Look across the ranks of almost any office, retail floor or faculty lounge, and you’ll see many workers doing essentially the same job. Peek at their pay-stubs, though, and you’ll likely find disparity. Pay differences among workers can hinge on objective matters like experience. But salary disparity is often a function of more arbitrary factors — raising the question of why establishing compensation hasn’t evolved into a more fair, equitable and objective system. How do qualities as intangible and unpredictable as work ethic, creativity and esprit de corps get translated into compensation?
“It may seem crazy and arbitrary, but there is no effective way to do this, because you are trying to trade off against goals that aren’t necessarily comparable,” says Wharton management professor Matthew Bidwell. “And so, if you want a system that is fair and equitable, preferably with a fair amount of transparency so people know the system is fair and equitable, you [also] want a system to attract and retain top performers and that rewards the right behaviors, particularly behaviors that are good for the organization.” The big challenge is that all of those things are hard to measure, Bidwell adds.
One of the big hurdles to a better model is the distorting effect that extremely high executive compensation has had on the entire compensation conversation, says Wharton emeritus management professor Marshall W. Meyer. “We created this culture of the CEO as someone who has exceptional talent and deserves to be rewarded exceptionally,” he says. “The ratio of CEO to worker pay used to be something like 20 to one, and now is more like 2,000 to one, and that makes compensation problematic. When people look at the numbers being pulled down by CEOs — with CEO salaries not just in the six-digit range, but the seven-digit range — while meat packers are getting paid the same as they were in the 1960s, that immediately raises difficulties. So, what is equity in compensation?”
The system often in place today, he says, lines up like this: “Salaries that don’t support a middle-class lifestyle, management gets rewarded for serving shareholders, and everyone is miserable.”
The Persistence of Pay Gaps
Part of the reason firms haven’t been able to develop a better way of setting salary is that it’s really difficult, says Wharton management professor Adam Cobb. “You could make the case that this is the biggest HR challenge in most organizations: How do you pay people fairly, in a way that’s motivating and encouraging the right kinds of behaviors? Because it’s a moving target. We are human beings, and our perception of these things changes over time. What you think is fair and equitable might not be what I think is fair and equitable.”
Still, there is good reason to believe that the current system for determining compensation can be more fair and equitable than it is. Though little talked about, arbitrary factors governing compensation shadow workers for their entire careers. Daniel Hamermesh, economics professor at the University of Texas at Austin, found that good-looking workers typically earn 3% to 4% more than workers who are more homely. Over a lifetime, that adds up to an advantage totaling $230,000 for the typical more attractive person, or even, for an average-looking worker, $140,000 more, he says in Beauty Pays: Why Attractive People Are More Successful. The disparity wasn’t found only in professions where looks might obviously matter — newscaster, for instance — but, he says, across all professions.
“How do you pay people fairly, in a way that’s motivating and encouraging the right kinds of behaviors?… [I]t’s a moving target.” –Adam Cobb
Relatively recent efforts to address the gender gap in pay may have suffered a setback. In April, the 9th U.S. Circuit Court of Appeals, in overturning a lower court decision, ruled that employers can pay women less than men for the same work when the determining factor is the difference in workers’ previous salaries. The suit was filed by a California school worker who discovered while having lunch with colleagues that her male counterparts were being paid more than she was. Her lawyer has argued that the decision perpetuates the gender pay gap, and the case appears headed for the U.S. Supreme Court. Women earn 79 cents for every dollar earned by men, according to the U.S. Census Bureau. In large part as an effort to close the pay gap, Philadelphia earlier this year became the first city in the nation to pass a law prohibiting employers from asking about a job applicant’s prior earnings, which tends to extend inequity.
The wage gap between black and white Americans is the largest in 40 years, according to the Economic Policy Institute. In 2015, the difference in hourly pay between blacks and whites widened, with blacks making an average of 27% less than whites with the same experience and educational level, according to the EPI.
Some industries have been able to move into more objective systems of compensation, with some apparent benefit to both worker and the firm. After Safelite Glass Corporation, the large auto glass company, moved to a system of piece rate pay from hourly pay, Stanford University professor Edward P. Lazear examined data from 3,000 workers over a 19-month period, and concluded that the change had a salutary effect on productivity as well as paycheck. The average level of output per worker rose by 44%, and pay increased by 10%, wrote Lazear in “Performance Pay and Productivity,” published in the American Economic Review in 2000.
“About half of the increase in productivity results from the average worker producing more because of incentive effects. Some of the increase results from an ability to hire the most productive workers and possibly from a reduction in quits among the highest output workers,” concluded Lazear. “More ambitious workers have less incentive to differentiate themselves when hourly wages are paid than when piece-rate pay is used. Claims by sociologists and others that monetizing incentives may actually reduce output are unambiguously refuted by the data. Not only do the effects back up economic predictions, but the effects are extremely large and precisely in line with theory.”
“The interesting part is, they are saying, ‘here is how the process works.’ By showing that process, at least everyone knows what they are signing up for….” –Adam Cobb
The system was not without its bumps. “One defect of paying piece rates is that quality may suffer,” Lazear writes. Workers were required to fix defects on their own time, though they don’t bear the cost of wasted glass or other costs associated with redoing the job. “Because re-dos are costly to the worker, he is motivated to get it right the first time around.”
The pay-for-piece program also drew a class-action lawsuit in 2015 from a technician who claimed that the system of compensation failed to pay for work such as cleaning, attending compulsory meetings and other tasks. The U.S. District Court of California’s Central District ruled partially in the technician’s favor earlier this year.
Toward a New Model of Setting Salaries
Not every industry, of course, can define success in units as easily measured as number of windshields installed per day. But the use of incentives and a heightened sense of entrepreneurship is what Haier Electronics was looking for in reorganizing its workforce of 60,000 into about 2,000 small teams. The goal of the “microdivisionalization” was to create teams that would operate like business units, accountable for financial performance, with their continuation and compensation dependent on that performance.
“As an initiative where you try to tie compensation to profitability literally at the team level in an organization, I would say it was a modest success,” says Meyer, who studied the Haier transition and co-authored “Microdivisionalization: Using Teams for Competitive Advantage,” recently published in Academy of Management Discoveries. “The idea is that you literally smash a 60,000-person firm into a couple of thousand teams — 2000 is probably too many — and through a managerial accounting system, hold each team’s feet to the fire, to a bottom line, so the team has got a P&L and a balance sheet, and those P&Ls are not necessarily determinative of compensation, but open the possibility of substantial awards and annual bonuses. Did that work perfectly? No.”
Team members were concerned about meeting aggressive targets in a slowing economy, and some thought the compensation system was overly complicated. “But in principle you devolve very large pieces of an organization into small pieces of organization, and hold them responsible to results and compensate them according to the results, and you work around some of the issues of inequity,” Meyer notes. “That old principle that you eat what you kill operates.”
“The whole idea is that the corporation becomes a huge makerspace where people do their thing consistent with an overall strategy.” –Marshall W. Meyer
Meyer says that in the end, the system is “probably too Darwinian, because getting rid of the low performers — no one likes that. Does it really work? I don’t know. In the next iteration, the test is not so much about profitability as innovation. Can you get these teams to start thinking outside of the box? That is ‘to be determined.’ The whole idea is that the corporation becomes a huge makerspace where people do their thing consistent with an overall strategy.”
Some companies have tried systems that aim to be fairer. Reddit rolled out a policy of not negotiating salaries, but instead offering what it calls “fair market salaries.” The company portrayed the move as a way to combat the gender pay gap, since some studies show that women are more likely to be lied to in salary negotiations. “We come up with an offer that we think is fair,” former CEO Ellen Pao told the Wall Street Journal. “If you want more equity, we’ll let you swap a little bit of cash salary for equity, but we aren’t going to reward people who are better negotiators with more compensation.”
Critics have noted that accepting a non-negotiated offer requires a leap of faith that the salary being offered is in fact in line with others doing the same work at the same company. On the other hand, the practice allows the company to signal something about the kind of worker it wants, says Cobb. “They are saying, we are offering a fair wage, but we also want people who are really excited about working here, not someone who is necessarily interested only in making the most money.”
He points out that the no-negotiation practice might make sense now that it has become relatively easy to search and sift data according to sector and region on sites like Glassdoor and LinkedIn Salary. “It does place the onus on workers to find out at least what a competitive wage is in the region, and it’s easier to do than ever,” he says.
“We want pay to do lots of different things, some of which are in conflict.” –Peter Cappelli
Buffer has taken transparency to an extreme. The social-media management tool firm has adopted what it calls an “open salaries” system, publishing all of its salaries, as well as the standardized formulas with which those salaries were calculated: Salary = job type x seniority x experience + location. In other words, a salary is determined by a base pay based upon job type; plus, a 5% to 20% bonus depending on seniority; plus, a multiplier based on experience; a premium tied to location (from no extra money if you’re based in Hanoi to an extra $22,000 if you live in San Francisco or Paris); and a choice of $10,000 more or more equity in the company.
Cobb says that while not everyone is going to be comfortable with everyone knowing everyone else’s salary, there is a value in such a system. “The interesting part is, they are saying, ‘here is how the process works.’ By showing that process, at least everyone knows what they are signing up for, and if they don’t like it they don’t sign up for a job like that.” If you look at the evidence, Cobb says, when people feel like they are being treated unfairly with pay, they engage in more dishonest and deceptive behavior, they petition management, they are more likely to reduce their efforts, and that imposes costs. “If everyone can see that there is a justification for why person X gets paid more than person Y, you’re hoping you can minimize the possibility of negative outcomes that happen when people find out they are being paid differently.”
Cobb says firms testing these kinds of innovations tend to get written about, but that, practically speaking, they are not likely to set off any big trends. “The firms that are going to do this are probably relatively high-skilled, with not a ton of variance from job to job, and the firms are going to be on the smaller side,” he notes. “I can’t image Tesla doing this. There is too much of a gap between the highest and lowest paid. You’re only going to get a particular kind of company that can do that, so it’s not likely it will really take off.”
The challenge in evolving the entire compensation system to a better model lies not in finding new formulas, says Wharton management professor Peter Cappelli, director of Wharton’s Center for Human Resources. “It is that we want pay to do lots of different things, some of which are in conflict. A generation ago, pay in large organizations was all driven by concerns about fairness, to make sure people were treated consistently — the value of an employee was calculated in the same way everywhere, and a unit of value contributed to pay the same way everywhere. Then we wanted pay to be a motivator, largely reflecting the rising influence of a financial approach to running businesses. So, we generated new systems, especially for executives, that based pay on firm performance and also individual performance. Then we opened up the labor market, with people being hired across companies. The focus shifted to basing pay on opportunities elsewhere.”
To some extent, he says, all of these forces are in play today.
“The trick is, how do we balance them? And that is in constant flux, depending on who is in charge, depending on business and labor market conditions. There isn’t a perfect system, and the shifting around is unlikely to change.”