CHAPTER 6: OVERVIEW OF FORMS OF COMPENSATION

Overview: This textbook chapter reviews the components of compensation packages, focusing on the changes brought about by economic changes.

Corresponding course: 03 New Economy Compensation

INTRODUCTION

In the 1980s, the U.S. economy underwent a transformation. Foreign competition and a national recession forced U.S. organizations to make drastic changes in order to survive. The 1980s spelled the end of the Old Economy. Middle management positions were eliminated in corporate downsizing; this process called for the number of employees in the work force in order to reduce or eliminate inefficiencies or duplication of efforts. Companies stopped guaranteeing employees life-long careers in their organizations, and employees began jumping ship rather than stay with companies where they would not be promoted. Employees began negotiating for their pay individually, and union influence declined. Then small, leaner organizations began to emerge. These smaller organizations formed the basis of a New Economy, with new pay policies.

This chapter examines the pay practice differences between Old and New Economy organizations. Then, it looks to the future of compensation, as the United States deals with a Soft Economy.

NEW ECONOMY VS. OLD ECONOMY

The single largest difference between Old Economy and New Economy organizations is their definition of the workplace.

Old Economy Organizations

Old Economy organization are traditional and stress internal job structure. They systemize the workplace and compensation programs. Old Economy organizations rely heavily on job analysis and job evaluation when setting pay. (See Chapter 14.) They create highly differentiated wage structures, in which only management enjoys perquisites and stock options.

New Economy Organizations

New Economy organizations are less structured. They do not set pay based upon the internal labor market (what other employees in the company earn). Instead, New Economy organizations base pay on what competitors (the external labor market) pay. At the same time, pay among employees is less differentiated. Often, every employee from the mailroom to the Board Room gets to participate in stock option plans.

They are also smaller and leaner. Fewer employees do more tasks and have a greater breadth of responsibility.

COMPENSATION OBJECTIVES

All compensation elements exist to achieve some purpose. A review of compensation practices for New Economy organizations as compared to Old Economy organizations includes a review of the following compensation objectives:

• Competitiveness

• Motivation

• Administrative Effectiveness

• Cost Control

• Internal Equity

• Cost Benefit Efficiency

• Tax Considerations

• Capital Accumulation

• Social Concern

• Government Compliance

Competitiveness

Organizations often cite "paying competitively" as their primary compensation goal. New Economy organizations do not appear to be as concerned over matching going average salary rates as their traditional counterparts. Instead, New Economy organizations compete with incentive and variable pay (gainsharing plans, profit sharing, stock option plans that extend down into the lower ranks, etc.).

Motivation

Many organizations utilize compensation as a means to shape individual and group behaviors. While the Old Economy counterparts stress the merit of the individual's achievement and reward for both merit and individual production, the New Economy organization is far more likely to reward the total organization and the team responsible for an achievement (rather than a few select key individuals).

Interestingly, New Economy organizations utilizing team sharing pay practices do not tend to use formal performance appraisals. (Performance appraisals appear to alienate both the bottom 20% of a work population and the top 20%, leading to a similar exodus from each group.)

While Old Economy organizations stress the merit of individual achievement, New Economy organizations are more likely to reward team effort.

Administrative Effectiveness

Oftentimes, pay plans are utilized because they are administratively simple and inexpensive. Administering base salaries is much less complicated than benefits or incentives. The pay plans used by New Economy organizations often appear unsophisticated compared to the complex pay schemes of Old Economy organization competitors. Simple, straightforward pay plans are the rule.

Cost Control

Compensation plans can also be designed to ensure cost control. For example, sales compensation that is only paid when profit or sales are achieved.

New Economy organizations appear to pay less due to:

• lower salary levels

• higher retirement and health benefits

• much higher equity compensation

Internal Equity

In Old Economy organizations, fairness in pay has been a traditional value. Job evaluation plans oftentimes exist solely because of this objective. New Economy organizations are far more heavily influenced by the competitive marketplace, and oftentimes pay little attention to this objective.

Cost/Benefit Efficiency

Governments can affect compensation practices with tax laws, making certain types of compensation less expensive than others. For example, U.S. rules relating to stock options and Employee Stock Options (ESOPs). Lower salary levels, higher benefits, and use of stock options translate into more cost effective use of compensation dollars in New Economy organizations. Cash conserving approaches are a reflection of many New Economy organizations' working environments.

Tax Considerations

Clearly, the use of stock options and benefits require an understanding and appreciation of tax codes, but rarely does one hear of this objective as being the driving force for the use of any particular compensation plan in New Economy firms. This is a change from previous decades within the U.S. and Canada, where Old Economy organizations often found their compensation designs dictated by tax accountants.

Capital Accumulation

A primary goal of several compensation elements is the creation of assets and estates for managers or employees (allowing employees to believe they are owners). Capital accumulation has traditionally been the province of only management pay. This has changed. New Economy organizations utilize both technology and stock options or equivalents. Starbucks, Cisco, Microsoft, and Netscape, followed by such stalwarts as Bank of America, have expanded the participation in these plans to the mailroom.

In the 1990's, many workers were willing to trade higher salaries at more secure and stable companies in exchange for stock options in New Economy organizations. Due to the fact that stock option programs required the employee to stay with the company for a set number of years before vesting (receiving full ownership of the stocks), these programs increased loyalty.

In many cases in the 1990's, employee stock option plans created millionaires. In recent years, however, they have proved a false promise for employees of the many software and technology firms that have gone under. The market, according to Esther Dyson, Chairman of EDventure Holdings, "was sending people the wrong signals by promising them $500,000, $5 million or $50 million for a couple of years' work."¹

Social Concern

Some compensation elements exist simply because owners, management, and boards utilize social concerns in their decision making regarding compensation elements. For example, long-term disability plans.

New Economy organizations often appear to have a concern for their human resources not shared by their Old Economy counterparts. This is reflected in turnover statistics and compensation plans pointed toward future (not present) compensation. Because the Internet is available to many employees both at the office and from their homes, organizations can communicate information that otherwise might not be known. This allows New Economy organizations to communicate both their plans and objectives more often and at less expense than is done by Old Economy firms.

Government Compliance

Pay plans are often designed for no other purpose than to meet government compliance issues. This is not as much of a concern in the 2000s as it was in the late 1970s and 1980s. New Economy organizations are too busy in a fight for survival brought about by foreign competition and technology changes to spend enormous time and effort on government compliance. Few believe, however, that the labor laws, equal and minimum pay laws, retirement plan laws and reporting, and other rules and regulations will disappear. All countries shape compensation plans in some manner. To review U.S. and Canada laws and regulations regarding compensation, visit the DLC Employment Law page. 

Matching Goals

The compensation plans used often depends on the way in which an organization prioritizes these discussed objectives. Oftentimes two are more objectives can be in conflict, making them difficult to be achieved by a single compensation plan. Because no two organizations have exactly the same goals, there is a diverse use of compensation elements.

COMPENSATION ELEMENTS

The following components make up compensation packages:

• Base Salaries

• Sales Incentives

• Annual Bonus Plans

• Incentive Plan Participation

• Company Wide Benefits

• Medical Plans

• Dental Plans

• Long-term Disability Plans

• Life Insurance

• Retirement Plans (Qualified and Non-Qualified)

• Stock Option Plans

• Executive Perquisites

Base Salaries

A base salary is a fixed amount paid to the employee. It can be determined as an hourly, weekly, monthly, or yearly rate. The term wage instead of salary is also used in the case of non-exempt (U.S.) or union employees. Salaries and wages account for the majority of most organizations' total compensation expense.

• lag traditional counterparts in salary increases. This is due to high hiring rates and the use of stock option substitutes.

• don't mind overpaying for an initial hire. This can create wage compression, as veteran employees see new hires earning more than they do.

• have less divergent salaries and wages among their staff

• pay higher salaries to producers, key software programmers and sales personnel. These salaries may be as much as 20% above what the market pays.

• give seniority increases and general across-the-board increases more commonly than merit increases.

• move production jobs off-shore whenever possible.

• rarely use job evaluation and job analysis.

• base salaries on the person, who is paid based upon his or her skills and talents. The position the individual holds is less important.

• Salary-only plans: employee receives a base salary only, no commission

• Commission-only plans: employee's pay is based upon a set percentage of the total amount that he or she sells

• Commission-plus-draw plans: employee receives a specified salary each payday. The total amount the employee is paid on each payday is called a draw. Then at periodic times (such as each quarter) the total commissions due the salesperson are calculated. The draw is subtracted from the commissions due the employee. The employee receives the remainder.

• Salary-plus-commission plans: employee receives a base salary AND a percentage of his or her sales

• Salary-plus-bonus plans: employee receives a base salary and a bonus that is tied to the employee's sales performance

• have more aggressive sales plans than Old Economy organizations.

• reward specific target takeovers of competitors' business.

• have a lower rate of account loss than traditional competitors.

• attract key sales personnel with high assured base salaries (draws) AND high incentives. Traditional companies use low draws and high incentives.

• have high turnover among sales personnel. In part, the high salaries (draws) of New Economy competitors produce this effect.

• have less complex sales plans than Old Economy competitors. Commissions from first dollar of revenue are common.

• appear to often have better than average success with medium-sized accounts than do Old Economy organizations.

• give less liberal automobile expense reimbursements than in the accounting-focused Old Economy organizations. Also these organizations may not take advantage of Fixed and Variable Rate Automobile allowances. (DLC Course 38: Fixed and Variable Rate (FAVR) Automobile Allowances, currently underdevelopment, will include more about this practice.)

• require revenue items to be $75,000/year per account, in order to attract "outside sales personnel." So, you do not find sales forces selling small items. This relatively high amount explains why software companies with products averaging $1,000 to $20,000 have such a difficult time staffing and maintaining a sales force.

• expect high bonuses for producers. Bonuses may run to 150% of base salary.

• team, group, and total cash profit sharing plans are more common than in Old Economy counterparts (many of which still utilize pension plans as their primary means of retention).

• bonus amounts are modest; it is as if the thought is worth the administrative effort. Amounts can be in the 10% range for the $20,000 earner, 20% range for the $50,000 wage earner, and 30% for the $80,000 earner. Compare this to the standard change of lifestyle goal for most Old Economy organizations' bonus plans. In these traditional companies, bonus amounts were designed to be significant enough to cause an individual to alter his or her lifestyle via major capital investment, a vacation, etc. Therefore, the Old Economy organizations' bonus levels appear higher on average than their New Economy organization competitors.

• bonuses are not guaranteed as is the informal case with Old Economy organizations. In traditional companies, managers are guaranteed their bonuses, regardless of performance.

• bonuses are more likely to be based on performance results, not performance appraisals.

• bonus plans are commonly used and often spread throughout an organization to levels of employees that are do not receive bonuses in Old Economy companies. For example, bonuses may be paid to receptionists and mail room clerks.

Incentive Plans

Incentives are lump sum payments that reward workers for productivity above certain standards. Unlike general salaries or wages, incentives are variable in cost and can be adapted to short-term circumstances.

• incentive participation is far more wide-spread than in Old Economy organizations. This reflects New Economy philosophies of employee involvement and risk-sharing.

• before the economy softened, high incentives were paid, even in loss situations. New Economy companies are willing to pay extra for talent in start-up operations and turnaround situations.

• retirement plans are almost universal. Only the smallest companies and start-up organizations don't offer retirement plans.

• in lieu of pension plans, they offer 401(k) profit sharing plans and deferred compensation plans. This means that new economy organization employees are expected to participate in their own retirement planning and funding.

• medical coverage is universal. However, long-term disability and other extra benefit plans are far less likely to be found in New Economy organizations. This reflects, in part, the youthful staff of many New Economy companies.

• self-insurance is found within extremely small organizations (those with less than 100 employees). Old Economy firms have more realistic medical benefit thresholds of 1,000 employees before they go self-funded.

Medical Plans

Group medical plans provide employees and their families with health care benefits such as hospital rooms, surgeon and physician fees, and pharmaceuticals. Employees typically become eligible for medical plans with 30 hours of service a week. In some cases, part-time employees are also covered. These benefits are typically received free of any income tax liability.

• medical coverage is extremely generous.

• there is occasionally a poor understanding of risk factors associated with self-insuring. Many small to medium-sized organizations are self-insured and face a very high risk of being wiped out by catastrophes. (Premature births and AIDS are two potential financial disasters for self-insured companies.)

• HMOs have become the standard medical plan offered by most organizations.

• hospice and outpatient care are rapidly increasing trends.

• medical and life insurance premiums may sky rocket during the next few years, especially as prescription drug coverage becomes standard.

• the Internet is used to outsource COBRA insurance and flexible cafeteria administration. This can save human resources workers time and trouble. (See www.benefitsreview.com.)

Dental Plans

Dental care benefits are considered an aspect of health care benefits, although insurance plans ordinarily separate the two. Dental insurance usually covers preventative care and treatment of teeth, gums, and the mouth. Plans might also cover orthodontia, X-rays and cosmetic work. Employees typically become eligible for dental care plans with 30 hours of service a week. In some cases, part-time employees are also covered. These benefits are typically received free of any income tax liability. In New Economy organizations:

• dental HMOs are replacing the traditional 3 levels of coverage (100%-0%, 80%-20%, and 50%-50%).

• orthodontic coverage is far more likely to be found. This is one of the reasons why group health plans of New Economy organizations are more costly than those of traditional organizations. (Assume $1,000 per employee cost.)

• full coverage of preventive treatment is the norm.

Long-Term Disability Plans

Long-term disability insurance pays an income benefit when the insured is unable to work due to illness or injury (even if injured on vacation). Benefits are paid weekly or monthly and determined at a percentage of the insured's past earnings -- normally 60 to 70%. Employees typically become eligible for long-term disability insurance plans with 30 hours of service a week. In some cases, part-time employees are also covered. These benefits are typically received free of any income tax liability. In New Economy organizations:

• the most popular plans cover both total and partial disability.

• $20,000/month maximums are not uncommon, although $10,000/month maximums are the norm.

• most companies pay for all long-term disability coverage.

• discrimination rules still do not apply to long-term disability plans within the United States. For example, a U.S. company could legally give this benefit only to employees who drive blue cars.

• long-term disability coverage is less common than in traditional organizations.

Life Insurance

Life insurance insures human lives. In a life insurance contract, the insurer agrees to pay a stipulated sum in the event of the death of the insured or of a third person in whose life the insured has an interest. In exchange, the insurance company receives payments of a premium (usually at stated periods). Employees typically become eligible for life insurance plans with 30 hours of service a week. In some cases, part-time employees are also covered. Life insurance benefits are typically received free of any income tax liability. In New Economy organizations:

• the amount of life insurance coverage is above average. New Economy organizations typically secure employee life insurance policies that pay 2.5x the base compensation. This is approximately twice the coverage amount provided by Old Economy organizations.

• any group rate above $0.19/ $1,000 coverage in today's market should be questioned. It may not be competitive.

• full company payment is the norm.

• most companies (New and Old Economy) will have elective group life insurance by the end of the decade.

• the new trend is to use group universal products, where employees purchase individual products.

Qualified Retirement Plans

Qualified retirement plans are employer-provided plans designed to allow employees to save money for their retirement. Under the U.S. IRS Tax Code, these plans have tax advantages, which allow employees to contribute before-tax dollars to their plans. Taxes are only paid on contributions when the individual withdraws funds at retirement. Qualified plans are secured, but are subject to restrictive rules and extensive regulations.

• defined benefit plan

• defined contribution plan

An employer comes up with a system that outlines how much an employee who is retiring will receive on a monthly basis for the rest of his/her life. The following are all taken into consideration when calculating the retirees' monthly stipend: years of employment with the employer, age and salary. For example: a pension plan.

Defined contribution plan

• pension plans are used less than in traditional organizations.

• pure profit sharing plans are disappearing. They are being replaced with 401(k) plans.

• the use of 401(k) plans is growing (in both New Economy and traditional organizations). 401(k) plans allow funding as you go, and funds are set aside for actual view by participants.

• due to the complexity and liabilities of retirement plan administration, many organizations use outside vendors to provide total administration services. Proper retirement plan administration is a problem for most companies. Companies that wish to do it themselves have to get involved in investment management, trust services, life insurance, bonding, errors and omission insurance, communications, administration, etc.

Non-Qualified Retirement Plans

Non-qualified retirement plans do not receive favorable tax treatment, but have far fewer restrictions than qualified plans. They are unsecured and subject to risks. Also they must remain "unfunded" to avoid current taxation. This means actual funding for benefits is NOT set aside. Basically, non-qualified retirement plans are a way for organizations to reward their senior staff. Due to the limitations imposed on qualified plans and changes in management compensation, companies are relying more on these plans to create attractive executive compensation packages. Some senior managers may receive 50-80% of their total retirement income from non-qualfied plans.²

Non-qualified vs. qualified plans

As we discussed in the previous section, qualified benefit plans (like pensions or 401(k)s) must meet U.S. tax codes. Qualified benefit plans are funded through a trust, and receive favorable tax treatment.

• Employees do not pay taxes on contributions. Instead employees are taxed when they receive the benefits.

• Employers get a tax deduction on contributions.

• There is no cap on employee contributions. (For example, in 2004, qualified 401(k) plans limit individual contributions to $13,000/year. No such limit applies to non-qualified plans.)

• The defined benefit is not limited to a dollar amount.

• There are no discrimination requirements.

• It does not have to be funded. (The assets do not have to be held in a trust for exclusive paying of the benefits.)

• There are no minimum age, service requirements, or vesting rules.

• Generally only 10% of employees participate in non-qualified plans.

• Non-qualified plans are used as a substitute for stock option and equity potential, a compensation element. This is especially important for privately-held New Economy organizations.

• Compensation is deferred under these plans with payments informally funded, often using life insurance as a capital accumulation device. This lets employees take advantage of the tax free build up of cash values, the same advantage as found in a qualified retirement plan trust.

• Rabbi trusts are being used to partially protect the assets of these plans. This is a company-owned trust that holds assets to help meet non-qualified benefit payments. Rabbi trusts are taxable.

Recap

Non-qualified plans are useful investment vehicles for executives in that they defer taxation of compensation contributed to the plan. The employee is only taxed on the benefit "constructively received." The executive can control when and how the payment is received, thus making them extremely popular among executives. Therefore, these plans are useful for attracting and retaining management. For more information, see DLC Course 74: Trends in Retirement Plans.

Stock Option Plans

• stock option plans are available to more employees. In Old Economy organizations, stock option plans are available only to management.

• if competition for talent exists between these two types of organizations, stock option plans can give new economy organizations a decided edge. However, the slumping stock market has led employees to prefer stable, secure organizations ahead of stock options.³

Perquisites

Perquisites are additional inducements or benefits that are used to retain and attract management and certain key personnel. In New Economy organizations:

• management perquisites reflect the search for a competitive edge. However, due to their long-time use in old economy organizations, management prerequisites are often more developed and utilized in traditional organizations.

• management perquisites may be more conservative than in Old Economy organizations. However, New Economy companies offer perquisites more liberally to the rank and file.

• many employees view dress codes (or the lack there of), physical fitness facilities, day care centers, etc. to be deciding perquisites in the decision to stay with an organization.

CONCLUSION

Between 1995 and March of 2001, the United States experienced unprecedented economic growth. New Economy organizations flourished and their stock prices rose thanks to:

• globalization

• deregulation

• new technology

• corporate restructuring⁴

1. Stock option plans will no longer be as important a draw.

2. Benefit plans will take the place of stock options. A 2000 survey of over 800 college students showed that graduating seniors rated 401(k) plans, health care, and annual bonuses as more important than stock options.⁶

3. Benefit programs will need to be made more cost effective. This will be a challenge as health insurance premiums continue to rise each year at double digit rates.⁷

4. The Internet will become even more valuable as an inexpensive way to communicate compensation programs to employees.

5. As unemployment rates rise, attracting and retaining talent will be less of a problem.

6. Base salary levels should drop. As Esther Dyson puts it, "salaries will reflect genuine value-added rather than valuations!"⁸

Internet Based Benefits & Compensation Administration

Thomas J. Atchison
David W. Belcher
David J. Thomsen

ERI Economic Research Institute
Copyright © 2000 - 2004

Library of Congress Cataloging-in-Publication Data

HF5549.5.C67B45 1987 658.3'2 86-25494 ISBN 0-13-154790-9

Previously published under the title of Wage and Salary Administration.

The framework for this text was originally copyrighted in 1987, 1974, 1962, and 1955 by Prentice-Hall, Inc. All rights were acquired by ERI in 2000 via reverted rights from the Belcher Scholarship Foundation and Thomas Atchison.

All rights reserved. No part of this text may be reproduced for sale, in any form or by any means, without permission in writing from ERI Economic Research Institute. Students may download and print chapters, graphs, and case studies from this text via an Internet browser for their personal use.

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