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(Book Excerpt) Compensation: How does money affect retention?

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This is an excerpt from a book I'm working on, titled Keep Your People: The Startup Manager's Guide to Retention. You may read the introduction to the book here, where I lay out the book's central premise: there are six categories of reasons that people leave companies. As a manager, you can influence five of those categories.

This chapter, on compensation, examines one of the five.

Update: Keep Your People is now out! Buy it here.


People stay when you give them lots of money. True or false?

To a certain extent, this is true. If I pay you a million dollars a year, you’ll probably think twice before leaving your job. But if I pay you a million dollars and psychologically abuse you for every day of that year … it’s also obvious that at some point, you’ll snap.

This is the conundrum with compensation. It’s clear to us that money affects retention. But it’s not as simple as ‘pay the person more, and that person stays.’ We’ll need a richer mental model of compensation and motivation if we want to use compensation as a tool in our retention toolbox.

The Wrong Way To Think About Compensation and Retention

The situation that I painted for you at the beginning of this chapter is perhaps too simplistic. It’s very clear to us that compensation isn’t all that matters when it comes to retaining and motivating employees.

So here’s a more difficult situation, one that you're more likely to encounter in real life:

A star employee has left your startup. She’s left you to join a large company, and her compensation at this large company is at least double what you paid. How do you react to this change?

Should you:

  • Increase your compensation levels? You can’t double everyone’s pay, but you can certainly increase it a little.
  • Change your selection process for hiring? Maybe there was something about this person that caused them to look at larger companies. Perhaps if you hired differently, your new hires would be less likely to leave. The spectrum that most people default to is that of skill: if you cannot hire skilled candidates at your current compensation level, perhaps you should search for less-skilled candidates!
  • Conclude that the current labour market, in the current location, is too competitive? If you conclude this, the logical move is to chose to go remote, or to open a new office in a less competitive labour market.

On the face of it, these are all reasonable options. In my previous company, we debated over these proposed solutions and more at various stages of our growth.

The problem with such assessments, however, is that they are limiting:

  • Competing on compensation is a fool’s errand — after all, you are a startup! You simply do not have the ability to match the compensation levels of larger companies.
  • How are you going to change your hiring? Hiring as a startup is already difficult as-is; if you add new requirements to filter for ‘personality’, or ‘risk-appetite’, or some nebulous ‘less-likely to leave’ness, you’re going to further restrict your available pool of candidates. (I’m not joking about this option, by the way — a friend’s boss once concluded that they should identify and hire subpar candidates, as these candidates presented less of a flight risk).
  • Concluding that your current labour market is too competitive is a valid move, but it should not be amongst the first set of options you consider. Every location presents a different set of tradeoffs. Hiring in Ho Chi Minh City is challenging in different ways from Singapore, or Seattle, or Taiwan. Concluding that a labour market is ‘too competitive’ is reductive; it closes off the kinds of thinking you need to analyse and develop a working hiring/retention strategy for your market.

In truth, all of these options stem from the same underlying worldview. The worldview is this: we think compensation is the most important factor for retention. Or, if we don’t believe it’s the most important factor, then we believe that it ranks in the top three.

Why do so many of us believe this? I suspect that we believe in this because we believe in the power of markets.

Markets are a powerful and useful analogy. We think that a labour market is like any other market: that is, employees are rational actors that seek compensation levels that match the value they offer. The more valuable the set of skills an employee has, the higher the expected compensation. Therefore, if an employee leaves you, it is because you cannot offer compensation that matches her skillset. And if you cannot compete with compensation, the rational response is to move to a less competitive labour market, or to settle for less-skilled employees.

On some level, this framing is true. The labour market is a market, employees do move around in search of better compensation, and people will use economic reasoning to justify a move. (How many times have you heard “they didn’t give me a good deal, so I went with the other offer instead”?) This is particularly true with sales, or in other domains where candidates have a more mercenary mindset.

But I do not think this is an accurate model of reality — at least, not for the majority of employees.

The first clue we have that reality isn't as simple is the observation that the people around us aren't rational, dollar-maximising machines. Through the psychologists Amos Tversky and Daniel Kahneman, we now have over three decades of research showing us that humans have all sorts of cognitive biases that prevent us from making ‘perfectly rational, utility maximising’ decisions. (See Kahneman’s 2011 book Thinking Fast and Slow for a summary of this broad body of work).

These psychological factors are especially true when it comes to retention.

Here are several concrete examples.

In the introduction to this book, I mentioned something I called the ‘ugh’ field. People do not usually enjoy venturing into the unknown. We may not be perfectly happy in our current job, but who knows if our next job is worse? So we stick around longer than we should.

In addition to this effect (called ‘loss aversion’ in the academic literature) people also fear the inevitable rejections that come during a job search. As a result of this fear, we build a fence in our heads around the idea of leaving our current role — a fence that stays up for as long as our needs are met across the six factors that influence retention. This fence is the ‘ugh’ field, and it meddles with a purely calculative view of compensation.

People do not leave the instant they realise “oh, the compensation that is given to me does not match the free-market value of my skills”. Instead, it’s always some combination of factors that lead them to go.

How do we reconcile the two views of this situation? Here’s how I think we should see it: people tend to maximise compensation when they are searching for a job. But when they’re already in a job, they are more affected by psychological factors.

My way of remembering this is to say that ‘the job hunting process brings out the inner economist in you’. This is especially true if you are evaluating offers from multiple companies — assuming you’re lucky enough to be in such a position, that is. But you become less affected by such rational considerations when you are already in a job. It is this second situation where psychological factors begin to dominate, and where we should take them into consideration.

This view suggests a very different approach to retention. In the old, market-based view of compensation, the only three responses to compensation competition is to raise rates, reduce job requirements, or go elsewhere for lower competition.

In this new view, we have more options available to us. Another way of saying this is that if we meet the psychological needs of our subordinates, we need not compete on compensation alone.

Coming Up With A Compensation Strategy … From First Principles

In 2015, I was facing a difficult problem at my company. My team was down to five people, thanks to a very painful pivot from consulting services to product. Because the product we built was so untested, early deployments were essentially month after month of customers yelling at us. No surprise, then, that morale was the lowest it had ever been in the history of the company.

I needed to do two things: stop my remaining teammates from leaving, and figure out hiring, quickly.

The first thing I did was to start doing one-on-ones. At the beginning, when I was new to the practice, I thought that I would use the monthly meetings to help my subordinates grow. I believed that focusing on their professional growth would give them a reason to stick around.

This worked — up to a point. The reason such growth-oriented one-on-ones worked was because it gave my subordinates something to look forward to. Every month, our one-on-ones would highlight a new challenge, a new lesson, or a new goal to achieve in the coming month. If a subordinate said he wanted to learn testing, for instance, I would make sure that a good portion of our testing tasks were assigned to him. And then we would discuss his progress in the next month.

Unfortunately, this monthly approach was also limited in its effectiveness. It meant that their long-term career advancement was opaque to them, because it wasn’t clear what benefits lay ahead in their future with the company — that is, beyond the plans we made for the next month.

Around the same time, I began to see an encroaching problem with the way we did our compensation. Like many small-to-medium-sized businesses, our salaries were set in an ad-hoc manner, and adjusted according to some ill-defined, irregular process. This meant that the salaries we paid were not well distributed across our team — the people who thought to negotiate harder, and to negotiate more often, were paid higher rates compared to those who did equally good work but who didn’t think to ask for a raise.

I realised that this would cause problems down the road. It didn’t make any sense to me that we should pay individuals based on their ability to negotiate; if we were found out, the employees who weren’t paid as well would probably quit the company in anger.

I also didn’t like the nature of such renegotiations. If a savvy subordinate thought the company was in a crunch period and desperate for staff, he or she might take the opportunity to ask for a raise. I was always unhappy when granting a raise in such situations: both when it was approved and when it was declined — the former meant that an employee was rewarded for his negotiation ability instead of his contribution to the company; the latter might be the trigger for the employee to leave, right when we needed him the most.

The solution I eventually settled on was to define a career ladder across the entire product team, with fixed compensation levels for each rung in the ladder. (Transparent career ladders are common in large tech companies, but relatively rare in small startups in South East Asia.)

Career ladders consist of two elements: a list of clear requirements for each level in the ladder, and a salary range attached to the levels. Since we were a small company, I set fixed salary levels for each rung — and made it a policy that we wouldn’t negotiate salaries for the levels. Instead, we would discuss if a job applicant or employee met the requirements for a specific level, and therefore deserved the attached salary. The only way to get a raise was to go up a level, which meant there was added financial incentives to work on one’s career path in the company.

The other big policy change I implemented was to say that we conducted levelling only twice a year: once at the end of June, and another at the end of December. This had the net effect of reducing the number of times managers had to deal with compensation issues. The rest of the year would be spent in monthly one-on-ones, and the established norm was for managers to help their subordinates with their growth (as dictated by the requirements in the career ladder), in order to score a level promotion as soon as possible.

(For those who are curious what a levelling document looks like, I’ve included the first version of our levelling document in the appendix of this book).

What I’ve described so far is fairly straightforward role-levelling, familiar to anyone who’s done a stint in HR. We must now consider my plan from the perspective of the labour market. What salary levels should I have set for each level in my proposed career ladder?

This is where compensation numbers actually do matter. I’ve mentioned earlier that hiring brings out the inner economist in us. The direct implication here is that one needs to set salary levels that’s comparable with the rest of the labour market.

I spent a couple of weeks calling people I knew in Ho Chi Minh City. I asked them about the current expected salary levels for software engineers at their companies. Eventually, my team and I settled on the following levels:

  • We had four levels in our salary scale. The bottom two levels were junior roles, meant for fresh grads from local universities.  For these levels, I set salaries at the top 80th percentile for the market.
  • For the senior levels, however, I decided on salary numbers that were lower than comparable roles in the market. I did this for two reasons: first, our strategy for recruiting senior engineers allowed us to remain competitive against other firms in the market, despite a comparatively middling compensation amount. Second, it made it easier for me to sell this compensation package (and levelling system) to my boss in Singapore.

How did we remain competitive with our offers at the senior end of the hiring scale? The answer lies in the structural nature of Vietnam’s labour market. At the lower end, we were competing against the best companies in Ho Chi Minh City for the best graduates their universities produced each year. At the top end, however, we weren’t competing in a particularly dynamic market. Instead, we were poaching talent from other firms.

Over a period of two years, I grew to realise that Vietnam’s technology industry at the time consisted primarily of outsourcing companies. These companies weren’t very fun to work in, and often had lousy pay, to boot. Our hiring strategy for senior engineers rested on the insight that good engineers could be found in outsourcing companies; that they were being overlooked by the VC-funded, high-flying startups in the country, and that we could filter for them and offer them salaries that were still higher than what they earned at their previous jobs. More importantly, I thought that the idea of working on and scaling a single product would be hugely attractive to them — and I turned out to be right.

Taken together, these compensation changes generated a number of benefits for the company:

  • It greatly simplified compensation discussions.
  • It made expectations for new employees radically clear. If a candidate made it to the final rounds of our interview, we would introduce the career ladder to the candidate and explain where in the ladder he or she was being hired at. The requirements for that level became the criteria for passing probation.
  • It created a clear career path for everyone in the company that stretched months or years into the future. During onboarding, we gave each employee a copy of their career path, along with the requirements needed to climb to each level. Because we practiced a monthly one-on-one meeting that focused on helping them with their career growth, our employees understood that if they stuck around, they were guaranteed to progress along the path. This made our employees more motivated, and more compelled to stay to benefit from the training we gave them.
  • Most importantly, it kept politics at bay. I’m fully aware that this system cannot last forever — at some point, above a certain number of people, we would probably have to return to a range-and-negotiation based system. But for a growing startup, below 150 people? This particular compensation system worked a treat.

Don’t misunderstand me: I’m not arguing that you should copy this system exactly as I implemented it. I’m comfortable revealing the hiring strategy we used in my old company because the market for talent in Ho Chi Minh City has changed today, rendering my old strategy useless. I’m merely telling you the context that I’ve operated in.

I believe that it’s possible to design systems for hiring that ties in neatly with systems for retention. The exact strategies will differ for your company, your industry, and your market. For instance, you could:

  • Use a salary range, not a fixed number.
  • Keep the salary fixed but negotiate stock or option grants.
  • Extend or shorten the career ladder depending on your company’s unique needs.
  • Introduce sub-levels within each rung.
  • Introduce performance bonuses to reward employees who are not able to earn promotions in time.
  • And, most importantly, develop a hiring strategy that reflects the structure of your labour market.

The general ideas are the most important bits of any case study. Now that I’ve given you some context around my practice of these ideas, let’s talk a little about the lessons that I believe may be extracted from the story above.

Lesson One: Compensate for a Lack of Compensation

As a startup, your ability to pay people high wages is limited by the amount of money you have. But that doesn’t mean that you can’t hold on to employees.

The trick here is to focus on the other factors that you have available to you:

  • Give employees the growth they deserve.
  • Let them have a say in the various processes and internal activities of the company, and back them when they show initiative.
  • Give them autonomy.
  • If possible, have a vision they can believe in (the topic of our next chapter).
  • Build a working culture staffed with people they enjoy working with.

Each of these psychological factors are a point in your favour. Not every large company can compete on these factors. They may have vicious internal politics. They may not prioritise rapid, free-form growth. And they aren’t usually set up to reward fast-movers.

The important thing to grok here is that compensation isn’t the only factor that affects your subordinates’s decision to stay. This is especially useful if you do not have a say in setting compensation levels — for instance, if you are a middle manager in a more established company. The good news for you, and for cash-strapped startups, is that compensation is merely one of six factors, and you should treat it as such.

Lesson Two: Remember that Hiring Math and Retention Math are Different

When you’re designing your compensation levels, you should be aware that the effects it has on hiring success is very different from the effects it has on retention.

People are more motivated by salary numbers when they’re looking for a job. They’re less influenced by their salary levels when they’re currently in a job.

Of course, that sounds like a ridiculous statement to make. And yet: how many of us have seen people grouching about their pay, and then carry on in their jobs for an extra year, or four?

I’m not arguing that you should pay your subordinates lower than they deserve. And I’m not arguing that you should overpay them, either — you should know by now that paying a higher salary isn’t enough to keep your people.

What I’m arguing instead is far simpler: recognise that people aren’t purely economic creatures. There are psychological factors at play. If your mental model for retention is purely economic, then you’ll likely be outmanoeuvred and outcompeted by those who recognise that things aren’t that simple.

Berkshire Hathaway vice-chairman (and famous investor) Charlie Munger has this thing he calls a ‘two-track analysis’. Munger argues that one should always apply two levels of analysis to any problem: in the first track, you consider the rational and economic factors. And then, in the second track, you consider the psychological factors that may distort the factors you’ve identified earlier.

When it comes to hiring, people are influenced by pay, benefits, stock options, health care and the like. But on a psychological level, they’re influenced by the pain of self-doubt that’s so common during job searches. This leads to an intense desire to stop the job search and settle for the first acceptable offer on the table — even if it isn’t the rational thing to do.

When it comes to retention, however, the math is more complex. In track one, people are influenced by their salary, their benefits package, their opportunity for advancement and their relationship with their boss. But on a psychological level, they’re influenced by inertia, by the ‘ugh field’, and by loss avoidance — the idea that if they quit this job, they might have to settle for lousier one elsewhere.

Understanding that these influences exist is the first step to being effective at both hiring and retention.

Lesson Three: Defuse Compensation Problems … Before They Happen

Compensation problems often leads to political problems. Or, more accurately, badly handled compensation design often causes political problems to emerge. Once infected, your startup’s culture becomes horribly difficult to change.

How does this happen? Well, I’ve hinted at one way earlier in this chapter. An employee comes to you and demands that they be given a raise. You grant this raise.  Once the news leaks (and it always leaks), everyone else gets the message that political behaviour is rewarded. Over time, your culture develops to reflect this truth: performance doesn’t matter. Negotiations do — and what you say and who you suck up to in order to influence your salary negotiations matters the most.

Inevitably, your high-performing, apolitical employees quit the company, leaving only the political players behind.

Retaining employees in a political environment is incredibly difficult. A political environment is an environment where people advance their careers (or their agendas) by means other than merit and team contribution. As we’ll see in Reason Six, operating in a political environment violates our sense of fairness. Seeing undeserving people getting promotions or advancing in the company sets us off in the worst possible way — making it nearly impossible to keep people for very long.

Conclusion

Compensation is important to our discussion of retention in two fundamental ways.

First, it is one of six factors that influences retention. A common mistake is to treat compensation like a special factor of its own. This mistake stems from a belief that people are fundamentally motivated by economic reasons. This belief isn’t completely mistaken: as we’ve seen, economic factors are influential in the hiring process. But significantly higher pay rarely deters a quitting employee; low salaries do not always lead people to leave — or at least, not immediately. The truth is that compensation does not usually dominate in the decision to stay.

Second, compensation matters for retention because it is deeply tied to the emergence of company politics. Designing a good compensation and promotion system is a key part of preventing company politics from taking root in your startup. And — as we’ll see in Reason Six — a political culture is especially bad for retention. Which is all the more reason to get compensation right, and to defuse political problems before they happen.


Keep Your People — The Startup Manager's Guide to Retention is available for purchase here.