Transforming merit: From flawed to fair 

Is it the quality of being particularly good at something and deserving of praise or reward — the formal definition of the word? Or is it more likely to remind you of the painful, cumbersome, and frustrating process that the merit process has become? Maybe it makes you think of your own underwhelming past awards, or the disappointment you expect from your next merit increase.

For decades, the merit pay system has been a cornerstone of pay-for-performance philosophies, intended to reward high achievers and drive organizational success. Today, many are questioning whether it truly delivers on that promise. Perhaps the more pressing question is: should rewarding performance even be the primary goal of merit pay?

The stakes for getting pay right are rising. Compensation is not only the largest expense for employers; it’s also the top reason employees join and stay with a company. With pay transparency and equity legislation on the rise, the risks are mounting. In response, 44% of employers now conduct regular pay equity studies (38% annually, and 6% more frequent than annually).

While pay equity analyses are a step in the right direction, we must ask ourselves: how much more are we willing to spend fixing pay equity issues year after year as transparency makes inequities more visible? How long will we continue to allocate as much as one-third of our compensation spend to off-cycle increases because we didn’t get pay right in the first place?

Market Research: Compensation Spend and Employee Satisfaction

A 2024 Mercer analysis found that nearly one-third of annual non-promotion related pay changes are not related to merit. These changes may include pay equity increases, counter-offers or minimum wage adjustments.

_{Sources and Methodology:
Merit Increases based on actual merit increase budgets provided in Mercer QuickPulseTM US Compensation Planning Surveys (April Editions).
Actual YOY Base Pay Change % based on analysis from Mercer’s US Benchmark Database (employee weighted, common incumbents – i.e., same org, same job).
Fair Pay Perceptions based on US normative data from Mercer’s employee engagement research, including findings from more than 450,000 employees per year (average).}

It’s time to face the truth: merit is broken, and it’s not sustainable to keep patching it up.

The good news? There’s a way forward. By adopting a more data-driven and flexible approach to merit — one that combines technology with human insight — we can create a merit process that’s not only fair but also designed to achieve the business results we need. Not everyone will be completely satisfied (after all, we all want more), but at the end of the day, we can feel good about the outcome.

As we explore new ways of delivering compensation, it’s important to first start with understanding the key issues that need to be addressed. And while there are many, a few key areas stand out:

1. Bias in pay systems

Pay systems are undeniably biased, with the gender pay gap showing minimal progress over the past two decades. Since pay equity legislation did not deliver the intended outcomes, lawmakers have shifted focus to pay transparency, believing that increased visibility will enhance accountability.

However, pay transparency in the US largely focuses on providing transparency to candidates to drive more equitable starting rates. But even if that’s the case — transparency alone may not prevent inequities from recurring. Current merit processes heavily rely on managerial discretion, which can reintroduce unconscious bias into the system.

Client case study: Pay disparities between men and women 

Manager discretion can lead to biased pay decisions that disadvantage certain protected classes. For example, at the client organization depicted here, we found that starting salaries of female employees were smaller than that of similar male employees, possibly indicating manager bias or differences in bargaining at time of hiring.

Similarly, in the client organization depicted below, we found that female employees with average and high ratings received lower rewards than male employees with the same ratings.

Organizations often attribute ineffective decision-making to managers’ lack of skills, but the real issue lies in the absence of data. Managers do not have visibility for all comparable roles within the organization to factor pay equity into the decisions. For instance, how many individuals in your organization manage administrative assistants?

We cannot simply upskill our way out of this problem; systemic changes in compensation decision-making are essential.

2. Incentivizing the wrong behavior

When it comes to whether merit truly drives performance, the numbers tell an interesting story. On average, employers offer a mere 2% premium for top performers compared to those who meet expectations. To put that into perspective, with the median US salary level of $60,000, post-tax, that translates to just $20 a week for the highest performers — who make up only about 7% of the workforce.

Market Research: Merit Pay for Performance

_{^{Source: Mercer QuickPulseTM US Compensation Planning Survey – March Edition}}

While this sheds light on how merit increases are awarded, our client analytics often show that total base pay levels are either rarely differentiated or misaligned altogether.

Client case study: Miscalibration between pay and performance

At this client organization, performance pay premiums are nominal, with nominal differentiation between low and high performers (0.1%).

What today’s pay systems do incentivize is job hopping. Despite employers' efforts this year to curb new hire premiums, on average, new hires continue to earn about 2% more than their peers who stay.

Median year-over-year change in annual pay by worker mobility

_{^{Source: ADP Pay Insights}}

Long-tenured employees often face pay compression. New hires are frequently brought in at similar or even higher salaries, while merit budgets struggle to keep up with market trends. This creates a “loyalty penalty,” where the expertise and experience of seasoned employees go unrecognized, pushing them to seek better compensation elsewhere. This is troubling, especially since research indicates that tenure is the largest human capital driver of both organizational and financial performance.

Client case study: The loyalty penalty

In the IT department of the client organization depicted below, there is a premium for new hires relative to incumbents, likely indicating compression issues. The blue line represents the impact of every additional year of tenure on pay relative to new hires.

3. Ineffective budget allocations

A third issue with merit is that organizations allocate their merit budgets like peanut butter, with 81% applying the same percentage across all leaders or business units. This is a critical flaw, as it hampers the ability to reward performance and address pay inequities, especially when gaps exceed budget constraints. Only 4% of organizations allocate pay based on business criticality, which undermines strategic objectives and disincentivizes employees in roles with declining skills from developing new skills, ultimately impacting their long-term employability.

4. Process inefficiencies

The year-end process is operationally complex, lengthy and inefficient — it leads to endless calibration meetings, extensive data collection, and ongoing adjustments. For large organizations, this can mean months of planning, draining managers’ time and energy. For example, one client quantified managers’ time investment in the year-end calibration process, finding it exceeded 100 days at a $60,000 daily cost — totaling nearly $7M. That’s a significant drain on productivity with minimal ROI.

So, what’s the solution? How can we ensure that the delivery of merit increases are fair, incent the right behaviors, and drive the right outcomes — all while streamlining the process? The good news is that data-driven insights and technology can make this possible. Here’s how to get started:

1. Assess what you are actually paying for

Client Case Study: Decomposing Drivers of Base Pay

Mercer commonly finds that pay grade is the main driver of pay, followed by experience and location — like in the retail organization depicted here. Unexplained variance in pay can sometimes be attributed to pay inequity.

First things first: Are you truly living up to your compensation philosophy? It’s essential to assess whether you’re rewarding employees as intended. This foundational step uses analytics to identify the factors influencing pay outcomes and eliminate those that shouldn’t, such as gender or ethnicity.

This isn’t just vital for merit processes; it’s also key to pay transparency. While many highlight transparency’s potential to expose inequities, what it really shows is whether you’re delivering on your promises. For example, if you state that experienced, performing employees should earn market rates, they can now verify that claim. This clarity around how you are paying today is crucial for building a compelling case for change.

2. Set the right budget

When setting budgets, many employers rely on compensation planning surveys to gauge market movement. While this can provide useful insights, it’s a data point — not a strategy.

Think of it like teaching a child to budget. You wouldn’t instruct them to start by asking their friends what they’re doing. Instead, you’d discuss goals, and build a plan for how to achieve it. The same principle applies to merit budgeting. After assessing your pay practices and identifying gaps, along with the critical business outcomes you aim to achieve, you can then set a budget that aligns with your objectives.

3. Guide decision making

With your budget in place, it’s time for execution. Start by allocating funds strategically across the organization — this isn’t a one-size-fits-all approach. To effectively address pay gaps, budget allocations must reflect your priorities. Optimizing compensation spend requires leveraging data-driven decision-making to correct existing flaws.

Market Research: Merit Budget Allocation

_{^{Source: Mercer QuickPulseTM US Compensation Planning Survey – August Edition}}

Next, empower managers with the data they need to make equitable decisions. Often, they lack the visibility required to ensure equity among comparable employees. A salary range (typically 50% wide or more) is likely too broad to guide fair and equitable decisions.

Market Research: Manager Discretion

_{^{Source: Mercer QuickPulseTM US Compensation Planning Survey – August Edition}}

Fair and equitable pay must be embedded in decision-making processes. Without this integration, employers risk falling into a cycle of making pay decisions only to spend more later to rectify them.

Enlisting a technology assist

Modernizing merit processes means harnessing technology to streamline decision-making and improve outcomes. Merit recommendations should be data-driven and reflect your pay philosophy in the context of your HRIS snapshot.

Tools like Mercer’s Merit Co-Pilot can empower employers to make more strategic, informed decisions, connecting managers with essential data and addressing key pain points.

How technology helps:

1. Budget optimization: Use advanced analytics to optimize merit increases, rewarding fairly within budget constraints
2. Process efficiency: Say goodbye to endless meetings by integrating data-driven recommendations directly into compensation management systems, providing managers with clear starting points.
3. Pay fairness and equity: Use built-in pay equity analyses to help ensure unbiased merit decisions that contribute to closing pay gaps.
4. Human oversight: Maintain a human-in-the-loop approach where managers maintain control over final decisions, but data-driven recommendations provide structure and fairness.

Does this mean AI will make pay decisions?

Not at all. This isn’t about removing managers from the process; it’s about using data and technology to ensure equitable decisions that align with strategic objectives, while ultimately empowering managers to make those decisions. This approach scales the process, boosts efficiency, and reduces bias, but it’s crucial to keep it people-led.

Managers are the subject-matter experts on their teams and understand the nuances that data alone may miss. Strategic decisions during the merit cycle should remain with them, even as AI-generated ranges help ensure consistency with organizational practices.

These technologies enable managers to make fair, consistent decisions by providing data-driven insights with the budgets to match. By streamlining processes, optimizing budgets, and minimizing bias, AI tools can significantly enhance the overall merit experience. Additionally, they simplify the work of compensation teams, allowing them to rely on these governance mechanisms as a “first line of defense,” limiting unnecessary approvals to areas outside established guidelines.

Modernizing your merit process

To thrive in today’s competitive environment, companies must adopt technology to scale their merit processes. A fit-for-purpose design and data-driven approach helps set smart budgets, eliminate wasteful spending, equip managers with effective and unbiased data, and proactively embed pay equity throughout the process.

With these elements in place, organizations can truly stand behind their claims of fair pay decisions. The ROI is undeniable: employees who believe they are paid fairly are 85% more engaged and 62% more committed than those who feel otherwise.

As you reflect on the challenges of your current merit system, ask yourself: Are you ready to redesign a merit process that is genuinely "meritorious"? One where rewards are fair and aligned to your strategic imperatives but also streamlines the experience for everyone involved?

This outdated process has outlived its lifespan, and we can no longer afford to ignore it. It’s time to embrace change and create a system that makes us all proud.