A detailed look at the pros and cons of merit increases

Organizations are continuously implementing various strategies for attracting and retaining top talent. One popular strategy is merit increases, also known as performance-based pay raises. Merit increases are a strategy meant to reward and motivate employees for excellent performance. As the workforce landscape has evolved over the years, questions about their effectiveness have become increasingly more prominent. 

In the 1980s and 1990s, rewarding for performance was a possibility because the increase budgets were double what they have been in the past 10 years. In the past decade though merit increases have felt more like cost of living adjustments and are often referred to that way.

Source: WorldatWork 2023-2024 Salary Budget Survey, Figure 27. ©2023 WorldatWork. All Rights Reserved.

Let’s look at the pros and cons of merit increases as a tool to reward and engage employees. As you read through the two sides of the argument, consider how this relates to the annual increases delivered at your company.

The proposition: the merit process is effective

There are a variety of beneficial impacts from the annual merit process.

First, the process enables companies to reward high-performing employees. Visibility into how pay decisions are made provides employees with clarity about the link between performance and compensation. They are able to become more engaged, motivated, and committed to achieving their goals. Employees are empowered to take ownership of their own career development. This contributes to higher job satisfaction and lower turnover rates.

Second, the merit process is an opportunity to educate leaders on the organization's compensation philosophy and pay practices, ensuring a foundational understanding of the factors that should influence pay decisions. With an emphasis on education, the merit process empowers leaders to make fair and informed decisions, leading to transparent, one-on-one annual pay conversations where leaders are accountable for those decisions. These open and transparent discussions also lead to higher engagement and foster a sense of trust and fairness.

As you know, compensation is one of the largest, if not the largest, investments made each year. A company-wide merit process is an opportunity to support and encourage managers to make effective, data-driven decisions around that significant investment. Without a single process that provides a comprehensive review of pay across the full employee population, pay increases are ad hoc, disjointed, and often made to address one-off hot spots, squeaky wheels, or loudest voices. This can introduce inequities and lead to pay decisions that are influenced by the wrong factors or, sometimes, just lead to bad investments.

According to Mercer's 2023 Inside Employee's Minds Study, employees who say they are paid fairly are twice as likely to say they understand how their employer determines their compensation. Being transparent about how pay is determined leads to employees feeling they are being paid fairly. Further, employees who say they are paid fairly are 85% more engaged and 62% more committed to their organization, as compared to employees who believe they are paid unfairly.

Third, the merit process is also an effective way to adjust compensation levels to remain competitive within the market, guiding leaders to make investments in talent that are based on both performance and market positioning.

The process also drives pay equity, ensuring pay investments are made in a way that mitigates the introduction of pay gaps or risks. The merit process requires a strong focus on leader education to ensure fair and informed decisions, which help drive pay equity. The process also provides an opportunity for additional investments that may be identified through pay equity analysis. Incorporating these pay equity adjustments in addition to leader-planned increases is an effective way to remediate pay gaps and mitigate risks.

Fourth, the merit process allows organizations to align pay with strategic objectives and business priorities. By linking both base and incentive pay to performance metrics and company goals, organizations can motivate employees to focus on activities that drive organizational success.

The merit process stands as a cornerstone of effective compensation management and organizational success. The annual cycle incentivizes excellence, fosters a culture of fairness and transparency, and promotes equity.

The opposition: the merit process is not effective

Too often, decisions around merit increases are subjective and are not linked to performance scores, which may themselves reflect subjective biases. As such, merit increase practices do a poor job of measuring and rewarding for performance.

Even when merit pay is based on objective goals, managers may still award it subjectively. The process often creates or reinforces a perception of favoritism — employees who are not satisfied with their merit pay may feel that there a manager who favors other employees, regardless of their performance reviews.

Overall, the merit process is not effective.

Subjectivity is the major challenge when it comes to the merit process. It's a complex task that requires subjective judgment and is often affected by personal biases, such as race, gender, or personal relationships that influence the evaluation process. Some companies incorporate a calibration session meant to align the ratings and awards proposed by different people managers. As you have probably experienced, however, the loudest voices in that room (or on that Zoom call) are the ones that have the most influence.

The merit process lacks transparency, making it difficult for employees to understand how decisions are made and how they can improve their chance of success. It demotivates employees and leads to a lot of frustration. Toiling away year after year only to receive the “meets expectations” rating over and over with little feedback or to hear (rumors, hopefully) of a forced ranking curve and how “no one gets more than X%” can certainly lead to complacency among employees.

In Mercer’s 2024 Global Talent Trends study, we looked at why employees stay with their employer. The number two reason (behind job security) is fair pay. Since 2020, “fair pay” has risen two spots in importance to employees. When employees want to believe their pay is fair but there is little transparency in the merit process, it erodes trust between them and their employer.

The merit process is incredibly inefficient. A study by HR Generation said that each year we spend about an hour per employee just on the merit process. If an organization has 15,000 employees, that means we're spending about 15,000 hours just to figure out what percent their pay should increase — typically less than 4% — at the end of the year. That’s a significant amount of time.

Similar to subjectivity, merit increases are based on imperfect performance management. As you know, that process is fraught with challenges and certainly is not free from bias. That's a huge challenge.

Another problem with the merit process is that it encourages burnout — do more, do better, get rewarded more is the idea behind it. According to that same 2024 Mercer Global Talent Trend study, 83% of people are feeling at risk of burnout — it’s a real problem. A merit-based pay system pushes us into a competitive environment where we always need to be doing more and where we're not doing enough. As employees, we hope that we are compensated for giving it our all, often to be disappointed.

Finally, we just don’t have enough in the merit budget. The small total increase budgets we have are meant to cover market increases, cost of labor inflation, skill attainment, growth and job duties, enhanced proficiency, time and role promotions, and proper positioning within salary structures. Never mind the problem of trying to differentiate based on performance within that small budget.

How do you see it?

Which of these arguments ring true to you personally? Are these the same arguments when you think about your role as a compensation or HR professional in the organization?

Maybe it’s time to take a look at how your compensation strategy can improve to better meet the needs of your organization, its managers, and, most importantly, your employees.

Mercer has consultants ready to work with you. Give us a call at 1-855-286-5302 or email us.