Incentive designs tested by tough economic environment

For HR, tough times can raise a host of questions about the value of incentive plans

Tough economic times often prove to be the true test of an incentive plan design, and often of an organization’s commitment to pay for performance.

Lean times can translate into lean incentive awards. And for organizations facing significant financial challenges, it can mean no incentive pay-outs at all.

This can be a harsh message to employees, especially since from their perspective, they are working just as hard as when the economy was booming — if not harder, thanks to the latest rounds of corporate downsizing. They haven’t quite forgotten the late 1990s when the market was hot and incentive payments were occasionally worthy of framing.

For many organizations, the inescapable reality is that incentive award opportunities aren’t what they used to be. And employees aren’t waiting for the year-end results to be unveiled before voicing their concerns.

For HR, tough times can raise a host of questions about the value and efficacy of incentive plans:

•How should we respond when employees raise concerns about year-end pay-out levels?

•How do we keep people motivated when we expect weak financial results and correspondingly lower incentive award levels?

•Will lower award levels prompt employees to become demotivated?

•Will our overall pay package become uncompetitive?

•Will our best people leave?

•Should we redirect our compensation dollars away from incentive pay and back into base pay?

The reality is that declining incentive award levels in the face of declining organizational performance is generally not a sign that an incentive plan is in trouble. In fact, incentive award levels should vary over time, in step with an organization’s financial performance and ability to pay.

To that end, incentive plans can play the same critical role of focusing people on what matters most in both good times and bad. The key is to be clear about what is required to ensure the organization’s recovery and ongoing success. Open communication, leadership, an effective goal-setting process and a commitment to recognize and reward top performers to the greatest extent possible are key success factors for making the most of an incentive plan.

It may be tempting to solve the problem by reducing the number of employees eligible for incentive pay and giving those who are dropped from the plan an additional bump to their base pay. While there may be times when changing the eligibility criteria is warranted, it is important not to lose sight of the reasons an incentive plan was introduced in the first place. These include the desire to:

•highlight the organization’s key business priorities and link rewards to achievement;

•recognize superior performance through superior reward opportunities; and

•better manage fixed costs (such as base pay) by maintaining a variable pay plan that is tied to business performance to ensure there is a link between compensation levels and the ability to pay.

There are some key issues to consider when assessing whether to make changes to your organization’s pay mix.

If the intent is to reduce the bonus component by redirecting more compensation dollars to base pay, is it important to consider if such a change is affordable? Ultimately, it would reduce variable costs and increase fixed costs. The hard reality is although the temptation to shift emphasis from incentive pay to base pay is greatest when incentive award levels are at their lowest, this is also likely to be a period when increasing fixed costs would be problematic.

Would such a change impact the organization’s ability to focus employees on key business priorities? Although broad-based incentive plans have become more common in recent years, it is important to consider line-of-sight issues when determining incentive plan eligibility criteria.

Can the participating employees have an impact on whether their incentive goals are achieved? It is also important to balance the time and costs associated with administering an incentive plan versus the return. The return, however, may be more than just financial. Some organizations ensure all employees have some portion of their pay at risk because it reinforces such organizational values as alignment to corporate results, team work and having a stake in the game.

An incentive plan can deliver the best value when it is well-designed and well-implemented.

Plan design considerations

When reviewing an incentive plan design, it is important to consider your compensation philosophy. Do the principles articulated by your philosophy still ring true?

The compensation philosophy provides the guideposts for the development and ongoing management of the incentive plan. To what extent is it still applicable given the business and economic environment under which the organization is operating? Key considerations include:

Eligibility: Based on both organizational values and competitive practices, what roles or organizational levels should be eligible to participate in the incentive plan?

Market positioning: What is the desired positioning versus the competitive market — from both a base pay and target total cash perspective? How affordable is that positioning?

Pay mix: What mix of base salary and incentives is appropriate given the culture and business strategy as well as competitive practices? Is the target opportunity competitive for a person’s position?

Prior to the design of a new plan or the review of an existing one, it is important for organizations to clearly articulate exactly what it is that they wish to accomplish with an incentive plan. What role will incentive pay play versus base pay? What types of behaviours and results will be emphasized and rewarded? What award levels and upside potential are appropriate? Some companies do not address these issues prior to plan design, increasing the likelihood that the plan will be ineffective after implementation.

In the last two years, poor plan designs have come back to haunt some organizations. Some companies have plans that seem to hum along nicely when times are good, but then fail to deliver when the going gets rough. For example, some plans pay out award levels that exceed the organization’s ability to pay because the link to financial performance is not strong enough or the goals are not calibrated appropriately. In some cases, the plan measures lack sufficient line-of-sight for employees, inhibiting them from fully understanding what they need to do to help the organization succeed. In other cases, the incentive plans fail to focus employees appropriately as there are too many, or conflicting, measures.

An effective incentive plan audit considers design elements such as:

Funding: Is the plan’s funding mechanism aligned with organizational needs? Is the plan budgeted, self-funding or a combination of the two? What is affordable for the organization? What are the potential payouts at different performance levels?

Eligibility: Are eligible employees capable of contributing to the achievement of the desired business results? Are performance expectations clear?

Goal-setting: Is the performance bar set appropriately? Are managers and employees doing an effective job at setting their goals and are managers holding employees to them? Is the level of “stretch” in goals consistent across the organization? Are the goals achievable?

Line-of-sight: Do employees understand how they can impact the achievement of their incentive goals? Do they receive regular updates on progress against goals?

Do employees understand their bonus plan?

Even the best-designed incentive plan will be less than effective if its features are not understood by employees. Yet, organizations often falter when it comes to ensuring employees understand incentive-related goals and the links to rewards.

A Towers Perrin study, Working Today: The Towers Perrin 2003 Talent Report, released last month, found that less than 25 per cent of employees believe that their organization does a good job of linking pay and performance. More than 50 per cent of employees have mixed or negative feelings when asked about management’s ability to create clear line-of-sight between individual contributions and overall company performance (see accompanying graphs).

The study polled 40,000 North American workers (4,500 in Canada) in large and medium-sized companies on their attitudes about their work and compensation.

One disturbing finding was that 56 per cent of employees considered their incentive goals unachievable.

While plan designs should be reviewed for effectiveness and affordability, these findings indicate that, at a minimum, most companies could do a much better job at helping employees understand what is expected of them and how their contributions will be rewarded. There is also room for improvement when it comes to communicating around business performance and the drivers of business success.

While it takes planning and effort to make the most of variable pay, taking into account how much is spent on awards should provide the incentive to try.

Claudine Kapel and Mairéad MacLure are rewards and performance management consultants in Towers Perrin’s Toronto office. Claudine can be reached at (416) 960-7515. Mairéad can be reached at (416) 960-7715.

Latest stories