Compensation & Pay Mix: Part 1 Pay Mix as the Key Differentiator
This article, Part 1 of 4 of an InSights series, demonstrates why the pay mix is often the key differentiator when it comes to recruitment and retention from the applicants’ perspective. The upcoming Part 2 analyses the effect pay mix may have on the firm’s financials, especially with regards to personnel costs. In Part 3 we will examines how pay mix should be adjusted in relation to the total cash compensation offered and how benchmarked market percentiles are the most effective indicator of competitive positioning. And, in the final Part 4 we will assess how pay mix may influence firms’ culture and performance, we will examine how pay mix may influence firms’ culture and performance.
Pay Mix as the Key Differentiator
Synopsis: One aspect of remuneration strategy is the ratio of variable to fixed pay (also called “pay mix”). Together they often make up the total pay of consultants. Unfortunately, the importance of pay mix is often underestimated or even overlooked.
When pay packages of competing firms are considered to be largely similar, the pay mix can become the key differentiator when comparing compensation, especially from the applicants’ perspective. Thus, when reviewing remuneration, firms should not focus on a single component of compensation (e.g. fixed or variable pay) as these alone will often not be the deciding factors. Firms should instead focus on the pay mix, i.e. the ratio of variable to fixed pay, as this ratio strongly influences an applicants’ choice. Depending on the risk-profile of the applicant, a lower level of total pay with a higher absolute level of fixed pay may be the better offer for many risk-averse applicants; conversely a higher level of total pay with a significantly higher variable component in the pay mix may be more attractive to risk-friendly applicants.
For professional services firms in particular, employee compensation is crucial to both successful recruitment and retention, i.e. hiring the right employees, continually motivating them to perform at their best, and retaining employees. Thus, together with firm culture, the importance of offering a competitive compensation package cannot be overstated.
In this InSights article we will take an in-depth look at the pay mix (i.e. the ratio of variable to fixed pay) within total pay, an aspect of compensation package design often underestimated. However, we will demonstrate that it can be as relevant as or even more relevant than the absolute amount of total pay (e.g. total cash compensation), especially from the perspective of new applicants.
To illustrate our arguments, the following Base-Case example will be applied:
An applicant for an entry and/or more junior-level consulting position receives offers from two comparable companies with similar status in the market. The two firms also offer comparable future development prospects to the applicant. For simplicity, the offers of employment made by the two firms are essentially the same to all applicants with the only differentiating factor being the pay mix of the compensation package offered (Exhibit 1):
Exhibit 1: Original offers of two competing firms with different pay mix
Both of the competing compensation packages offered total to USD 100k and from an economic point of view the upside potential of the two firms’ offering is the same (at USD 100k). However, while Firm 2’s offer provides the same total pay, it also offers the higher fixed pay component, which guarantees greater annualised financial security (65k vs 60k). Since Firm 2’s offer also provides the higher intra-year fixed pay (+8%) it would be considered “safer”. It would thus seem reasonable to assume that applicants will prefer Firm 2’s offer.
Assuming furthermore that the compensation packages being offered are transparent to all applicants, the result of this example would likely be that Firm 2 is able to hire all of the applicants it requires. Only when all of Firm 2’s vacancies have been filled, would the remaining applicants be forced to take the offer from Firm 1. Thus, Firm 1 would only be able to hire the applicants not needed by Firm 2 and would lose the competition for talent.
How could Firm 1 adapt their compensation model in order to be more attractive to potential applicants and be in a position to compete with or better Firm 2’s offer in the war for talent? Three alternative options stand out for Firm 1:
· Alternative 1: Changing the pay mix;
· Alternative 2: Increasing total pay (with the same pay mix);
· Alternative 3: Both of the above.
Alternative 1 – Changing the pay mix
Increasing the fixed component of pay at the expense of variable pay will provide applicants an even safer offer without the need to change the total pay of USD 100k (Exhibit 2). In our example, Alternative 1 increases Firm 1’s fixed pay from USD 60k to 66k at the expense of the variable pay (reduced to USD 34k from 40k). From the applicant’s perspective, changing the pay mix as suggested in Alternative 1 now makes Firm 1’s offer even safer and thus more attractive than Firm 2’s offer. Thus, following the arguments used in the Base-Case, Firm 2 would now only be able to hire the applicants not needed by Firm 1 and would lose the competition for talent.
Exhibit 2: Alternative 1 - Changing Firm 1’s Pay Mix
It is important to keep in mind, however, that this alternative also changes the financials for Firm 1: Firm 1 would now incur higher fixed costs due to the change in Firm 1’s pay mix, i.e. they now offer a higher fixed pay component in their total pay. The implications of such a change will be examined in Part 2 of this series.
Alternative 2 – Increasing total pay (with the same pay mix)
The result of an increase in total pay by increasing the fixed pay component with the same pay mix is shown in Alternative 2. In this alternative Firm 1’s total pay is increased to 105k, while the pay mix remains the same with variable pay equal to 67% of fixed pay (Exhibit 3):
Exhibit 3: Alternative 2 – Increasing the Total Pay Offered by Firm 1 with same Pay Mix
Increasing Firm 1’s total pay offering to USD 105k whilst maintaining the ratio between variable and fixed pay may make Firm 1’s “Alternative 2” offer more attractive than Firm 2’s offer of USD 100k. However, whether applicants prefer this offer over that made by Firm 2 will depend in part on the risk profile of the applicant: The more risk-taking or self-confident applicants will probably prefer this alternative offer since they can potentially earn more although a greater portion of pay is at risk. Conversely, the more risk-averse applicants may still prefer Firm 2’s safer offer with a fixed pay of USD 65k versus the alternative of USD 63k offered by Firm 1.
Alternative 2 again has implications on the financials for Firm 1: Firm 1 would now have to manage both higher fixed costs due to the increase in fixed pay (USD 63k versus 60k), as well as potentially higher variable costs due to the increase in variable pay (USD 43k versus 40k).
Alternative 3 – Increasing total pay and changing the pay mix
When considering the possibility of changing both the pay mix and at the same time increasing total pay, a number of alternatives are possible. A representative sample of these are examined in Exhibit 4.
Exhibit 4: Alternatives 3a to 3b for Firm 1 by increasing Total Pay and adjusting Pay Mix
From the applicants’ perspective, Alternatives 3a to 3b are both better than Firm 1’s original offer in that they offer a higher total pay (USD 105k versus 100k). Alternatives 3a and 3b may also be better than the offer being made by Firm 2. However, here the situation should be further examined by considering the differentiated pay mix:
· Although at USD 105k Firm 1’s Alternative 3a offers a higher total pay it remains riskier than Firm 2’s offer because at USD 60k the fixed pay portion is still lower than Firm 2’s offer of USD 65k. Hence, whether applicants prefer Firm 1’s Alternative 3a over that made by Firm 2 will again depend in part on the risk profile of the applicant. Some more risk-averse candidates may not be inclined to go for the higher total pay being offered by Firm 1’s Alternative 3a since in case of under or non-performance, the higher fixed pay offered by Firm 2 continues to be the safer harbour.
· Firm 1’s Alternative 3b again offers a higher total pay (USD 105k) but also offers the higher fixed pay at USD 69k versus Firm’s USD 65k. It is thus per definition the safer offer. Alternative 3b furthermore offers the higher variable pay at USD 36k versus the USD 35k of Firm 2. In essence, this is a win-win situation for the applicant: Less risk, as well as higher upside potential. Independent of any applicant’s risk profile, it is the more attractive offer.
In practice we often observe that some applicants are not attracted by the marginally higher total pay packages that come with a riskier pay mix (i.e. higher percentage of variable pay). In addition, in some countries and with some firms, the targeted variable pay may not be considered realistically achievable. Thus, the only value that counts, especially from the perspective of the applicant, is fixed pay (i.e. the “bird in the hand” argument).
In this respect, the solution in an ideal world would be very simple: Companies offer applicants the highest fixed pay compared to all other “competitors for talent” (which can be market participants within the same industry, but also in other sectors) hoping to attract and to retain the best performing employees in the market. In the real world, however, the interests of other stakeholders, such as the firm’s owners often stand in the way: Owners (or stockholders) are interested in sustainable profits and above-average growth rates and are therefore generally only prepared to accept above-average pay for employees if these also perform exceptionally well. Or to put it another way: “In the world of consulting, there is no free lunch”.
We are at your disposal for further questions and suggestions regarding how you may optimise the design of your pay mix (and/or remuneration systems) at your company.
Andy Klose is an Associate Partner at Vencon Research International and leads the firm’s advisory service. Erwin Harbauer is Vencon Research International’s Managing Partner.
Vencon Research International is a leading provider of compensation benchmarking and research, as well as of compensation and performance-related consulting services for professional service companies, especially for audit and tax, management consulting, and IT services companies. Vencon Research International provides services to a full range of clients in more than 70 countries worldwide and is proud to name more than 85% of the world’s major consulting and/or professional services companies as its clients.