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How to Use Merit Raises in Your Compensation Strategy

Recent history has demonstrated that anything can lure workers away from a job. And amid the Great Resignation triggered during the COVID-19 pandemic, low pay and lack of advancement opportunities are at the top of the list.

In a Pew Research Center survey of US workers about why they left a job in 2021, 63% of respondents cited low pay as a major or minor reason why they left. That same percentage attributed their resignation to lack of opportunities for advancement. But these reasons for quitting aren’t new; a 2017 Glassdoor study found that offering competitive pay is a key way to keep workers on the job, along with opportunities for advancement in compensation and title.

Any employee retention program requires a series of strategies, from compensation to the right corporate culture. When it comes to pay, one integral tool at an organization’s disposal is the merit raise, giving employees the chance to earn more money as they work toward their goals.

“As long as you’re using the merit [raise] appropriately and it’s transparent, it can definitely boost productivity [and] performance,” said Jodi Brandstetter, founder and Chief Talent Strategist of Lean Effective Talent Strategies (LETS), a hiring and recruitment consultancy. “It’s something that employees are excited to get.” 

However, there are some essential points to consider when awarding merit raises — as well as crucial pitfalls to avoid. Here’s what you need to know to effectively use merit raises in your compensation strategy. 

What Is a Merit Raise? 

Plenty of employers confuse merit raises with other pay increases, including cost-of-living adjustments (or COLA), and pay bumps required to shore up internal pay equity. But these types of pay increases are not the same and need to be approached and calculated differently.

A cost-of-living raise is intended to help counteract inflation, so employees can continue to afford their daily expenses as the price of consumer goods rises. Salary increases to ensure internal equity typically come after a pay equity audit that has uncovered that one class of workers is earning less than another.

On the other hand, merit pay rewards an employee’s high performance over the past year. Merit increases should be based on an employee’s performance and role, said Brandstetter, and are usually awarded as a result of an employee’s performance on goals established during their previous annual performance review

There’s typically some variance when distributing merit pay increases. For example, your merit pool — the amount of money available for pay raises across a company — might be 3%. However, top talent who have exceeded every goal might earn 4%, while average performers may get 3%, and lower performers may take home 2%. 

But, as managers make decisions like these about just how much their direct reports should earn in the coming year, they’ll need to be mindful of both the benefits — and bungles — of doling out merit raises.

“As HR professionals, we’ve got to reach out and make sure managers are aware of those biases…”

Pros and Cons of Merit Raises

Employees want acknowledgement, and for companies that don’t recognize and reward their workforce, there could be a high price to pay: Workers who say they haven’t been “adequately recognized” for all that they do are twice as likely to quit within a year, according to one Gallup survey. A merit pay system is one way to acknowledge an employee’s performance — and keep your workforce satisfied and retained

But managers and HR leaders must also be aware of the missteps that can lead to the unfair distribution of merit raises. These cognitive biases, or errors in thinking, might cause managers to dole out merit increases unfairly. For instance, recency bias could result in a manager awarding a better merit increase to an employee who just finished a complex project than to someone who completed a similarly difficult project earlier in the year. Or, managers may unconsciously favor people who look or think like them. 

“As HR professionals, we’ve got to reach out and make sure managers are aware of those biases and teach and talk to them about them,” said Courtney Berg, founder and owner of HR consulting firm CourtSide Consulting. If biases aren’t addressed and corrected, merit raises could do more harm than good.

Merit Raise Methodology 

Once you’ve made managers aware of the pitfalls that can crop up with performance evaluations, you’ll need to ensure that they’re fairly and equitably evaluating employees. Here’s how to scrub as much bias from the equation as possible and get your merit raise methodology right. 

1. Determine eligibility.

An organization’s compensation philosophy may not involve distributing raises in the same way to every employee. Some senior employees may earn stock options based on the growth of the company they helped lead in the past year. Others, such as salespeople who earn compensation beyond a base salary, may earn a higher sales commission for strong performance. And others, such as individual contributors or junior-level employees, may qualify for merit raises. Policies can vary widely, depending on each organization’s roles and needs. But whatever your policy is, it’s essential to clearly spell it out.

When it comes to merit raises, Berg stressed the necessity of having clearly defined processes and policies in writing. “If you’re going to create a scenario where you’re offering [some] employees merit raises, I would recommend writing out the reasoning and decision-making behind it, so you can reference that any time you’re considering whether or not to offer someone a merit increase,” she said. “You want to make sure there’s no claim for discrimination.”  

“It wasn’t a shocker if someone scored a two instead of a three or four on something…They already knew [because] we had that consistent dialogue.”

2. Establish merit metrics.

Employees are typically evaluated on both objective and subjective criteria, and performance reviews usually include specific targets that individuals must meet or exceed to earn a merit raise. 

Objective goals are straightforward and easy to define for some roles. For instance, key performance indicators, or KPIs, for a salesperson would include hitting specific sales numbers, while a recruiter, Brandstetter noted, may be evaluated on the length of time it took them to fill roles.

But subjective goals can be more difficult to evaluate; the salesperson may also need to demonstrate that they can communicate effectively internally, and a recruiter might have to improve their relationship with a hiring manager

When Brandstetter was a manager, she used a scorecard, or performance management system, that included metrics, feedback, survey insights, and other data to monitor employees’ performance, accolades, and missteps. In the example of the recruiter, a system like this might track their communications with the hiring manager. Brandstetter said that reviewing the scorecard monthly with employees helped enable consistent communication and keep direct reports apprised of whether or not they were on track to hit their goals.

Once it was time for their performance reviews, employees already had a good idea of how well they’d done. “It wasn’t a shocker if someone scored a two instead of a three or four on something,” Brandstetter said. “They already knew they were going to score that because we had that consistent dialogue.”

3. Grade the goals.

Once goals are set, it’s important to connect them with how they’ll impact a merit raise. When evaluating employees, Berg likes using a 100-point scale, assigning points to each goal. If the employee earns 100 points, they get the highest raise available. If they earned 75 points, they get 75% of the raise available, and so on. 

How points are assigned to an employee will depend on the role. For a salesperson, 90% of their merit raise might be based on achieving their objective goals, and 10% would be distributed based on how well they met subjective goals, Brandstetter said. For other roles, the subjective goals may be weighted more heavily.

4. Check for fairness and consistency.

To ensure that merit raises are distributed fairly, assign an individual, often an HR department leader who is aware of how biases can creep in, to review all merit raise decisions, advised Berg. That individual can evaluate whether one manager gives higher raises across the board than another, for instance. This review process could also uncover biases that lead to certain classes of workers receiving higher raises than others, she said. Berg pointed out that having this type of oversight in place will help avoid biases in the merit increase process — or at least, identify and correct them as soon as possible if they exist.

Explaining Merit Raises to Your Team 

Discussions about money can be among the trickiest conversations to have with employees — and, when not handled right, can lead to harmful rumors if there’s a perception by employees that they aren’t being paid fairly. That’s why it’s critical to inform all employees about your company’s processes and policies around merit increases. Here’s how to explain merit raises to your team.  

1. Make sure it’s a part of your company’s compensation philosophy.

Every organization should have a compensation philosophy that explains the guiding principles behind how employees are paid. And, while there are a lot of factors to include in any compensation philosophy, how employees can earn bonuses or raises (through merit or otherwise) shouldn’t be overlooked, said Kimberly Prescott, founder and President of Human Resources consulting firm Prescott HR.

Compensation philosophies are generally based on a company’s goals. So, for businesses that signal through their goals that they aim to reward their best employees for their hard work, a merit raise naturally fits in with this objective. 

A “really clear and transparent compensation philosophy,” Prescott said, is an important way to explain the reasons behind why companies make any compensation decision — including merit raises — to team members. It helps ensure that everybody is on the same page.  

2. Put it in writing.

Clearly explain the basis for making merit raise decisions and any metrics that are considered, beyond how well an individual employee is doing. This might include a disclaimer that merit raises aren’t always guaranteed, and are only offered when the business is doing well, said Shannon Curtis, a Human Resource business partner for HR consulting firm Employers Advantage.

“If you’re going to create a scenario where you’re offering employees merit raises, I would recommend writing out the reasoning [and] decision-making behind it, so you can reference that any time you’re considering whether or not to offer someone a merit increase,” advised Curtis.

This will not only help managers make fair decisions, but will also help employees understand why decisions were made; if an employee is dissatisfied with their merit increase (or lack thereof), their manager can point to specific, written policies that informed the decision.

3. Keep the conversation going.

If an employee’s goals from their performance review have been part of ongoing conversations during weekly or biweekly one-on-ones with their managers, no merit raise decision will be a surprise because it’s been top of mind all year. Berg said it’s important to keep an employee’s progress toward their goals at the forefront of these regular check-ins. She recommended that during one-on-ones, managers routinely ask their direct reports questions like, “What accomplishment are you really proud of since we last met?” and “What goal have you achieved or moved toward in the last week or month?” 

”You want to be able to have a conversation with [your direct reports] about what they’re doing and how close they are to accomplishing their goals…and what action steps [they] are taking to get there,” said Berg. “That needs to be an ongoing conversation.”

It may take some additional effort, but making sure to have clear communication about merit raises and how well employees are doing throughout the year pays off in the long run. Aside from the benefit to employees, there’s also a return on investment for managers. “[As a manager], being able to have these types of conversations in a professional manner helps you get promoted, [too],” Brandstetter said. “So it’s a win [for everyone] if we can learn how to communicate appropriately.”

And with happier and more motivated workers, there’s a return on investment for the company, too. “You’re going to have increased employee engagement [and] increased employee satisfaction,” Berg said. “And [your employees are] going to see all this transparency and see that you’re doing everything you can to help them succeed. And that’s going to increase employee loyalty.”

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