Firms that make top-tier rankings on the Fortune or Forbes list have one thing in common: a strong compensation philosophy. This tactic helps create an environment of employee satisfaction and inclusivity, resulting in a successful business.

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If you want to design a winning plan, you’ll first need to identify your goals in the market. This article takes you through the designing process, helps you execute your strategy and improves your knowledge of the role compensation management software plays.

Article Roadmap

• What Is a Compensation Philosophy?
• Types
• Developing a Philosophy
• How To Include Deduction Information in Your Policy
• Is It Time to Update Your Philosophy?
• Compensation Policy Software
• Next Steps

What Is a Compensation Philosophy?

A compensation philosophy is a set of principles and standards a company adopts to determine employee pay. It’s a strategic framework for planning and implementing compensation systems.

This framework answers the “why” behind employee pay. It reflects the worth placed by the organization on the role and helps keep it consistent.

A well-rounded compensation philosophy reflects a company’s mission, vision and values. They frequently come under the microscope when HR professionals and surveyors look for what the business hopes to accomplish through its compensation plans.

This philosophy assists employers with the following:

• Outlining hiring intentions and goals for employee compensation
• Creating fair and inclusive benefits programs
• Promoting uniformity, fairness and transparency

Types

Let’s look at four types of compensation philosophy:

Pay-For-Performance

This philosophy focuses on rewarding employees based on their performance, productivity and contribution to the organization’s success. They often include merit increases, bonuses and other performance-based incentives.

Amid the pandemic, some companies provided stipends for services like broadband, home office supplies and groceries. The sustained demand for these benefits, along with the continued prevalence of hybrid and remote work, suggests that stipends could become a permanent and integral part of compensation philosophies.

Gen Z workers are more than twice as likely as their counterparts aged 45 and above to consider stipends an essential component of their compensation.

Example

Buffer: This social media management company tackles a prevalent issue in its approach to compensation. They actively combat pay secrecy by publicly sharing the salaries of all employees, including the CEO, on their website, aiming to foster transparency and fairness.

Pros:

• Encourages high performance and productivity
• Aligns employee and organizational goals
• Helps attract and retain top talent

Cons:

• May lead to unhealthy competition among employees
• Can be difficult to measure performance fairly and accurately

Market-Based

Market-based compensation philosophies involve benchmarking pay and benefits against the market rate. This approach requires regular market research to determine the prevailing pay rates and benefits for similar roles within the industry. Companies express this kind of compensation philosophy via percentiles.

At any given time, by elevating its benchmark to surpass market standards during an analysis, a company can reestablish itself as a market leader in the following year. This approach reflects a lead-lag position, with the company aiming for pay levels above the market in the first half of the year and trailing behind in the second half.

If the benchmark is consistently at or above the market throughout the year, it constitutes a lead-lead strategy.

Conversely, maintaining the midpoint below the market for the entire year is categorized as a lag-lag strategy.

Example

Cisco: Cisco Systems is among the highest-paying companies in Fortune’s annual ranking. They employ a market-plus approach, determining the prevailing rate for a specific job and adding a percentage to it.

Pros:

• Ensures competitiveness in the labor market
• Attracts and retain top talent
• Promotes external equity

Cons:

• Can lead to pay disparities within the organization
• May not adequately account for employee performance and contributions

Job-Based

A job-based philosophy focuses on compensating employees based on the value of their roles within the organization. Some companies class their roles according to set earning potentials. This approach requires evaluating roles based on factors such as responsibilities, required skills and experience.

Example

Google: Google employs a data-centric strategy in shaping its compensation. This approach encompasses performance-based salary structures designed to recognize and reward top-performing individuals, along with flexible work arrangements aimed at fostering a positive work-life balance.

Pros:

• Ensures internal equity and fairness
• Provides a clear structure for pay and job progression
• Encourages employees to take on additional responsibilities

Cons:

• May not adequately account for individual performance
• Can lead to rigidity in the compensation structure

Person-Based

This philosophy prioritizes individual employee characteristics, such as skills, experience and education. Firms emphasize individual skills recognition, continuous learning and development.

It uses values to represent policies instead of numbers. Companies adopt skill-based or competency-based pay systems in this approach.

Examples

Patagonia: Prioritizing social responsibility and environmental sustainability, this outdoor apparel company supports employee engagement in environmental activities by providing paid time off.

Adobe: Conducting a thorough initial assessment, Adobe reviewed its global employee compensation structure and implemented adjustments to achieve pay equity. The company maintains an ongoing commitment to reviewing its compensation strategy, ensuring it remains current and aligned with evolving standards.

Pros:

• Recognizes and rewards individual skills and expertise
• Encourages continuous learning and development
• Retains high-performing employees

Cons:

• May be challenging to implement and manage
• May not adequately account for job responsibilities and organizational contributions

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Developing a Philosophy

A well-defined compensation philosophy is critical to your firm’s human resource strategy. Follow these steps to develop one that aligns with your organization’s goals.

Establish Your Goals: Align all salary bands within your company with the same percentile to ensure consistency and fairness. Explicitly link each job to a relevant dataset for precise salary estimates, utilizing role matching and market data.

Well-defined objectives help you design compensation that aligns with your overall business strategy.

Determine Market Positioning: Strategically position your firm in the market based on goals and resources, choosing to pay at, above or below the market rate. Justify compensation policies with non-monetary rewards for a low budget, or opt for a competitive package to attract top talent for specialized positions.

Evaluate Internal Equity: Promote internal equity by ensuring fair compensation based on experience, abilities and job duties. Address discrepancies to reduce turnover and maintain a positive work environment.

Determine External Equity: Offer competitive wages based on market research and industry standards to maintain external equity. Reduce the risk of losing key personnel to higher-paying opportunities.

Match Performance: Create a performance-based compensation system to encourage excellence, connecting pay to merit-based raises, bonuses or incentives. Consider employee needs to ensure payments cover living expenses and travel costs while fostering a culture of continual improvement.

Communicate the Philosophy: Transparently communicate the reasoning behind compensation and perks to employees for higher job satisfaction, loyalty and engagement. An Indeed study reveals job seekers value transparency — 87.6% of hiring decision-makers believe that pay transparency simplifies the process of attracting candidates.

Regularly review and update your compensation philosophy to ensure relevance.

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How To Include Deduction Information in Your Policy

In your effort to frame a transparent compensation philosophy, you might encounter a frequent bone of contention among employees: salary deductions. The good news is that doesn’t have to be the case.

Here’s how to integrate deductions in your policy that’ll outline the dangers of noncompliance to all concerned:

Deduction Compliance: Emphasize the importance of adhering to legal requirements and regulations when making deductions from employees’ pay.

Legal Deductions: Clearly define the types of deductions required by law, such as wage garnishments and payroll tax reporting. Ensure that these deductions comply with relevant regulations.

Employee Communication: Communicate the potential types of deductions from their pay. Ensure transparency and understanding regarding the reasons for these deductions.

Independent Contractor Payments: Establish explicit procedures for deducting and reporting payments to independent contractors. Include the requirement to issue Form 1099-MISC for payments exceeding $600 in a year.

Risk Mitigation: Highlight potential risks associated with misclassifying workers as independent contractors. Stress the importance of adhering to rules and regulations governing such classifications.

Is It Time to Update Your Philosophy?

Companies revise their compensation philosophies when there are significant changes in the corporate environment, such as shifts in market rates, fluctuations in the economy, or changes in labor laws.

Internal issues like adjustments to company culture, employee expectations or corporate expansion may also usher changes.

Here are some guiding questions that can help you decide whether your compensation philosophy needs an update:

Have your hiring needs evolved?

Compensation philosophy alteration examples differ by industry, but almost all companies adapt when they venture into newer talent pools.

For instance, if you’re hiring graphic designers and your current philosophy is person-based, you might need to revise it temporarily and advertise a job-based philosophy to attract designers.

How do you approach remote pay?

Pre-pandemic payment practices included compensating per the organization’s headquarters’ rules. Payment surveys have now generated additional compensation schemes, particularly geographical pay zones.

Geo-differentiating is an excellent compensation philosophy example for startups as it saves money on salaries.

Opting for pay untied to specific locations allows startups to attract high-caliber talent while controlling costs efficiently.

Furthermore, aligning the philosophy of distinguishing based on geography with the organization’s market positioning and overarching goals is essential. This strategy embodies the principles of the lean startup methodology, emphasizing experimentation and iterative design rooted in customer feedback.

By tailoring their compensation philosophy to geographical factors, startups can synchronize their approach with market positioning and business objectives, thereby enhancing their market success.

Where do you want to position your firm in the market?

Market positioning significantly affects your compensation policy. Paying above or below the market rate is just the tip of the iceberg.

Some companies target a set percentile for all the positions, while others set different percentiles for different positions. Extensive research into the compensation policies of top players in the industry will help you decide which percentile to target.

There are two primary methods for evaluating your compensation against the market:

Calculate the market ratio (also referred to as the market index) or determine market variance.

Consider this example: if the average pay for a particular job is $60,000, and the market data at the 50th percentile (your target market position) is $55,000, the calculations would be as follows:

Calculate the market ratio:

Calculate the market variance:

Typically, anything within +/− 10% of the market (or 90% to 110% for the market index) is considered competitive. However, your organization may choose a +/− 20% range, provided you can document, communicate and consistently apply your decisions.

What are your bonus and equity plans?

Commissions reward salespeople for meeting their targets, but what about the others?

Consider exploring newer ways to reward employees by matching payments with their performances.

You’ll also need to decide whether your entire workforce will be eligible for equity or only executive employees will receive it. Compensation philosophies clearly outline how much of the package would feature equity and whether the share would vary with job roles.

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Compensation Policy Software

Poor compensation data will have you rolling out non-compliant compensation philosophies. Additionally, with evolving working locations, your compensation policy must cater to your employees’ precise contexts.

The surefire way to accomplish that is by accessing good compensation data.

Let’s look at how compensation software molds your philosophy for the better:

1. Set Clear Market Benchmarks: Compensation tools can provide data on industry standards, regional averages, and job-specific pay rates to ensure your pay scales are competitive and fair.

2. Ensure Equity and Fairness: These tools can help identify discrepancies or potential biases in your pay practices, ensuring pay equity across the workforce regardless of gender, ethnicity, age, or other protected categories.

3. Provide Performance-Based Pay: Compensation tools often include performance management features, allowing you to link pay increases, bonuses or other compensation to measurable performance metrics. They also help companies define how they plan to use different types of compensation, like base pay, bonus or variable pay, commissions, equity and profit-sharing.

4. Manage Budgets: These solutions usually come with features for budgeting and forecasting, allowing companies to create sustainable pay structures that scale up as the company grows.

5. Stay Compliance: Software can help your business remain compliant with local, state and federal wage laws to avoid costly fines or lawsuits.

6. Enhance Communication: Some compensation tools may have features that facilitate communication about compensation to employees, aiding transparency and helping employees understand their total compensation package.

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Next Steps

The right compensation philosophy can help an organization attract and retain the best talent while ensuring that employees receive fair compensation for their contributions.

Every company is unique in its market position and goals, so its imperative not to borrow one-fits-all strategies. Our guidelines help you start from scratch and deploy software to enforce your policy in the workplace.

Read our free comparison report for an analyst-backed, apples-to-apples comparison of the top vendors on the market.

What are some roadblocks you’ve encountered while designing a compensation philosophy? Tell us in the comments.