Why HR Should Toss the Annual Compensation Review

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Most of us are familiar with the annual performance review process (whether we like it or not!). In addition to annual performance reviews, some companies also implement an annual compensation review process. Sometimes the compensation review is linked to the performance review process, and sometimes it’s not. But regardless of how it’s positioned, the annual compensation review is one potentially destructive practice.

What Drives Annual Compensation Reviews?

When a company chooses to review compensation on an annual basis, the decision is generally driven by a Finance process rather than an HR process. In other words, the review is motivated by budget management concerns rather than retention and succession planning objectives. Understandably, this results in conversations about “how little can we get away with paying this person,” which (especially with top performers) typically leads to a negotiation—and often a confrontational one.

What’s worse, standard compensation review processes seldom (if ever) involve employee feedback or any other information outside the projected salary budget Finance is aiming for. Typically the manager pushes out the proscribed increases to staff based on this limited information, practically ensuring a high error rate, broken trust and employee dissatisfaction. One wonders why any organization would choose to use a process designed to produce bad salary decisions?

Annual Feedback Doesn’t Work

When compensation review is an annual process, it also means that managers can only make corrections or changes at this one time in the year. Knowing this, managers invariably “over steer” since they’ll be locked in for a year once a decision is made. This tendency is further complicated by the manager’s awareness that any change in compensation will be seen as feedback. Employees perceive (rightfully or not) that increased compensation means a job well done, and that static compensation implies sub-par performance. There is growing awareness of how ineffective annual feedback is as compared to ongoing feedback in managing performance and fostering employee engagement. Since changes in compensation are a feedback mechanism, why limit them to once per year?

More Reviews Provide Better Data

Finally, for the Finance department, even from a budgeting and data monitoring perspective, limiting the organization to annual, discrete changes in compensation reduces the richness of data that payroll, finance, CRM, and practically every other system collects. If, instead, a more organic approach was taken to compensation increases, the same macro information would be available (i.e. how much more do we spend each year?) while allowing for deeper analysis of compensation trends based on other parameters (e.g. seasonality, time since hire, correlation to performance, etc.). As an added bonus, cost savings could be realized from the elimination of process overhead.

Aside from creating obstacles for managers, annual compensation reviews also create challenges for employees. If an employee knows he’ll be taking on greater responsibility and additional tasks in six months due to a planned project or anticipated hires on his team, he will face a difficult choice: does he fight now to be paid more than the position is worth, knowing in six months his compensation will be better aligned, or does he accept appropriate pay now and live with being underpaid for the last six months of the year. Employees who understand the implications will typically fight for the earlier raise, which means the organization is both incentivizing employees to ask for premature raises, while at the same time setting employees up for frustration when a deserved raise lags a promotion or greater responsibility.

A Better Approach to Raises

To alleviate this problem, organizations can separate the idea of organizational cost-of-living or pay band adjustments from merit increases. Annual Cost of Living Adjustment (COLA) raises, calculated based on inflation, can be applied automatically on a convenient annual cycle. Similarly, adjustments to pay bands, which are designed to keep up with external market factors and are calculated based on external information, can be applied automatically without requiring review. By removing these elements from performance-based compensation discussions, the organization removes a critical time constraint from the equation and allows managers to offer merit increases when they are most relevant. Feedback is best delivered “in the moment”, and merit increases should follow this rule. Allowing managers to provide increases when deserved (e.g. when taking on more responsibility, or achieving significant growth milestones) gives them the flexibility to provide effective and timely feedback. This, in turn, will result in more trusting and satisfied teams.


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