.bodytext {float: left; } .floatimg-left-hort { float:left; margin-top:10px; margin-right: 10px; width:300px; clear:left;} .floatimg-left-caption-hort { float:left; margin-bottom:10px; width:300px; margin-right:10px; clear:left;} .floatimg-left-vert { float:left; margin-top:10px; margin-right:15px; width:200px;} .floatimg-left-caption-vert { float:left; margin-right:10px; margin-bottom:10px; font-size: 10px; width:200px;} .floatimg-right-hort { float:right; margin-top:10px; margin-left:10px; margin-bottom:10px; width: 300px;} .floatimg-right-caption-hort { float:left; margin-right:10px; margin-bottom:10px; width: 300px; font-size: 10px; } .floatimg-right-vert { float:right; margin-top:10px; margin-left:10px; margin-bottom:10px; width: 200px;} .floatimg-right-caption-vert { float:left; margin-right:10px; margin-bottom:10px; width: 200px; font-size: 10px; } .floatimgright-sidebar { float:right; margin-top:10px; margin-left:10px; margin-bottom:10px; width: 200px; border-top-style: double; border-top-color: black; border-bottom-style: double; border-bottom-color: black;} .floatimgright-sidebar p { line-height: 115%; text-indent: 10px; } .floatimgright-sidebar h4 { font-variant:small-caps; } .pullquote { float:right; margin-top:10px; margin-left:10px; margin-bottom:10px; width: 150px; background: url(http://www.dmbusinessdaily.com/DAILY/editorial/extras/closequote.gif) no-repeat bottom right !important ; line-height: 150%; font-size: 125%; border-top: 1px solid; border-bottom: 1px solid;} .floatvidleft { float:left; margin-bottom:10px; width:325px; margin-right:10px; clear:left;} .floatvidright { float:right; margin-bottom:10px; width:325px; margin-right:10px; clear:left;} Despite the universal, critical role money plays in our day-to-day work life, evidence of the efficacy of merit pay is limited at best. Nearly all U.S. corporations use merit pay, yet merit pay systems have failed to live up to their meritorious expectations.

U.S. workers received, on average, a 3.9 percent pay increase in 2006. The average inflation rate for 2006 was approximately 3.2 percent. In other words, the real pay increase in 2006 was around 0.7 percent. According to the U.S. Census Bureau, in 2006 the estimated median Iowa income was about $55,700. A typical Iowa household saw its income changed by about $390 or $7.50 per week. Just enough to buy two extra gallons of gas for your car! Is this a significant pay increase? Will this motivate employees?

Edward E. Lawler III, a renowned compensation scholar, argues that merit pay plans are not for managers who like to play “a piker’s game.” Merit increases must be meaningful to employees; in other words, perceived as large enough. How should one evaluate the underlying cognitive algebra to estimate a meaningful pay increase?

If you have coffee with sugar, how much more sugar must you add before it tastes sweeter? In other words, at what point is there a noticeable difference? Likewise, when managers give raises, they presume that employees will feel a noticeable difference in their wallets and link that to their job performance. Let’s go one step further: Consider that sometimes monetary incentives might not motivate, but rather demotivate.

U.S. firms spend a great deal on merit pay. Yet there is limited empirical work to assert that a merit raise of 0.7 percent is large enough to motivate or even that a 20 percent raise is large enough.

My colleagues and I attempted to determine how large a merit raise must be before employees see it as a raise, since only then can the amount of money make a difference in people’s attitudes and behavior. Our research found that:

• People given between 7 to 10 percent merit pay raises felt the raises were linked to their performance and were satisfied with the increase in pay.

• People given more than 10 percent merit pay raises were happier, but it didn’t necessarily enhance motivation.

• People given less than 7 percent merit pay raises were less likely to believe that good performance is being rewarded – even if those small raises were, in fact, performance-based. They also were less likely to be satisfied with their pay rates.

Our research challenges the traditional idea that small merit raises, at worst, can do no harm, and that huge raises are beneficial. Merit raises that are substantially larger than 7 to 10 percent don’t help, and raises that are too small can jeopardize improved employee performance. This holds true regardless of the level of base pay. Given the research, here are some things for business owners to consider:

• Merit pay increments should be clearly separated from other components, such as the cost-of-living adjustments, seniority-based rewards and so on.

• Smaller percentage raises may be meaningless and even demotivating. People at higher pay levels could be demotivated and unhappy if their percentage raises are relatively small.

• To ensure that compensation plans achieve the desired effects, managers should differentiate among employees’ performance levels and allocate large merit increases to superior performers.

When facing limited merit budgets, bonuses and variable pay might be good alternatives to merit pay plans.

Atul Mitra is an associate professor of management in the College of Business Administration at the University of Northern Iowa.