An incentive plan tune-up helps make the most of variable pay dollars

At their best, incentive plans serve as cost-effective compensation vehicles that focus employees on key business objectives while creating meaningful links between results and rewards.

Which of the following best describes how employees in your organization will most likely respond upon receiving their bonus for 2001:

a) What is this for?

b) Is that all?

c) How did you come up with this amount?

d) Thank you! I really feel that my contributions over the past year have been fairly recognized and rewarded.

e) Can I take this in stock instead?

The most effective incentive plans deliver on two fronts: design and execution.

From a design perspective, an effective incentive plan features:

•a few key measures;

•well-calibrated goals that require an appropriate amount of “stretch” to be achieved;

•competitive incentive award opportunities; and

•clearly defined plan administration rules that address such issues as eligibility criteria, timing of awards and the implications of employment status changes.

From an execution perspective, key success factors for an incentive plan include:

•clear communication about how the incentive plan operates and what individuals need to do to earn an incentive award;

•open discussions about how individual roles contribute to business results;

•ongoing coaching and feedback from managers to help employees achieve performance goals and optimize their incentive earnings; and

•ongoing communication about how the business is performing, including the need for mid-year course corrections.

Performance management is key

The importance of a good performance management process — one that emphasizes effective goal-setting, ongoing dialogue and feedback, and a strong link between results and rewards — cannot be overstated.

While a good design is important, it is through the execution of the plan that an organization focuses and engages its people. In fact, a key goal of effective incentive plans is to help reinforce line-of-sight, to help foster employee ownership behaviour (see page 10).

The reality, of course, is that incentive plans don’t always live up to their potential. If you think your incentive plan may need tweaking, you may want to review its current design — and also how well it is being executed.

Does your incentive plan measure up?

When did your organization last complete a diagnostic or audit of the effectiveness of your incentive plan(s)?

Do you know what return your organization is getting on its incentive plan? Is your plan competitive, and are you using appropriate measures? Is it really eliciting the behaviours you want? Is it perhaps eliciting the wrong kinds of behaviours unintentionally?

With the slowing economy and heightened attention on achieving corporate results, all eyes will be on company incentive plans in the coming months. Employees will be focused on whether their plan will pay out — and on how much they will earn this year, versus in years past. Organizational leaders will likely be more focused on ensuring incentive award levels are appropriately aligned with corporate financial performance. The priority will be to ensure that incentive plans are delivering value for the money invested.

As a result, HR professionals may face mounting pressure on many fronts to ensure existing incentive plan designs make sense. To that end, an incentive plan audit may be in order, to ensure that plans are supporting the achievement of key business goals — both from a design perspective as well as through how the design is operationalized day-to-day by line managers. It is important to note that if an incentive plan isn’t paying out significant awards this year — or not paying out at all — it doesn’t necessarily signal a design issue. (See “Is your plan going to pay out this year,” page 7.)

The following is a blue print for conducting an incentive plan audit. It is a good practice to review incentive plans annually to test for ongoing alignment with the needs of the business.

Step 1 – Define the business context

To ensure an incentive plan continues to support the needs of the business, it is critical to understand how the business itself is evolving over time.

Understanding the business context can be achieved by reviewing both developments within the industry, as well as developments within your own organization.

From an industry perspective, consider:

•What are the major issues facing the industry today?

•What is happening on the competitive landscape? Is the industry growing, stable or on the decline? Are organizations consolidating? Are there new competitors?

•What are consumers looking for?

•What are employees in the industry looking for? Is your industry one that attracts key talent or is it losing people to other sectors?

From a company perspective, consider:

•What is your company’s business strategy? How has it evolved?

•What differentiates your company from its competitors? What is your company’s competitive advantage? Is it sustainable?

Step 2 – Test for alignment

The review of the business context lays the groundwork for reviewing the extent to which the incentive plan supports the business strategy.

Some points to consider include:

•How does your compensation philosophy incorporate incentive pay? What is the desired balance between base pay and variable pay in your total cash compensation package? What role is it expected to play in shaping employee behaviours and reinforcing key priorities?

•Does your current incentive plan design measure up with the expectations that were set for it? Does it align with the current needs of the business?

•Do the measures used still make sense, given the current business strategy? Do you need to revisit the kinds of measures? Should you consider adding team or individual measures to strengthen line-of-sight? Do you have too many measures? (See chart, page 7.)

•How competitive is your incentive plan versus the market? How competitive is your total cash compensation package?

In auditing an incentive plan, it is important to consider not only how the plan compares to the external market, but also the impact it is having internally in driving employee behaviours and results and in yielding a meaningful return on investment.

Some points to consider include:

•How do the employees perceive the incentive plan design? Do they consider their award opportunities to be fair? Motivational? Achievable?

•Do employees understand what they need to do to earn an incentive award? Do they understand the key measures and how awards are calculated? Are there any barriers to delivering optimal performance?

•Does the incentive plan do an effective job of focusing people on what matters most? Or has it become “stale” or just another “entitlement?”

•Should you expand who is participating in the incentive plan?

Incentive plans are most effective when employees can see how they contribute to bottom-line results — and how their contributions will be recognized and rewarded.

Towers Perrin’s recent Compensation Effectiveness Survey indicated that few organizations actually measure the return on their investments in incentive plans. Do you know if your organization is getting a fair return on the money spent on incentive pay? Is it self-funding?

Step 3 – Protect stakeholders

One component of a well-designed incentive plan, which can get overlooked, is governance. Does your plan currently have a governance component?

If you do not have one, develop a time frame for the incentive plan that protects all stakeholders. Determine what the expected duration of the plan will be and what factors will impact its ability to pay out.

Some points for consideration include:

•What is the plan period being addressed?

•Under what conditions will the plan not pay out any awards? How is the circuit breaker defined? Is it reviewed regularly?

•What types of approval are required to introduce changes to the plan design?

Step 4 – Develop administrative procedures

While a solid design is essential for a successful incentive plan, it is equally important to have a solid set of administrative procedures that ensure the design effort is not wasted. Review the company’s procedures and ensure there are appropriate support systems to administer the incentive plan.

Regulations in various jurisdictions need to be well understood. Are there regulations around eligible earnings that might affect the payment of awards?
Impact benefit programs? Pensionable earnings?

Administrative procedures should be clearly documented and updated as plan design and plan administration changes are introduced. For example, what happens if an employee changes roles or leaves part way through a plan year?

Step 5 – Implement plan changes

Once the plan is designed and the administrative procedures defined, it’s time to execute. Poor execution can cause even the best designed plan to fail.

When planning for the launch of any incentive plan changes, it is important to consider the needs of all internal stakeholders.

Important elements of a good implementation plan include the development of:

•key messages around the design changes, including the reasons for the changes and how these changes affect plan participants;

•communication materials that explain performance expectations and reward opportunities;

•management training programs that help managers make pay decisions and that position the incentive plan as one of numerous mechanisms for engaging employees and rewarding their contributions; and

•business scorecards and award calculators, as needed, to help employees track their progress and to help focus people on key or changing priorities, as the fiscal year unfolds.

It is important to note that the rollout of incentive plan changes is more than a one-time event. There needs to be ongoing communication on business issues and an ongoing focus on performance management to optimize individual contributions.

There is a lot to consider when designing and managing an incentive plan. But for organizations prepared to invest the time and resources necessary to get it “right” — from both a design and execution perspective — the ensuing focus and delivery of key results ensures there is a meaningful return.

David Grigsby and Claudine Kapel are compensation consultants in Towers Perrin’s Toronto office. David can be reached at (416) 960-7082. Claudine can be reached at (416) 960-7515.

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