The Tragedy of Compounding Compensation

Ryan (true story but not his real name) was an outstanding customer service representative. Incredibly responsive, all of his customers raved about him and he took his role as their advocate inside the four walls of the contract finisher for which he worked seriously and personally. He followed through on details, making sure the commitments his teammates made on due dates and expedites were kept by the company. He was consistently upbeat and friendly, and on the rare occasion that he had to deliver bad news to a customer — the line went down and their order was going to be late, for instance — he did so professionally, apologetically and transparently and in a way that maintained the strong relationship. His superiors loved him, his teammates loved him, his customers loved him, he was a near-perfect employee.

And for that, he was rewarded very well each time annual raises were determined. His employer’s practice when it came to compensation was to review readily available market data of average percentage wage increases for industrial employers. For instance, if the typical industrial employer was increasing wages by 4% on average in a given year, Ryan’s employer used 4% as the starting point for determining raises. The average employee, one who “meets expectations”, had their hourly rate or salary increased by 4% that year. Those that exceeded expectations saw increases in the range of 5-6% while team members whose performance was substandard might get raises in the 0% to 2% range.

Which brings us back to Ryan. Following his first year of employment, he wasn’t just exceeding expectations, he was crushing it. By his employer’s logic, he deserved a raise even above the “exceeds expectations” range. His employer smiled broadly while telling Ryan about his 8% raise. Ryan was ecstatic.

Another 12 months went by and Ryan was still performing at a phenomenal level. “Well,” reasoned his employer, “we gave him 8% last year, if we give him something less than that he’ll feel we are ungrateful.” Ryan got another 8% raise. And so the cycle continued, year after year, with Ryan significantly exceeding expectations and his employer granting him raises in the 7-10% range for eight or nine years.

Anyone who understands the amazing impact of compounding returns in the investment realm knows exactly what happened to Ryan’s salary. While market compensation rates increased annually in the range of 2-4%, Ryan’s salary was compounding every year at 7-10%. The mess that Ryan’s employer had created for itself is likely obvious. By the time anyone decided to compare Ryan’s salary to the market salary for a similar position, his compensation was more than 30% higher.

Now the conundrum. Ryan’s employer was facing some economic headwinds as the industrial economy slowed and revenue atrophied. The resulting deterioration in gross profit dollars left his employer in the position of needing to reduce overhead to make ends meet.

Those who have been in the position of having to decide which costs to cut when overhead needs to be reduced know that it’s no fun, especially when payroll is one of the variables under consideration and people’s jobs are at stake. Which brings us to Ryan, who could be replaced — albeit perhaps by someone less effective— thereby reducing his employer’s overhead by 30% of his salary.

The incredible irony is that by trying to reward Ryan over time for his outstanding commitment, skill and effectiveness, his employer had literally put Ryan in a position where his job was at risk.

What’s more, Ryan had gotten himself accustomed to a lifestyle significantly beyond what he could have afforded on a market salary. His home mortgage, car payment and other expenses were commensurate with his outsized salary relative to his role and if his employer chose to let him go, he had little chance of finding another job that paid him what he was earning.

Generally, his employer’s alternatives were to continue to overpay Ryan for his work at a time when it could not afford to do so, to cut his salary back to a market rate sending a horrible message to Ryan, or to cut him altogether and send him into a job market unlikely to come anywhere close to his current compensation. The choice his employer ultimately made is virtually irrelevant because all of the options were miserable ones. And all of this because his employer lacked discipline in its compensation practices.

To avoid a predicament like the one Ryan’s employer found itself in, follow these simple rules:

Avoid the temptation to throw money at employees because you’re worried about making them unhappy by a market-driven compensation adjustment.

Stay in-tune with market compensation rates. Conversations with other employers, association compensation surveys and reviews of similar positions on recruiting sites are great sources of information. If this data falls short, outside consulting organizations will provide wage reviews benchmarked to market for a relatively minimal fee. In any event, know the market.

Never base adjustments solely on percentage comparisons like Ryan’s employer did. These compound over time and as Ryan and his employer learned, can lead to very negative outcomes.

In a year when you want to recognize a team member’s over-the-top performance and to avoid baking in an increase that will compound annually into their base salary, do so using a one-time bonus. Make it crystal clear to the team member, though, why the bonus is being granted and that it is not necessarily annual in nature such that no unintended expectation of future bonuses is created.

Employee compensation can be a complex matter. By following a handful of best practices, however, many pitfalls can be avoided.