As a manager, you have the most prominent impact on your direct reports.

When it comes to compensation, you play a critical role in making decisions when it comes to employee pay and serve as the primary contact through which your employees understand how their pay is determined.

Yet despite how important compensation is, many employees don’t feel empowered to discuss it. 

As a manager, to show how you value your team and ensure everyone has opportunities to engage in compensation conversations, it’s important to proactively bring up the topic of pay.

However, discussing pay is a complex and sensitive topic that needs to be approached carefully. According to a survey by Visier, 41% of respondents have had negative experiences discussing pay with their employer.

Unsurprisingly, these issues lead to employee dissatisfaction and turnover. According to ICONIQ Capital, 75% of tech employees leave due to compensation, with 24% citing it as the primary reason.

Having the right knowledge and tools about compensation can help you decide how to equitably reward your team and have productive discussions that build trust with them.

In collaboration with Jim Miller, VP of People & Talent at Ashby, we wrote this guide to make sure you have the right knowledge to make the best decisions for your team.

Let’s dive in.

The Basics

Compensation Philosophy

Compensation philosophy details the why behind how employees are compensated. Establishing and understanding a clear philosophy creates a clear framework for how compensation decisions are made and communicated.

Having a compensation philosophy provides the framework to make objective decisions based on what makes sense for your company and team rather than ad hoc decisions that may help you secure talent quickly, but lead to cascading problems later.

As a manager, ensuring that you understand how compensation is determined lets you know how you can best leverage it to support your team and company.

As Jim Miller puts it, “if you, as a leader, haven’t taken the time to look under the hood to understand the mechanics, then you will never be able to use compensation as the effective tool it’s been designed to be, in leading your organization.”

If you find yourself without a strong understanding of the key components of your firm’s compensation philosophy, reach out to your People Lead! It’ll help you be a better leader, partner, and advocate for the people you work with.

The key components of a compensation philosophy are:

Compensation Strategy

A strong compensation strategy aligns the compensation structure for your employees to business goals. For instance, it lays out how a bonus structure will incentive employees towards performance goals and how that will contribute to the success of the business as a whole.

Core principles

Core principles provide the framework for what rules your compensation strategy will follow. This may include equity, competitive positioning, and performance.

While compensation strategy determines how your compensation decisions support business goals, core principles ensure that you make those decisions according to your firm’s ethical values. 

Pay strategies & structures

Pay strategies & structures define how the salary ranges are determined and what they are for the roles and levels within the organization.

Companies will vary greatly in what pay strategies they employ and how that works out in a practical sense. For instance, companies often consider the location or tenure of employees when determining compensation, while others will focus only on the role and performance level of employees.

Understanding the pay strategies your organization employs will help you and your team members make sense of their compensation. 

Merit pay model

The merit pay model lays out how compensation for performance (raises, bonuses, etc.) are determined. Understanding how your company determines merit pay can help guide your raise decisions and offer transparency for your employees.

Components of Pay Increases

Both factors within and outside an employee’s control may impact their compensation. 

Differentiating between the two is a key component of determining and explaining any pay changes for employees.

Raises

Raises are more straightforward, entailing an increase to an employee’s pay based on strong performance.

Adjustments

Adjustments involve changes to compensation for reasons outside the employee’s control, such as changes to the market rate for the role or cost of living.

These allow the company to stay equally competitive in their compensation for the role and/or provide the employee with similar spending power.

Why the difference matters

When there is a pay increase, ensure that this is properly communicated to your team. Are they receiving a pay increase due to performance, or due to market changes?

Without the right context, a pay increase may seem arbitrary and even send the wrong message. 

Let’s say there’s a consistently strong performer. In her first year, she received a 7% pay bump – 4% for strong performance, 3% due to market adjustments. In her second year, she only receives a 4% pay bump – all due to performance.

Without the proper context for where the difference came from, she may take away that the team believes she underperformed. In reality, it was simply due to the external market.

How do my employees’ compensation stack up?

External Metrics

External metrics tell you what the market for the role looks like, providing context for whether your compensation package is competitive against other potential offers.

The most important metric is what the pay in the market is for similar roles, levels, and geographies (if applicable). This can be found from professional associations (such as the SHRM) or companies that specialize in human capital and compensation, which often conduct their own surveys.

Compa Ratio

Compa ratio (short for comparative ratio, if you’re curious) provides insight into the compensation of your employees relative to the market. It is computed by dividing the employee’s salary by the midpoint of the pay range.

A ratio of 1.0 indicates that the employee is being paid at the midpoint of the market rate for the role. Below 1.0 indicates that the employee’s pay is lower (for instance, a 0.9 ratio indicates the employee is paid 10% below the market midpoint), and above 1.0 indicates that the employee’s pay is higher (for instance, a 1.2 ratio indicates the employee’s pay is 20% higher than the market midpoint).

Internal Metrics

Pay Bands (Pay Ranges / Salary Ranges / Salary Bands)

Pay bands show the possible range of salaries assigned to specific job roles or positions. Keep in mind that a role may have multiple titles. For example, a engineering role may have a different titles such as Software Engineer or Data Engineer. The range for a role typically includes the minimum, midpoint, and maximum. A target is the computed starting point for level.

For instance, for a role where the range is from $90K - $110K, the minimum represents the lowest end of the range ($90K), the maximum represents the highest end of the range ($110K), and the midpoint represents the middle of the two ($100K).

This simple metric provides the foundation for determining how much your team members should be paid based on your compensation philosophy. Some companies may not go "out-of-band" or out of range, in other words.

Midpoint Differential

The midpoint differential is the percentage difference between the midpoints of two salaries, usually in the context of role progressions.

For instance, if a given role has a midpoint of $100K and the midpoint of the next level is $120K, then the midpoint differential is 20% ([$120K - $100K] / $100K).

For employees that may be getting a promotion, the midpoint differential provides information on what a raise may look like. It's also helpful in visualizing that you may have employees making the same compensation at two different levels when your bands overlap.

Range Spread

Range spread describes the distance between the minimum and maximum of the pay range by calculating how much higher the maximum is than the minimum (in percentage form). 

If a role has an $80K minimum and $120K maximum, the range spread is 50% ([$120K - $80K] / $80K).

Knowing the range spread of roles can help you determine if there are issues of pay equity within or across roles. Determining what you want the range to be can help you determine how much you are willing to and want to differentiate compensation between employees in the same role.

Range Penetration

Range penetration provides a metric that allows managers to be strategic with their raises by identifying how much employees are compensated relative to the total pay range.

It’s computed by taking the difference between the Employee’s Salary and Range Minimum for the role and dividing it by the difference between the Range Maximum and Range Minimum.

Creating standards for what an employee needs to show to be at different range penetrations can create an objective and transparent assessment of what fair compensation for an employee looks like.

OTE

On-target earnings (OTE) provide a simple metric of the expected total pay for an employee that meets performance standards. It includes base salary plus the bonus and commission that an employee will be paid if they meet their quota or performance standards.

OTE defines expectations for all stakeholders. For employees, it represents how much they expect to earn, and what they need to get there. For the company, it represents how much in labor costs they expect to incur. For you, it represents the targets for performance you expect from your employees.

An OTE should balance being both realistic and challenging. The achievement rate of the OTE – the percentage of employees who reach the OTE – can be a useful metric to anchor on.

An ideal achievement rate should be around 50-70%, ensuring that OTE represents a realistic yet challenging goal.

If the achievement rate is too high, you may not be pushing your employees enough. If the achievement rate is too low, your expectations may not be realistic, and may demotivate your team.

Compa Ratio, Again

Compa ratio can also be used to determine how much an employee is getting paid relative to their peers at the firm in similar roles and levels.

In this case, instead of comparing relative to market data, the ratio is computed using the midpoint of the pay range that your organization has set.

When am I involved?

Discussions regarding compensation can arise at any time. A new employee may want help understanding what their compensation package means. Existing employees may have questions about how their raises are being determined.

As a manager, the best way to approach compensation is to be proactive about it. Making sure you have the right knowledge about how compensation is determined and having the data to back it up provides you the tools to make important decisions and communicate them effectively with your team.

With that said, we will cover a couple instances you will regularly run into as a manager and what you need to know.

Hiring: What to Know

Building your team is exciting!

But it’s easy to get carried away, and it needs to be done carefully. It’s easy to throw money at candidates in hopes that they join your team – the issue is, if not done carefully, costs can easily compound.

Setting a high salary off the bat sets expectations high. Salary isn’t a one time cost – it is paid year over year, and that employee may expect a raise year over year. It may end up being the case that you end up overpaying for what can very well be just mediocre talent.

Furthermore, you risk creating internal equity problems. Existing employees feel that they are undercompensated relative to their new peers, which can be expensive to remedy. 

To directly address this issue may require raises across the board, a cost that also compounds. Without raises, there may be issues with employee morale. Research from Gartner shows that there is evidence of decreased engagement and intent to stay at just a 3% pay gap between existing and new employees.

Instead, base your compensation decisions on your compensation philosophy and data. Set strict boundaries on where you’re willing to negotiate (if at all) and how much, and be firm with it.

Jim Miller’s advice is “Stick to your structure. Make a compelling offer the first time around, and allow them to walk away if they are not interested.”

By focusing on creating a strong, competitive package upfront, it’ll set you apart from the competition and build rapport with the candidate.

Furthermore, your pitch to candidates should also encompass much more than just compensation. In fact, the non-monetary components of a job have become more important than ever, with Deloitte research showing that salary – though still the highest priority –is less important for Gen Z candidates than any previous generation.

Thus, your value proposition should account for everything the company has to offer, such as career development opportunities and work-life balance.

Compensation Cycles: What to Know

Compensation cycles (“comp cycles”) are regular reviews of your employees’ total compensation. It involves benchmarking your employees’ compensation against market data and company objectives.

Most companies will review their compensation annually or semiannually to ensure that they stay competitive with the market. Generally, they will coincide performance assessment and promotion cycles.

The goal is to ensure employees are being fairly compensated and rewarded given their role and performance.

Key steps:

1. Plan

In this stage, there will be many different teams involved. The Finance team may have insight into the financial resources available, while the Human Capital team may have insight into the market competition.

Furthermore, determine what your goals are for the cycle. For instance, a goal may be to provide higher raises to top performers or to ensure pay equity.

Lastly, not everyone will be involved in every compensation cycle. For instance, new employees or existing employees who have recently received a raise may be excluded.

2. Collect Data

Collecting data from the market allows you to see how your compensation packages compare to the market. This provides insight into whether changes to bands are needed to remain competitive.

3. Budget & Allocate

Determine how much budget you have for the compensation cycle. Factors that may influence this include external market data, performance reviews, and the company’s financial health.

How you allocate pay changes depends on the compensation philosophy of your company.

Merit Matrix

A common practice is to use a merit matrix with two axes:

1. Performance: how did the employee perform?

2. Compa Ratio: how much is the employee being compensated relative to their peers?

By focusing on both factors, raises will help employees reach the compensation they should be at, rather than being overly depennt on their current compensation.

For instance, in the matrix below, an employee with an "Outstanding" rating but a low compa ratio (0.80-0.89) would receive a large raise of 9% to account for both their high performance and current lower pay relative to their peers.

On the other hand, an employee with an "Outstanding" rating but a high compa ratio (1.11-1.20) may only get a 3% raise, reflecting their already high pay relative to their peers.

4. Communicate

As a manager, this is where you play the most important role. Communicate raises and rewards to employees, and help them understand the decisions behind changes to their pay and address questions they may have.

Most importantly, make sure communication is a two-way street. Jim Miller’s biggest piece of advice for any manager – regarding both compensation and everything else – is to “ask your team more questions.”

While your compensation process may be fair, generous, and thorough, it may not necessarily be what your employees need or expect. For instance, while your startup may be generously rewarding employees with more stock options, some employees may state they simply need more cash.

By proactively listening to your team, you can ensure that your compensation strategy also addresses their needs.

Conclusion

As a manager, you have the most direct and impactful roles for your team. As a result, you play a critical role in pushing the needle on effective compensation practices and understanding.

Compensation is a highly personal and complex issue that needs to be approached carefully. Ensuring you have the right foundation is the first step in ensuring that you can make smart, strategic decisions for your team and have an honest discussion.

Much of what’s covered in this guide only scratches the surface of compensation terminology and philosophy. To learn more about how to create a strategic plan that drives results for and from your team, follow our blog for more!

The full interview can be found below!