new Sales Representative 197 ◼◼ CRUnCH tHe nUmBeRS! CalCUlating Pay Range minimUmS, maximUmS, anD Pay Range OveRlaP 198

•  Endnotes  198

Part IV Employee Benefits 201

Chapter 9 Discretionary Benefits 202 Origins of Discretionary Benefits 202 Categories of Discretionary Benefits 204

Protection Programs 204 Paid Time Off 209 Services 211

legislation Pertinent to Discretionary Benefits 214 Internal Revenue Code 214 Employee Retirement Income Security Act of 1974 (ERISA) 215 Pension Protection Act of 2006 216

Designing and Planning the Benefits Program 216 Determining Who Receives Coverage 217 Financing 217 Employee Choice 217 Cost Containment 218 Communication 218

the Benefits and Costs of Discretionary Benefits 220 ◼◼ COmPenSatiOn in aCtiOn 221

Summary  222  •  Key Terms  222  •  Discussion Questions  223

xii Contents

◼◼ CaSe: time Off at Superior Software Services 223 ◼◼ CRUnCH tHe nUmBeRS! 401(k) Plan COntRiBUtiOnS: allOWaBle amOUntS anD emPlOyeR matCH 224

•  Endnotes 225

Chapter 10 Legally Required Benefits 227 Origins of legally Required Benefits 227 Categories of legally Required Benefits 228

Social Security Programs 228 Workers’ Compensation 233 Family and Medical Leave 234 Health Insurance 236

Health insurance Program Design alternatives 237 Fee-For-Service Plans 237 Managed Care Approach 239 Specialized Insurance Benefits 240 Consumer-Driven Health Care 241

additional Health Care legislation 243 Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA) 243 Health Insurance Portability and Accountability Act of 1996 (HIPAA) 243

the Benefits and Costs of legally Required Benefits 244 ◼◼ COmPenSatiOn in aCtiOn 245

Summary  246  •  Key Terms  246  •  Discussion Questions  247

◼◼ CaSe: a Health Savings account at Frontline PR 247 ◼◼ CRUnCH tHe nUmBeRS! CalCUlating taxeS UnDeR tHe Patient PROteCtiOn anD aFFORDaBle CaRe aCt 248

•  Endnotes 248

Part V Contemporary Strategic Compensation Challenges 251

Chapter 11 Compensating Executives 252 Contrasting executive Pay with Pay for nonexecutive employees 252 Defining executive Status 253

Who Are Executives? 253 Key Employees 253 Highly Compensated Employees 255

executive Compensation Packages 255 Components of Current Core Compensation 255 Components of Deferred Core Compensation 257 Equity Agreements 257 Separation Agreements 259 Clawback Provisions 260 Employee Benefits: Enhanced Protection Program Benefits and Perquisites 260

Principles and Processes for Setting executive Compensation 262

The Key Players in Setting Executive Compensation 262 Theoretical Explanations for Setting Executive Compensation 264

Contents xiii

executive Compensation Disclosure Rules 266 Securities and Exchange Act of 1934 266 Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) 269

executive Compensation: are U.S. executives Paid too much? 270

Comparison between Executive Compensation and Compensation for Other Worker Groups 270 Strategic Questions: Is Pay for Performance? 271 Ethical Considerations: Is Executive Compensation Fair? 272 International Competitiveness 273

◼◼ COmPenSatiOn in aCtiOn 274 Summary  275  •  Key Terms  275  •  Discussion Questions  276

◼◼ CaSe: CeO Pay in the news 276 ◼◼ CRUnCH tHe nUmBeRS! COmPaRiSOn OF Pay WitHin anD aCROSS inDUStRieS 277

•  Endnotes 277

Chapter 12 Compensating the Flexible Workforce: Contingent Employees and Flexible Work Schedules 280 the Contingent Workforce 280

Groups of Contingent Workers 281 Reasons for U.S. Employers’ Increased Reliance on Contingent Workers 286

Pay and employee Benefits for Contingent Workers 287 Part-Time Employees 288 Temporary Employees 289 Leased Workers 290 Independent Contractors, Freelancers, and Consultants 291

Flexible Work Schedules: Flextime, Compressed Workweeks, and telecommuting 293

Flextime Schedules 294 Compressed Workweek Schedules 294 Telecommuting 295 Flexible Work Schedules: Balancing the Demands of Work Life and Home Life 295

Pay and employee Benefits for Flexible employees 296 Pay 296 Employee Benefits 296

Unions’ Reactions to Contingent Workers and Flexible Work Schedules 297 Strategic issues and Choices in Using Contingent and Flexible Workers 298

◼◼ COmPenSatiOn in aCtiOn 299 Summary  300  •  Key Terms  301  •  Discussion Questions  301

◼◼ CaSe: telecommuting at medex 301 ◼◼ CRUnCH tHe nUmBeRS! CalCUlating tHe COStS OF FUll-time anD PaRt-time emPlOyment 302

•  Endnotes 303

xiv Contents

Part VI Compensation Issues Around the World 305

Chapter 13 Compensating Expatriates 306 Competitive advantage and How international activities Fit in 307

Lowest-Cost Producers’ Relocations to Cheaper Production Areas 307 Differentiation and the Search for New Global Markets 307 How Globalization is Affecting HR Departments 307 Complexity of International Compensation Programs 308

Preliminary Considerations 308 Host Country Nationals, Third Country Nationals, and Expatriates: Definitions and Relevance for Compensation Issues 309 Term of International Assignment 309 Staff Mobility 309 Equity: Pay Referent Groups 310

Components of international Compensation Programs 310 Setting Base Pay for U.S. expatriates 310

Methods for Setting Base Pay 311 Purchasing Power 311

incentive Compensation for U.S. expatriates 313 Foreign Service Premiums 313 Hardship Allowances 313 Mobility Premiums 314

establishing employee Benefits for U.S. expatriates 314 Standard Benefits for U.S. Expatriates 315 Enhanced Benefits for U.S. Expatriates 316

Balance Sheet approach for U.S. expatriates’ Compensation Packages 317

Housing and Utilities 318 Goods and Services 319 Discretionary Income 319 Tax Considerations 319

Repatriation Pay issues 320 ◼◼ COmPenSatiOn in aCtiOn 320

Summary  321  •  Key Terms  322  •  Discussion Questions  322

◼◼ CaSe: Jenkins goes abroad 323 ◼◼ CRUnCH tHe nUmBeRS! CalCUlating an exPatRiate’S BaSe Pay anD inCentiveS 323

•  Endnotes 324

Chapter 14 Pay and Benefits Outside the United States 325 Pertinent Concepts for Quantifying elements in the Discussion of Pay and Benefits Outside the United States 326 north america 327

Canada 327 Mexico 329

South america 330 Brazil 330

europe 331 Germany 331

Contents xv

asia 333 India 333 People’s Republic of China 334

◼◼ COmPenSatiOn in aCtiOn 336 Summary  337  •  Key Terms  337  •  Discussion Questions  338

◼◼ CaSe: north american expansion for threads apparel 338 ◼◼ CRUnCH tHe nUmBeRS! COmPaRing tHe RateS OF CHange in gDP PeR CaPita FOR SeleCt COUntRieS 339

•  Endnotes 340

Epilogue 343

Chapter 15 Challenges Facing Compensation Professionals 344 Possible increase to the Federal minimum Wage Rate and Strengthening Overtime Pay Protections 345

Raising the Minimum Wage 345 Strengthening Overtime Pay Protections 346

Rising Wages in China 347 Underemployment and the Compensation–Productivity gap 348

Underemployment 348 The Compensation-Productivity Gap 351

Workforce Demographic Shifts 352 Labor Force Diversity 352 Relevance for Employee Benefits 353

Summary  353  •  Key Terms  354  •  Discussion Questions  354

◼◼ CaSe: Benefits for Part-time Workers 354 ◼◼ CRUnCH tHe nUmBeRS! CalCUlating RegiOnal anD inDUStRy Pay DiFFeRenCeS in CHina 355

•  Endnotes  356

Glossary 357

Author Index 376

Subject Index 378

xvi

Preface

The measure of a company’s success is as much a function of the way it manages its employ- ees as it is a function of its structures and financial resources. Compensating employees represents a critical human resource management practice: Without strategic compensation systems, companies cannot attract and retain the best-qualified employees. Spending more than is necessary to attract and retain top talent adds costs unnecessarily to companies in search of competitive advantage.

The purpose of this book is to provide knowledge of the art and science of compensation practice and its role in promoting companies’ competitive advantage. Students will be best pre- pared to assume the roles of competent compensation professionals if they possess a grounded understanding of compensation practices and the environments in which business professionals plan, implement, and evaluate compensation systems. Thus, we examine the context of compen- sation practice, the criteria used to compensate employees, compensation system design issues, employee benefits, challenges of compensating key strategic employee groups, pay and benefits around the world, and challenges facing compensation professionals.

New to the Ninth Edition

1. Crunch the Numbers! are data driven exercises written to provide students with an opportunity to analyze data about one or more compensation issue contained within the respective chapters. One of the key skills a successful compensation professional should have is quantitative analysis for making informed compensation decisions. There are two exercises per chapter, which are assignable. The first exercise is contained at the end of each chapter and in MyManagementLab. An additional exercise appears in MyManagementLab only. Answers are found in the Instructors Manual and in the instructor’s section of MyManagementLab.

2. Dozens of new company examples, including Apple Computer, Boeing, Uber, and Wyeth Pharmaceuticals, appear throughout the book, bringing discussions of compensation prac- tices to life.

3. The ninth edition includes 39 additional concepts and practices to maintain the book’s position on leading edge knowledge and practice. Some of these concepts and practices include definitive proxy statements, point factor leveling, and the newly approved CEO pay-ratio rule. More than 150 new endnotes document the substantially updated material. For example, Chapter 15 includes a discussion of a possible increase to the federal mini- mum wage rate and its potential impact on a company’s practice.

4. Each chapter contains a feature titled Watch It which highlights a short video of a company’s experience with particular elements of compensation or HR-related issues, and it is integrated within the chapter material. The video and accompanying questions are available in MyManagementLab.

5. The ninth edition has 15 chapters, which is one fewer than in the eighth edition. Specifically, Chapter 10 in the eighth edition on retirement plans and health care plans has been revised and streamlined, and the material redistributed to Chapter 9 (Discretionary Benefits) and Chapter 10 (Legally Required Benefits). In the ninth edition, employer-spon- sored retirement plans appear in Chapter 9 and employer-sponsored health care appears in Chapter 10, to properly represent this practice as a legally required benefit under the Patient Protection and Affordable Care Act of 2010.

6. An expanded chapter summary is organized by learning objectives.

Preface xvii

MyManagementLab Suggested Activities For the ninth edition, the author is excited that Pearson’s MyManagementLab has been integrated fully into the text. These new features are outlined below. Making assessment activities available online for students to complete before coming to class will allow you the professor more discussion time during the class to review areas that students are having difficulty in comprehending.

Chapter Warm-Up Students can be assigned the Chapter Warm-Up before coming to class. Assigning these questions ahead of time will ensure that students are coming to class prepared.

Watch It This feature recommends a video clip that can be assigned to students for outside classroom view- ing or that can be watched in the classroom. The video corresponds to the chapter material and is accompanied by multiple choice questions that re-enforce student’s comprehension of the chapter content.

Crunch The Numbers There are two data-driven exercises per chapter, one in the book and both in MyManagementLab. Answers are found in the Instructors Manual and in MyManagementLab.

Assisted-Graded Writing Questions These are short essay questions that the students can complete as an assignment and submit to you, the professor, for grading.

About This Book This book contains 15 chapters, lending itself well to courses offered as 8-week modules, 10-week quarters or, 15-week semesters. The chapters are organized in six parts and an epilogue (contained in Chapter 15):

•◼ Part I: Setting the Stage for Strategic Compensation •◼ Part II: Bases for Pay •◼ Part III: Designing Compensation Systems •◼ Part IV: Employee Benefits •◼ Part V: Contemporary Strategic Compensation Challenges •◼ Part VI: Compensation Issues Around the World •◼ Epilogue: Challenges Facing Compensation Professionals

Course instructors on an 8-week module schedule or a 10-week schedule might consider spend- ing about two weeks on each part. Instructors on a 15-week schedule might consider spending about one week on each chapter.

A practical approach to teaching compensation will focus on the considerations and prac- tices common in the field of compensation. This textbook is well suited to a variety of students, including undergraduate and master’s degree students. In addition, this text was prepared for use by all business students, regardless of their majors. Both human resource management majors and other majors (e.g., accounting, finance, general management, international management, marketing, and organizational behavior) will benefit equally well from Strategic Compensation. After all, virtually every manager, regardless of functional area, will be involved in making com- pensation decisions. Both practitioners beginning work in compensation and current profession- als will find Strategic Compensation a useful reference. Among the features, Compensation in Action will clarify the connections between compensation and other functions.

xviii Preface

Available Teaching and Learning Aids The teaching and learning accessories are designed to promote a positive experience for both instructors and students.

A feature titled Compensation in Action appears at the end of every chapter in the text. This feature provides clear operational points to illustrate how line managers, employees, and compensation professionals interact to put compensation concepts into practice. The feature was prepared by Mr. Gentz Franz, Director of Development at the University of Illinois.

Short end-of-chapter cases have been included in the text. These cases were w