Thomas Davenport 

Thomas O. Davenport

Senior Consultant, Research and Innovation Center

Norman Ramion 

Norman Ramion

Senior Consultant, Organizational Surveys and Insights

Half the money I spend on advertising is wasted; the trouble is, I don't know which half.
John Wanamaker, U.S. department store founder (1838 – 1922)

For many organizations, this observation by department store mogul John Wanamaker also applies to investments in total rewards (see box below). Finding and reducing waste is especially important in this era of low growth and financial pressure, when elements of reward budgets can seem tempting targets for reduction to fund other internal capital requirements.

Finance executives need to know whether (and how effectively) their organization's significant expenditures on reward programs are producing the intended performance and talent retention outcomes — and whether some part of that investment might be unnecessary or misaligned with broader financial or workforce goals. A company with 10,000 employees can expect to spend upward of $600 million per year on wages and salaries, health care coverage, retirement plans and savings, and other rewards. If even a small portion of this expenditure is misallocated or undervalued, it means a lot of money is not producing a suitable return on investment.

So difficult questions loom: What is the right level of total investment? What impact would reward reallocations or cuts have on our financial and workforce goals? What return is our investment producing now, and how could we improve on that?

Defining Total Rewards

Towers Watson defines "total rewards" to encompass all programs and policies — monetary and nonmonetary — that an organization provides to attract, retain and engage employees, including elements such as pay and benefits, training, career development and work/life balance assistance.

The ultimate goal is a high return on the financial capital the organization is investing in rewards in the aggregate and a high return on the human capital (knowledge, skill and talent) investment made by employees.

The Total Rewards Sweet Spot

Identifying reward investment sweet spots — the smallest possible investment required to achieve the largest possible positive effect on employee attitudes and behaviors — requires more than instinct, experience or conventional marketplace data. We have found that, in most organizations, some inefficiencies have crept into the reward investment strategy over time. Historic reward programs may no longer fit current workforce needs and aspirations. Executives' perspectives about what employees want are colored by their own experiences, which don't always align with what employees require from their work. Competitors have added or changed rewards, and may be winning the recruiting wars. To paraphrase John Wanamaker, some part of the reward expenditure almost certainly is not producing the maximum desired effect. But how do you identify where the investment inefficiencies lie?

The answer comes down to quantifying the critical relationships between reward expenditures and the employee behaviors they are supposed to encourage and support. The ultimate goal is a high return on the financial capital the organization is investing in rewards in the aggregate and a high return on the human capital (knowledge, skill and talent) investment made by employees.

Traditionally, organizations have tried to understand this relationship by surveying employees. But when it comes to asking people how they feel about their rewards, and their pay in particular, survey responses are often notably skewed toward the negative. Virtually no employees believe they are overpaid for the work they do (and they likely would not admit it if they did). So the best way to understand what rewards are really important to employees is to understand what trade-offs they would make if they had to decide between higher or lower amounts of different elements of their total rewards portfolio.

Lessons From the B2C World

A sophisticated survey technique requiring reward trade-offs does just that. This approach, called "conjoint analysis," calls for people to make choices among different reward elements in a structured, statistically derived pattern of questions. The result is a reliable hierarchy of reward preferences that tells a richer story than typical employee survey results can.

This survey methodology has been successfully used for decades by market research professionals in business-to-consumer organizations to understand customer preferences and spending patterns. We've adapted it for the workforce side, where it has proved to be equally effective for understanding what employees truly value from their rewards. In a very real sense, after all, employees are consumers of the portfolio of programs your organization offers, particularly as they shoulder an increasing share of the cost for many of those programs. It makes sense to use the same sophisticated tools to understand employee attitudes toward rewards as your company uses to gain critical insights into your customers' needs and preferences.

The true power of this approach, however, comes from combining the employee preference data from the conjoint process with data on the actual costs of the various programs. This provides insights into the optimal reward combinations — those that provide the highest value to employees for the lowest cost to the organization. We call this Total Rewards Optimization (TRO).

  • With TRO, an organization can answer three critical questions:
  • What is the right level of our total investment in rewards?
  • What is the best way to allocate that investment across reward elements to maximize the employee behavior we want to drive, for example, retention or general perception of value?
  • How do these results vary across targeted employee groups, for instance, by skill, function, job level, tenure, age, location and performance level?

The following chart shows the outcomes for nine reward elements commonly studied in our TRO work with clients. These data pertain specifically to organizations in the high-technology sector. The outcomes reflect how employees' perceived reward values change with increasing or decreasing organizational investment in each reward.

Improving Return on Reward Investments
Click to enlarge

TRO in Action

In this example, we see that any one or a combination of 401(k) contribution increases, career development increases and health insurance premium decreases would improve perceptions of reward portfolio value — and at a much lower cost than increases in compensation (merit pay, bonus or long-term incentive). So in this scenario — where competitive base pay rates are a given — an organization could achieve positive employee outcomes for a much lower additional cost than taking the more traditional route of upping the merit-pay budget.

Even more striking is the opportunity to achieve a significant increase in employees' perceived reward value through investments in career development or a sabbatical program. That's because these reward areas are more efficient — offering a higher unit of perceived value increase per reward dollar — than many financial rewards. Of course, if pay is considerably below market rates, the most efficient rewards may not alleviate poor perceived value, but they could then be used instead of, or in combination with, pay increases to achieve the same or better outcomes at lower cost.

Today, of course, many organizations are more focused on reducing than increasing their reward investments. Referring again to the chart, this analysis indicates that decreases in bonus levels, while certainly not welcomed by employees, can often produce savings that far outweigh the accompanying decreases in perceived value. Having this insight between bad and worse choices will help to mitigate downside risk to an organization as much as possible.

Think of this analytical approach as a way to conduct the search for a mutually attractive value proposition to achieve ROI. In fact, any employment value proposition involves give and take between the employer and employee. Both expect a return on their respective investments: financial (by the organization) and human capital (by the employee). Organizations have limited financial and other resources with which to provide rewards, and employees have many different ways to invest their abilities and their energy. Therefore, both parties benefit from a relationship that provides a mutually satisfactory relationship between investment and return.

The combination of a trade-off survey with financial optimization has helped many of our client organizations and their employees reach this mutually beneficial goal. Two recent examples:

For a large health care organization, TRO modeling led to recommended changes to rewards that generated a savings of $4 million in year one. In addition, turnover dropped from 33% to 21% (a 36% improvement over three years), yielding estimated savings in unwanted turnover of $10 million per year, while employee engagement rose nearly 10% in the same time period.

In a major customer service organization, actions taken from TRO results led to retention increasing more than 30 percentage points in 13 out of 17 business units worldwide within six months. Within nine months, all but one business unit had achieved a monthly retention rate of 92% or greater. Savings exceeded $10 million annually.

Bringing Rigor to Reward Decisions

Senior leadership in general, and especially finance executives, will continue to face increasing challenges managing reward costs while meeting the talent needs of their organization. In some industries like technology, shortages in critical skills are bringing upward pressure on wages and benefits. In other industries, five-plus years of low-single-digit pay increases are forcing organizations to think creatively about maintaining performance and engagement among workforces struggling to keep up with inflation.

Compounding these problems are factors like pension cost volatility and health care reform, both of which can severely reduce corporate financial performance, absent sound risk management. While changes in the health care system will present new opportunities to manage the expense associated with health care coverage, they also increase the pressure to spend those funds effectively, since employee expectations for employer assistance with health coverage are not likely to abate any time soon.

Finance professionals have good reason to think hard about how to manage these reward investments to ensure that the organization minimizes reward cost while simultaneously maximizing the attraction and retention impact of rewards. In an increasingly data-rich, but insight-poor, decision-making environment, the approach we've described offers a comprehensive and statistically powerful way for finance executives to assess employee preferences relative to cost, and make the best possible decisions on allocating reward investments.