Annual pay raises don't work. The salary increase serves two purposes: to motivate workers and to keep employees from leaving for a better-paying job. In its current form, the traditional raise does neither of those things very well.
"You can't really do a lot with the annual raise," said Evren Esen, director of survey programs at the Society for Human Resource Management. When the economy is decent, annual pay adjustments come in at 1 percentage point or 2 percentage points ahead of inflation for a given year. That doesn't go far. Employees expect to get at least the cost of living adjustment, and a measly 2 percent increase in pay doesn't do much to encourage or change employee behavior. At best, the most stellar employees are getting a 5 percent raise, only slightly more than their average colleagues, who in 2016 can expect a 3.1 percent bump—if that. In the end, it's too small an increase to make a difference.
Historically, the best way to receive a significant raise is to either get a promotion or jump to a new company. With the job market tightening for certain white collar workers in competitive and growing industries, companies have started rethinking compensation packages to keep people around. That has not only resulted in a perks and benefits arms race but in new ways of thinking about pay increases. The yearly ritual of doling out incremental and somewhat disappointing salary increases is quietly disappearing. "The conventional process of giving an annual increase is being studied, reviewed—under siege, you might say," said Steve Gross, a senior partner at human resources consulting firm Mercer.
A once-a-year payment schedule is too infrequent to change someone's work ethic. In theory, money signals how good (or not) someone is at their job. But, it's impossible to give someone feedback on an entire year's worth of work with a nominal pay increase. Plus, it's rarely an indication of how well someone did the job over a full year. Managers don't remember how people performed all year long, and they admit to rating sub-par workers the same as stand-out employees. Workers also complain that hearing about their flaws once a year gives them no chance to respond and change behaviors.
Many companies, including Adobe Systems Inc., Accenture PLC, and Gap Inc., have already abandoned the annual performance review for those exact reasons. These organizations have ongoing review processes that, in theory, more accurately reflect someone's output on the job. As reviews become more frequent, so should raises. "If we have performance reviews all the time, we're not going to have annual increases," said Esen. As of now, 90 percent of companies give everyone raises on the same day, once a year, according to an annual compensation survey by Mercer. That is already changing.
GE Company, which recently moved away from the annual review, is considering scrapping annual compensation hikes. "We uncovered an opportunity to improve the way we reward people for their contributions," Janice Semper, GE’s head of executive development, told Bloomberg. GE declined to elaborate on what its new system might look like, but Semper cited the vague goals of "being flexible and rethinking how we define rewards."
Other organizations are achieving such flexibility via bonuses. Variable pay has become an increasingly large part of pay packages, making up a record 12.7 percent of compensation, according to an Aon Hewitt survey from last year. It's a much more effective way to tell people they did a good job. "With bonuses, you're specifically rewarding someone for their behavior in a given year. And they're more able to directly see the line of sight between their performance and the reward for that performance," said Esen. "It gives companies the ability to really make a meaningful gesture to their top performers—to say you did well and you're getting this bonus."
Bonuses also help companies keep compensation costs down. It's hard not to give people raises, and it's even harder to cut people's salaries, but employers can give bonuses at will. If a company has a bad year, it doesn't have to give out bonuses. On an even more granular level, an employee who has a bad year might not get a bonus that year, either. Companies can use them as sticks or carrots, as needed.
The bonus is just one version of the changing nature of compensation. Whatever happens to the raise, it will become more granular and regular. "Companies are trying to break away from this old-school you get an annual increase," said Esen. "Nobody really values that increase that much because it's usually not that high."