Redoing math on performance bonuses

Bonuses tied to individual performance, not overall company, gaining traction
By Angela Scappatura
|Canadian HR Reporter|Last Updated: 05/04/2009

Companies are changing the way performance-based pay is calculated for mid- and lower-level employees, according to an HR consultant.

Traditionally, bonuses have been determined based on a company’s overall performance. While that is still a consideration, companies have begun taking a tiered approach to bonus calculation, which is increasingly defined based on division, says Robert Levasseur, a senior executive compensation consultant at Watson Wyatt in Toronto.

Incentive plans became prevalent after the recession in the early 1990s in an attempt to keep inflation down on compensation costs, says Levasseur. Since then, companies have been working to refine the calculation process.

Adding an increased level of accountability for employees, some companies are measuring bonuses through evaluations of individual goals and performance.

The work of an employee responsible for entering inventory data is an example of how the tiered approach works, he says. Because such a position would not have direct influence over stock performance or a company’s profitability, some organizations are focusing on specific objectives within that individual’s division. Managers evaluate the employee based on milestones or specific goals, such as improving the efficiency of filing systems, says Levasseur.

This evaluation process, combined with the overall performance of the company, are creating an individualized bonus structure more representative of employee contribution, he says.

Fair treatment?

With a segmented system of bonus evaluation, companies face the challenge of balancing a desire to treat all employees fairly while, at the same time, recognizing key talent, says Lynn Stoudt, an Ottawa-based principal in the human capital group at consulting firm Mercer.

The evolving bonus calculation system is changing, she says, because organizations have realized the areas in which staff members are contributing the most must be recognized to achieve certain results.

“We’re looking at performance-based pay but (also) the whole performance management program being part of a much larger talent system within an organization,” says Stoudt. “It isn’t just about pay, it’s about development and leadership.”

Organizations are also starting to examine the types of performance compensation given to employees, she says. To do that, company leaders need to understand the types of compensation employees value.

“For some — younger generations (aged) 25 to 35 — a cash component is of real value. Others may be looking more in terms of stock and security,” she says. “It’s about understanding your workforce and what is meaningful to other employee groups.”

Performance pay for executives

Increased public scrutiny of executive pay and bonuses has led company boards to re-evaluate the way compensation is calculated, says Jeffrey Gandz, a professor at the University of Western Ontario’s Richard Ivey School of Business in London, Ont.

In March, it was revealed executives from struggling financial firm AIG collected millions in bonuses not long after the company received billions of dollars in bailout money from Washington. While most executives eventually gave the money back, the incident sparked a debate about the balance between compensation payouts for retention and reasonable rewards for corporate performance.

As boards observe the backlash caused by executive bonuses, they are becoming more sensitive to the overall performance of the organization when drafting compensation agreements, said Gandz.

The basic thinking is the right type of variable compensation will achieve alignment between the interests of shareholders and interests of executives, he says.

“One of the appalling problems of the last year is that you’ve had a huge amount of executive pay that was variable compensation, that was not aligned to the shareholder interests because it didn’t take risk into account,” said Gandz. “It took income into account but their income was in many, many cases obtained as a consequence of much increased risk on the balance sheet.”

While outright payouts are being re-evaluated, boards have also virtually eliminated stock options for executives, he says. Now, there is a clear trend towards deferred stock units.

Providing stock options to executives created a misalignment in interests and created a situation where the company could do badly but the executive “could merely not gain,” says Gandz.

“With real stock, if the shareholders lose, the executive loses, so there is a closer alignment when it is done with stock rather than stock options,” he says.

In an effort to make executives more accountable, boards have begun to discuss deferred payments based on performance, says Gandz.

Last year, there were a couple of situations where compensation, to be paid the following year, was calculated based on positive business performance, he says. However, the severe deterioration between the time the bonus was calculated and the payout deadline led boards to re-evaluate the waiting period for compensation.

“Increasingly, there is a trend towards saying, ‘Look, we will do executive compensation but it may be subject to what happens in the next couple of years of performance,’” says Gandz.

It’s a deferred payment depending on the outcomes, he says. “If a CEO has magnificent performance until June 2009 and they are granted $2 million in compensation but the bottom falls out in the next year, that may not be a firm $2 million.”

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