Serving up flexible compensation

By Edward Elliott and Claudine Kapel
|Canadian HR Reporter|Last Updated: 09/04/2003

You recently made job offers to two promising candidates — and you really want them to accept. You’ve been searching for months for people with their particular skill sets.

But both individuals have come back expressing concerns with their respective job offers. The first wants more stock options —and the second wants a higher base salary and less emphasis on incentive pay.

Human resource professionals have long understood that employees differ in what they want out of an employment relationship. This reflects the fact that employees also differ in their life stages and circumstances — including demographic influences — which impacts what they expect and value.

In addition, employees also differ in their risk tolerance, which specifically impacts how they respond to compensation packages that include an element of pay at risk.

An organization could conclude that neither job candidate in the opening scenario represents a good “fit” because both individuals are seeking a different “deal” than the one that was offered. But organizations today face intense competition for top talent. As a result, organizations are becoming more flexible in how they define what they have to offer to optimize their ability to recruit, retain and engage employees.

A key part of establishing a more flexible employment deal lies in giving employees more choice regarding how company dollars are used on their behalf. The application of such enhanced flexibility is illustrated by the growing use of flexible benefit programs. Such programs enable employees to tailor their benefits coverage to better meet their individual needs, within specific parameters defined by the program design.

An organization doesn’t need to spend more to offer flexible benefits. But employees get some choice in how company dollars are allocated — and so are more likely to place value on the investments the company is making on their behalf.

But what if organizations could go beyond offering flexibility within the context of a specific program? What if organizations could enable employees to customize their whole employment deal?

Instead of making choices simply around their benefits coverage, employees could choose to make trade-offs across a broader array of total compensation elements to define an employment deal that worked for them. This means an employee could, for example, elect to have a total compensation package that put more emphasis on stock options — or less emphasis on variable pay.

The notion of total flexible compensation isn’t new. But organizations are revisiting the concept because it can help them recruit and retain employees at a time when the competition for talent is especially fierce.

Organizations are being squeezed demographically as they grapple with the combined effects of an aging workforce and fewer new entrants into the labour market. This reality has left some companies grappling with how they will fill major holes in their organizational structure in the coming years, as more and more baby boomers retire.

But the HR challenge is about more than just managing numbers. The new labour market has its own unique characteristics that will drive changes in how employment deals are defined. As many organizations can already attest, the current labour market doesn’t always provide ready access to the kinds of skills and knowledge they need to manage their business. As a result, more and more industries are grappling with skill shortages — and not just in the arena of high tech. Hot skills are emerging in a number of areas, including sales, management — and, yes, even human resources.

Adding to the complexity is that fact that the employees who will fill the shoes of their baby boomer predecessors have their own distinct views on what they want out of an employment deal.

In response, organizations are finding that they must rethink approaches to how they recruit and retain talent. They’re discovering that a one-size-fits-all approach to the employment deal is a definite liability in the war for talent.

As a result, organizations are taking a renewed interest in more flexible total compensation arrangements.

The idea is to allow employees an element of choice regarding how they are paid. Flexible benefits plans have typically provided employees with choice across health, dental and insurance options. Perquisite spending accounts also provide employees with choice, but only amongst perquisites.

Flexible rewards systems go one step further, and provide employees with choice across a broad spectrum of programs, including base pay, short-term incentives, long-term incentives, benefits and perquisites.

It’s important to understand that flexible rewards — as with flexible benefits — isn’t necessarily about spending more (although there may be additional systems development costs, at least initially). It’s about optimizing the value of an organization’s current programs by giving employees some choice in how dollars are allocated. If employees understand and value what they have, they’re more likely to remain with a given organization and to help that organization succeed.

The key to success with flexible rewards systems lies in how employee trade-offs are managed. In their broadest application, flexible rewards systems enable employees to make trade-offs across all rewards programs. In essence, an employee can reallocate a specified number of dollars associated with one program to increase what they have in another program. For example, an employee could reduce base pay in exchange for more stock options, or vice versa.

The following is a glimpse into a flexible rewards system. In this example, we see the “before” and “after” total rewards pictures for an employee who has chosen to trade a portion of salary and target bonus for additional stock options and vacation. (See Table A.)

In this scenario, the employee has traded off base pay and incentive opportunity for additional stock options because the individual believes the company’s stock is going to experience significant growth in value in the coming years. Through the trade-offs, the employee has also acquired additional vacation time because the individual wishes to take an extended vacation.

The employee has also forgone a flexible spending account to balance the value of stock options and increased vacation. The dollar value a company attaches to the various elements in its compensation and benefits package will vary according to an organization’s strategies and circumstances.

Flexible rewards systems involve the following three steps:

•first, a company must define the value of its current total rewards package, as well as the relative value of individual reward components (“before”);

•the company then educates employees about each component, the relative reward values, and opportunities for making trade-offs; and

•finally, employees remix their individual rewards package based on their preferences (“after”).

This leads to three critical issues that need to be addressed in developing a more flexible approach to total compensation or total rewards.

1. The organization must define the trade-off relationships on a dollar-for-dollar basis. For example, the organization must define what an employee can acquire in other programs by trading off a dollar in base pay. This does not imply that a dollar of salary is equivalent to a dollar of bonus or a dollar of stock options. Rather, the trading prices between each element are established by the company, and reflect not just their valuation, but risk, supply and the company’s own compensation strategy and objectives.

A cash-strapped company, for example, may want to provide a more favourable rate of exchange as an incentive for employees to trade salary and/or incentive pay for stock options. Conversely, a company with high dilution may want to provide an incentive for employees to select salary and/or incentive pay over stock options.

A company with a strong pay for performance philosophy may provide an incentive for employees to trade salary and/or perquisites for incentive pay and/or stock options.

It is important to note that there is no “right” answer when it comes to defining trade-off values under a flexible rewards system. Each organization needs to establish its own unique framework that reflects its business strategy, its financial situation and the types of employee behaviour it seeks to elicit.

2. The organization must also define the degree of latitude that employees will have to reduce their participation in any given program. Given that an organization’s compensation programs have most likely been designed with some strategic intent in mind, it is essential that the ability for employees to make trade-offs does not undermine the effectiveness of any particular program. For example, a team incentive plan would be undermined if some employees “opted out” of the plan completely by trading their full incentive opportunity for more benefits or more stock options.

3. The organization needs to have a strategy and an administrative system for managing and tracking employees’ choices over time. This is crucial not only to ensure smooth administration, but also to maintain an official record of offerings and choices. The advent of Web-based enrolment tools is helping to simplify the implementation of flexible rewards systems — at its simplest, the enrolment tool generates files that interface with payroll and other HR systems.

There is a definite trend toward offering employees greater flexibility and choice in how rewards packages are structured. Employees want a say in the types of rewards they receive, and they want the ability to modify their total rewards packages to match their changing needs (for example, changes in family income, perspectives on risk, and lifestyle needs). Companies that choose to promote employee choice in rewards will be better able to retain current talent, and they may even be able to attract those who might otherwise not have considered opportunities with the company. In the end, organizations that understand how to customize their employment deal will have a significant competitive advantage in the war for talent.

Edward Elliott is an executive compensation consultant in Towers Perrin’s Toronto office. He can be reached at (416) 960-2841.

Claudine Kapel is a compensation consultant in Towers Perrin’s Toronto office. She can be reached at (416) 960-7515.

SIDEBAR

Is a flexible rewards system right for your organization?

Flexible rewards systems may not be feasible or make sense for every organization. Companies are not likely to realize the full benefits of such a system if they:

•are not experiencing problems attracting and retaining talent;

•have a homogeneous employee population; or

•are not able to provide the necessary systems support and education.

The benefits of flexible rewards systems are more likely to be realized by companies that:

•are looking for a competitive advantage in recruiting and retaining talent;

•employ a diverse workforce (culturally, demographically or in terms of the types of jobs/business units);

•are involved in mergers and acquisitions;

•are committed to employee education;

•have an Internet-savvy employee base; or

•are transitioning to new rewards programs.

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