A client told me this story—how someone at her firm mistakenly e-mailed the compensation census for the entire company to all of her employees. Within an hour, every staff member was looking at how much everyone had made in the last year, bonuses included. She said that two employees quit the same day, and she spent the rest of the year dealing with the aftermath of that one e-mail.

I call this the “refrigerator test.” What would happen if you were to post everyone’s compensation on the office fridge? Would you face a revolution or would everyone shrug and look for their yogurt? In my mind, while excessive disclosure of compensation is somewhat distasteful, in a healthy company, if you were to make that post, there should be no surprises and no conversations you would fear having.

I am not advocating open-book management, but rather suggesting that you should have nothing to hide. Because if you do, the compensation chickens always come back to roost and the eggs they lay are quite rotten.

Compensation Philosophy

First of all, no firm ever sets compensation by saying “we want to be unfair, unreasonable, cheap and create chaos.” The road to hell is truly paved with good intentions, as they say. Firms start out by looking to be fair but then get tangled up in the circumstances. We hired Ed away from another firm, so we had to pay him more to make him leave. Judy turned down health insurance, so we promised to give her a bit more salary (a frequent and possibly illegal practice). Adam has been with us for 20 years, but he has not been promoted in 10. All these circumstances add up to a labyrinth of decisions that can easily go astray, and they usually do.

The best, and perhaps only, place to begin is for every firm to very openly formulate what its compensation philosophy is. How are compensation decisions made? A good philosophy will state who makes the decisions, what factors are considered, what data is used and how often this evaluation is performed. Business owners should consider the market for the position they’re hiring and the various skills and characteristics of each team member. A good system will always start with the market, but will not end there.

Compensation Is Not Actuarial Science

There is a very strong temptation among managers and business owners to treat compensation as some form of actuarial science. Many owners believe that somewhere in a vault there is this “Magic Book Of Compensation” where you can look up the exact number for each and every person, if only you could enter all the variables—their experience, education, credentials, work-ethic score and so on. The reality of compensation decisions is quite different and much less precise.

Perfect compensation information does not exist and cannot conceivably exist. Even with the emergence of outstanding compensation surveys and a variety of transparency tools such as Glassdoor, we still can’t perfectly measure the market. Simply put, each person is different, and many of the factors that influence their compensation cannot be captured by surveys or are only available after the fact.

Compensation surveys are very useful in measuring the market, but they can suggest only a range of values that are acceptable and not one that’s specific and perfect. I frequently experience this with our next-generation leaders—when we show future managers and leaders of advisory firms information suggesting that someone is paid less than the average for the industry, many of our G2 leaders immediately react that the person is underpaid. When we show them information that a person is paid $10,000 more than the average, many tend to declare the person overpaid.

Realistically, 50% of the employees in any position in any market are paid less than the median, and many positions will demonstrate variance well beyond $10,000 and into the hundreds of thousands. “Overpaid” and “underpaid” are very strong terms that should be used very carefully and require a good definition (see the section on compensation philosophy).

The surveys can at best suggest the range of values that a company wants to use as its definition of “normal.” That range can be tighter or broader, and the decision is entirely the prerogative of management as long as that definition is well known and well communicated to the staff of the firm.

It’s very important that each employee be well aware of the factors that cause changes within that range. If Brandon and Philip are in the same position, their compensation should be within the same range of values suggested by the marketplace, and it’s very important that the two both know why one pay package is higher than the other. Perhaps Brandon has more experience, perhaps he has more credentials, perhaps he has been more productive. Whatever the factors are, we should know and understand them well.

You Better Be A Good Surfer

However, no compensation system can be driven only by the marketplace. To do that would be to create a mercenary culture where internal dynamics are ignored and all team members are encouraged to constantly “mark themselves to market.” Such an atmosphere would undermine any team building. Just imagine a basketball team where all the players are free agents every season and everyone is playing for a new contract. They may play hard, but they aren’t likely to help one another, and might instead demonstrate hostility and even aggression toward their teammates.

To create a good compensation system, a firm has to also constantly review internal “fairness.” If Brandon is paid more than Philip, does that mean he is a better contributor? Ideally the answer is always “yes!” Whenever the answer is “no” (or not clear) we won’t be able to pass the fridge test.

The internal pecking order always exists, even if companies have never spelled it out explicitly. There is always a perception within a team of who the “good” players are. It seems to be inherent in any human group. I once asked a surfer in Hawaii how the flock of surfers know who is supposed to go for what wave. He explained that it has to do with where they are relative to the wave but also, very importantly, how good they are. The better you are, the more you can pick your wave and the others have to wait for you. Even surfers don’t have a “flat organization.”

The internal hierarchies are inevitable, and firms are better off spelling them out and discussing them rather than pretending everybody is on a flat playing field. The internal dynamics have to be recognized in the compensation system, otherwise it will never be seen as fair, and if the team is likely to create their own pecking order, a CEO is always better off suggesting what the rules of that pecking order should be. This is especially true in professional positions where knowledge, performance and contribution are displayed daily and fairly visible. It doesn’t matter if employees went to Harvard and worked for McKinsey—if they are not seen as good advisors capable of working with the top clients, their compensation will always affront their colleagues, even if the market numbers would suggest they should be the highest paid members of the group.

Sending Signals

It’s inevitable that every compensation system will send signals to team members—indicating whether they are doing well or not. In most firms, good performance is rewarded with bigger pay raises. A history of strong performance then takes an employee toward the higher ranges of the pay scale for the position.

In my mind, firms have to be very careful with the signals they send through compensation. There has to be a realization that eventually the good performance will push the limits of the compensation range for that position. If we keep sending encouraging signals to an employee but don’t promote that person, at some point we will have a problem. This is another example of paving the road to hell: Firms often reward good performance even though it’s not really leading to the next step in the career track. There has to be an understanding in every firm that even if you are very good at your current job, if you don’t move up to the next job you may reach the limits of your salary increases. This statement frequently gets a strong reaction: “How could you possibly not be rewarding a good contributor?!” Think of it this way: How much would you pay a “good” backup quarterback who is never developing enough to be a starter?

I tend to think that incentive compensation is much better for this purpose. Large salary increases should be reserved for those progressing toward the next step in their career tracks, rather than just offering good performance in their current roles. Incentives (bonuses) can reward those who are doing very well in their current positions.

Create Transparency

Coming up with compensation for an employee means making a triangulation among three variables—what the market surveys say his or her role is worth, what the internal equity of the company says the role is worth, and what the employee’s performance history suggests. This entire process works best when it is transparent and well understood. When everyone knows what the rules are and how the decisions are made, the chances of conflict, misunderstanding and haggling are fewer. You would never try to wrangle over the price of a souvenir you are buying from the Museum of Modern Art gift shop, where all the prices are posted, but you would likely try to bargain with a street artist outside the museum because you perceive that everyone does that and it’s the only way to get a fair deal.

Firms can be shockingly shy about discussing compensation. Most of the firms I have worked with are reluctant to talk about it with their employees and approach the subject the same way I approach buying underwear: They try to get out of there as quickly as possible and with the minimum amount of talking possible.

But there is no reason for that.

My experience is that everyone tends to figure out how much others are making anyway. People form surprisingly accurate perceptions by simply looking around, observing lifestyles and peeking at data here and there. The secrecy serves no purpose of privacy because there really isn’t any. It only serves to create suspicions.

One of our clients once called me. He was very upset and was planning to fire one of his best young employees. The team member was a star performer, but he had committed the sin of going to the CEO’s office and asking for a $20,000 raise. My client, the CEO, saw it as greed and a lack of team spirit. He thought it best to “nip the bud” and just fire the employee before his “disruptive” behavior poisoned the firm.

It turned out the young employee, who was very inexperienced, had read an article suggesting that if you want to get a raise you need to ask for one. The employee had no idea how his salary was determined, so he figured that everyone asked.

Instead of a black box, I would propose a system where all the rules and inputs are very well known and understood. It is well known how compensation is determined, when and by whom. When all the rules are known, then compensation discussions become relatively easy and focus on merit and contribution—and that is the right conversation. So … you don’t have to post the salaries on the fridge. But hopefully if someone does it, nobody notices.   

Philip Palaveev is the CEO of the Ensemble Practice LLC. He’s an industry consultant, author of the books G2: Building the Next Generation and The Ensemble Practice and the lead faculty member for the G2 Institute.