A prescription to heal your bonus plan

First-aid for short-term incentive plans

Is your bonus plan feeling tired and run down? Is it stuck in a rut?

If it’s any consolation, your plan is not alone. There appears to be an epidemic of short-term incentive plans desperately in need of some first aid and, in some cases, major surgery. In this article we explore some of the common bonus plan ailments and how to diagnose them. Then, depending on the condition of the plan, we look at a number of steps organizations can take to get the plan back on its feet; or more importantly, back to helping drive and reinforce the business strategy.

History of the epidemic

There has been a tremendous focus on the long-term incentive (for example, stock options) element of total compensation plans over the past few years. Because of this attention, much of the organization’s compensation design focus has been on long-term competitiveness and updating the plan. As a result, many of the annual incentive plans have fallen ‘out-of-sync’ with the direction of the organization. Compounding this issue is the reality that long-term incentive plans are coming under more and more scrutiny, placing increasing pressure on the other elements of pay, particular on short-term incentive plans such as short-term bonus plans or annual incentives.

Leaving a bonus plan ‘untreated’ can have some serious negative effects. It may be working against an organization by continuing to focus and reward outdated behaviours and results. For example, if the bonus plan rewards lowering finding and development costs but fails to reinforce the need to replace reserves, which happens to be one of the organization’s key objectives, a firm could be rewarding its employees for working against the business strategy!

Identify the symptoms

While there are many different types and designs of short-term incentive plans, the symptoms of an ineffective plan are generally very similar. The signs that your short-term plan is performing sub-optimally include:

•lack of support or challenges from the board or other key stakeholders on the bonus program;

•the formula results in a proposed payout that the company cannot afford;

•tremendous “push-back” and surprise from employees upon distribution;

•‘windfall’ bonuses or ‘no bonus’ situations resulting from environmental factors that employees could not influence;

•the perception by employees that bonuses are ‘just a part of base pay’;

•failure of employees to shift efforts to align with the new business strategy;

•inordinate focus on a few, but not all, of an organization’s key business metrics;

•poor performers receiving too much and outstanding performers too little;

•employees not understanding the connection between their bonus payout and their individual performance;

•awards reinforcing silo behaviour when integrated or matrixed behaviour is the goal; and

•multiple or exclusive programs alienating some key groups of employees and reinforcing inappropriate

hierarchical distinctions.

Diagnose the severity of the problem

There are seven key design features which determine, in large part, the potential effectiveness of the bonus plan. They are:

1. Alignment with business strategy and culture

2. Economics of the plan

3. Performance metrics

4. Formula/scorecard

5. Participation

6. Leadership commitment

7. Communication and on-going monitoring

As an organization complete the diagnosis of its incentive plan’s effectiveness, here’s what a firm should consider in each of these key design areas:

1. Alignment with business strategy and culture:

•Does the bonus plan support the current business strategy?

As obvious as this may seem, it is amazing how often short-term incentive plans can be reinforcing an ‘old message’ to employees. When a company analyzes all of the pieces of the incentive plan, including how it is actually distributed, it should be rewarding performance that is consistent with the current business direction.

•Is the incentive plan viewed as one driver of business strategy; versus the cure for all organizational evils?

•Executives often believe all they need to do is implement the incentive plan and business performance will take care of itself. In practice, unfortunately, quite the opposite situation can occur. Employees quickly realize they are not able to earn their incentive awards because other critical strategies and processes haven’t been designed or implemented. The result can be frustration and deterioration in the level of performance.

•Has the culture of the organization been reflected in the short-term incentive plan design?

•Corporate culture has evolved from a soft, ‘hard to wrap your arms around’ concept to something that clearly has an impact on successful strategy execution and organization results. Incentive plans are no exception — for example, a company that demonstrates trustworthiness, openness and respect for employees stands a much better chance of reaping the organizational rewards of an effective incentive plan.

2. Economics of the plan:

•Has the plan funding been carefully calibrated?

•Many incentive plan designers without a solid grounding in finance neglect to conduct the proper analysis to ensure the design can stand up to rigorous financial tests, such as self-funding.

•While often incentive plans are not self-funding ‘out of the gate’, all should aim to be after a certain length of time, usually within two to three years.

3. Performance metrics:

•There are many considerations when it comes to selecting performance measures for a plan. Are the following considerations reflected in the design of the program?

The use of a ‘balanced’ group of performance measures – Regardless of whether a company uses a ‘balanced scorecard’ or a more formula-based approach, it is critical that the incentive plan incorporate a variety of measures. Measures which encourage short-term profit (such as increased production volume) need to be ‘balanced’ with those that ensure future value is simultaneously created (for example, property rationalization). And all together they should support the business strategy.

Cascaded performance measures - Corporate goals are aligned to business unit goals, which are then linked to team goals, and are finally linked to individual goals. This way, employees at all levels of the organization are able to see how their job and their performance help to drive business strategy.

‘Line of sight’ – employees should be able to have some impact on the performance measures used in the bonus plan. Obviously external factors (such as commodity prices, weather and wars) may have an effect that no one in the organization could either control or take credit for. But employees should be able to understand they can effect the attainment of the performance goals with their performance or mitigate the effects of these ‘uncontrollable’ external factors. While simplicity in design helps to illustrate ‘line of sight’, rather than targeting the bonus plan measures down to the lowest level of understanding, the employees should be educated in the performance metrics and shown how their role can have an influence on the outcomes.

4. Formula/scorecard:

•How complex is the current bonus formula?

•The general rule of thumb is to keep the plan design as simple as possible. Typically, everyone involved in the initial design process starts out with the objective to keep it simple. But as the design process unfolds, and details about the business strategy and objectives come to light, a desire to capture everything the business needs to accomplish emerges.

•Using the balanced-scorecard methodology as the foundation for incentive plan design can facilitate this process. The strategy map makes the linkages between performance measures much more clear to employees. Then the incentive plan isn’t merely a compilation of measures, but rather another powerful vehicle for communicating business strategy.

•Is there a high level of award differentiation between strong and weak performers?

•Many managers continue to be uncomfortable with the concept of differentiating pay based on performance. Typically this is because managers are not equipped with the skills or training required to coach an employee through the performance improvement process.

•This situation is often exacerbated by the incentive plan design as many plans do not provide sufficient reward differentiation for superior versus poor performers. And, even when incentive plans do incorporate the ability to differentiate rewards, many managers gravitate to the middle when assessing individual and team performance.

•A reluctance to differentiate rewards based on performance can have an extremely negative impact on the ultimate success of the incentive plan.

5. Participation:

•Plan participation is an important consideration. Companies have been pushing their bonus plan participation further and further down into the organization. This is particularly true in the oil and gas industry. Organizations will need to examine the marketplace practices as well as the organizational culture to determine whether bonus plan participation or eligibility is appropriate.

•The degree of risk that employees can tolerate or desire is an important consideration when determining the organizational levels to include in the plan.

6. Leadership Commitment:

•Have leaders really ‘bought in’ to the bonus plan measures and objectives?

•Often, bonus plans end up being driven by the human resources department (or blamed on HR, when they are not working.) In order to utilize the bonus plan as a strategic business tool, it must be universally seen as owned and valued by the leaders of the organization. Best practice organizations ensure that top management is not only on-side, but, in fact, are the key drivers of their incentive plans.

7. Communication and on-going monitoring:

•Did employees receive communication before, during and after the incentive plan was implemented?

•Many organizations employ a ‘black-box’ approach to incentive plan design and then wonder why employees aren’t enthusiastic about the program when it is rolled out. By opening up the bonus plan process (including measures, distribution process and link to individual performance) to employees, trust and support is built for the program.

•Even if the short-term incentive plan was not well communicated initially there is still an opportunity to enhance the effectiveness of the program by establishing a communication process for tracking progress and illustrating the link to the business strategy.

•Has the business strategy been clearly articulated?

•The plan should directly reflect an organization’s business strategy. But if the strategy has not been clearly articulated and translated for employees, the incentive effect of the bonus plan is tremendously reduced.

•Were the potential challenges associated with gathering, tracking and reporting potential performance measures recognized and addressed early in the implementation process?

•Finance and systems people should have been engaged early in the project so that they had sufficient time to put the necessary processes in place.

•If these implementation issues were not addressed early in the game they can confound and complicate the implementation and result in disappointment, frustration and failure of the plan rollout.

Prescribe a treatment plan remedy

Once an organization has completed the diagnosis and has identified the incentive plan design features that require some attention, it is time to put the treatment plan in place. An effective design process encompasses four key features:

1. Use a bonus review committee comprised of managers and employees (where appropriate). This committee should:

•collect input on the effectiveness of the current program;

•retest the role of the bonus plan within the total compensation strategy;

•review market data for competitive positioning;

•articulate how the incentive plan is changing to provide alignment with the business strategy;

•generate interest and excitement for the revised incentive plan;

•define the plan’s guiding principles;

•oversee and guide analysis, redesign and implementation; and

•review the ongoing effectiveness of the revised plan.

2. Involve employees in the process:

•Typically, one of the most important objectives in revising an incentive plan is to realign employee behaviour.

•Conducting employee focus groups as part of the redesign process can accomplish a number of important objectives, including gathering insight on employees’ understanding of business strategy and objectives, and gauging the likely impact of the updated incentive plan on employee behaviour and performance.

3. Develop a realistic roadmap for redesign and implementation of the revised incentive plan:

•The roadmap should identify the sequence of the redesign and implementation activities. There are a number of ‘moving parts’ in any incentive plan design project, and a detailed project plan is critical to successful project completion.

4. Avoid getting ‘sent back to the drawing board’:

•Check in frequently with the group that will ultimately be responsible for approving the revised plan design. Too often the redesign team proceeds on the assumption that the executive team and board is ‘on the same page’ only to find out at the 11th hour there is disagreement on something as fundamental as the plan’s guiding principles.

Bonus plan health management

To ensure the incentive plan stays healthy once it has been resuscitated, it is important to consider the following:

1. Recognize the business strategy process is an ongoing cycle of formulation, implementation and evaluation:

•The incentive program needs to be continually tweaked and fine-tuned to stay aligned with the business strategy. Failure to undertake this ongoing adjustment is a major source of misalignment resulting in an ineffective bonus program.

2. Commuicate, communicate, communicate:

•The incentive plan sends clear messages about what is important to organizational success. It also motivates employees to continuous improvement and provides them with a stake in the business. It is truly an exceptional vehicle for continually communicating how the company is doing with respect to strategy execution and financial performance.

3. Provide frequent feedback and coaching to managers and supervisors on the effective use of the bonus plan as a pay-for-performance vehicle (in conjunction with effective performance management):

•This is a great opportunity to provide managers and supervisors with coaching on giving and receiving feedback and how to set effective goals.

4. Integrate the incentive program into the everyday activities and normal operations of the business:

•The incentive plan should be part of an integrated set of tools for managing the operation.

•Include incentive plan updates as an ongoing agenda item in leadership meetings and operational status reports.

•Proactively share business information and provide links to the incentive program.

•Include measures on the business unit’s overall scorecard.

5. Ensure someone has accountability for ongoing program success.

6. Use a formal process for measuring and assessing program effectiveness.

Post-mortem

So now the cycle is complete. You have completed a diagnostic revealing the health status of the incentive plan. Even if the bonus plan appears healthy on the surface, it is still important to conduct an annual check-up to ensure that it is still performing optimally.

If the plan is exhibiting some of the symptoms outlined above, it is critically important to diagnose the severity of the situation. Whether the plan needs only a band-aid or a multiple bypass, it should be addressed as soon as possible. Overlooking bonus plan issues will not only minimize the return on compensation investment but, more importantly, it can work against the attainment of an organization’s business goals. The plan may be reinforcing and worse yet, rewarding, business efforts that are counter to the new business strategy and cultural change efforts. So scrub up and begin to diagnose your bonus plan to ensure it operates as a strategic tool as any well-designed bonus plan should.

Jackie Goldman is senior consultant with Buck Consultants in Toronto and a member of the strategic human resources and compensation practice. She can be reached at (416) 644-9287 or [email protected]. Arden Dalik is a founding partner of RainTree Consulting and is based in Calgary. She can be reached at (403) 303-3382 or [email protected].

Latest stories