Merit Pay, Equity, and Reward Systems in Organizations

Introduction to Merit Pay and Compensation Strategy

In order to stay competitive in today's market, it is critically important to retain and nurture talent. However, the acquisition, retention, and development of talent are closely connected with the compensation packages being offered. Merit pay and sound remuneration strategies play a pivotal role in employee retention, motivation, and overall performance. For this reason, organizations today seek to strike a balance between flexibility and equity when developing merit remuneration strategies. Flexibility is needed because of growing concern that payment systems may sometimes fail to match actual performance, and equity is important because employees need to find the system fair when comparing their pay package with those offered to others doing the same or similar jobs.

A rapidly growing body of literature and research indicates that flexibility and equity have now come to occupy a vital place in remuneration schemes, and that the inability to strike a balance between them can result in a breach of the psychological contract. This context brings several relevant concepts into focus for the discussion of merit pay systems today.

Internal Equity and External Competitiveness

Internal equity in an organization refers to justice and fairness in salary maintained across the job structure. In other words, how employees feel about their salary in relation to that of others within the firm is called internal equity. This equity must be maintained in order to attract the best talent and retain it. However, for many companies, another important concept comes into conflict with internal equity: external competitiveness. Sometimes, in order to attract the very best candidates, a firm may need to go beyond standard norms in developing its compensation package. For example, CEOs in most organizations may be paid extraordinarily high salaries simply because other organizations offer equal or better packages.

Internal equity is maintained through several basic practices of compensation and reward management, including job analysis, job evaluation, and performance appraisal (Bratton, 2003). These methods give employees a clear understanding of what is being rewarded and why they are being paid a certain salary. The firm must also be clear about what it rewards: hard work, overtime, honesty, talent, or dedication. For a nonprofit organization, dedication may play an especially important role; for most other organizations, it is hard work and measurable results that are rewarded. Most firms will also reward good values such as honesty, commitment, and positive relationships with customers.

While employees in most cases will develop positive feelings about internal equity if they believe they are being paid fairly, there will inevitably come a time when they compare their salaries with those offered elsewhere in the industry. This gives rise to the question of external competitiveness. There is no guarantee that an employee will not leave when he or she discovers that other firms are paying more for the same role and title. In today's dynamic labor market, no such guarantees exist, and retention can become a serious problem if employees find it relatively easy to switch jobs. It is therefore important to take external competitiveness into account as well.

The Psychological Contract and Pay Fairness

The psychological contract is another important concept that has informed the development of merit pay systems. Argyris (1960), who coined the term, described it as a "set of practical and emotional expectations of benefits that employees and employers can reasonably have of each other." Since then, the term has been defined and redefined numerous times, with Rousseau's definition becoming the most influential:

"An individual's belief regarding the terms and conditions of a reciprocal exchange agreement between the focal person and another party… A psychological contract emerges when one party believes that a promise of future returns has been made, a contribution has been given, and thus an obligation has been created to provide future benefits." (Rousseau, 1989)

Pay is generally the most important element within the contents of a psychological contract. In a UK study conducted by Herriot et al. (1996), it was found that employees cited fairness and pay most frequently when discussing the work environment — the two factors that consistently topped the list of employees' concerns when workplace conditions were examined.