Straight Talk About Incentive Compensation
Many employers offer compensation packages that include a mix of both base compensation (guaranteed wages or salary) and incentive compensation (at-risk variable compensation). While base pay tends to be relatively straightforward, incentive compensation presents unique challenges and planning opportunities.
Some companies spend considerable time and effort considering whether (and demonstrating that) their compensation programs, and the mix of base and incentive compensation opportunity provided to employees, are consistent with industry trends and averages. There is certainly a place for this type of benchmarking, but it sheds no light on the question of whether the employer is receiving meaningful value for its investment in incentive programs. Accordingly, in addition to understanding whether an incentive program is competitive, it is critical that an employer understands (1) whether its program provides meaningful incentives, and (2) how the various components of the employer’s compensation program coordinate, whether any such coordination is intentional or accidental, and whether the employer recognizes value as a result of any such coordination.
To help kick start this analysis, here are a few thoughts on how to get the most out of an incentive compensation design:
Choose the Right Targets for Performance-Based Bonuses. This is the Goldilocks issue of executive compensation – the performance-based metrics should not be too easy or too hard to achieve – they should be “just right” (or as close to that as is possible). If the targets are set too low, then the incentive award might become essentially “guaranteed” — that is, a payment that, although nominally structured as a performance-based incentive, is likely to be paid without regard to individual or collective performance. This might be the case where the “threshold” and even “target” bonus levels are relatively easy to achieve. In those circumstances, employees are not particularly motivated by the performance-based metrics because their achievement is assumed.
On the flip side, programs that make the “threshold” or “target” bonus too difficult to achieve, such that the program effectively provides an incentive only if the employee produces extraordinary results, may demotivate employees. Further, since incentive programs might be affected by conditions and events beyond the control of the employee — for example, economic conditions or an industry downturn — it is conceivable that in any particular performance period, the “target” performance result might effectively be out of reach, such that the incentive program arguably provides no real incentive for that period.
Set and Communicate Clear Metrics. The first step in designing an incentive compensation program generally involves choosing the right type of incentive – for example, individual incentives, team-based incentives, and/or spot awards. Once that decision has been made, it is important to settle on the right metrics. Some employers are tempted to get fancy at this stage – designing an incentive compensation program with multiple formulas and requiring the use of numerous spreadsheets. However, more complicated programs may result in an unintended consequence — interfering with an employee’s “line of sight.” If the employee cannot easily explain the incentive plan, then the employee may be more likely to disengage.
Monitor the Coordination of Bonus Plans and Other Benefits – Manage Plans that “Bonus the Bonus.” Some employers’ compensation and benefit programs effectively provide unintentional additional benefits – for instance, by providing a “bonus on the bonus”. As a simple example, assume that an employer has both an annual bonus plan and a 401(k) plan to which the employer makes an annual contribution equal to 10% of the employee’s total compensation. If an executive receives a bonus award for exceptional job performance equal to 40% of base pay, the practical effect is that the employee will receive not only the 40% bonus, but also an additional 401(k) contribution equal to 4% of base pay (10% of the bonus). There is nothing inherently improper with this, and using “total compensation” in the 401(k) plan design makes compliance with certain 401(k) rules easier. However, was the coordinated design — in which the executive’s annual bonus operated to increase the 401(k) contributions made on behalf of the executive — intentional or accidental? And, did the interaction of the bonus and 401(k) plans create additional motivation for the employee? Do employees even realize that they are getting this extra benefit? There are no wrong answers in this category, so long as the employer has made a conscious decision regarding the interaction of its various benefit plans and clearly communicated it to employees. A plan design in which each program is viewed in isolation might produce unintended consequences.
Thus, employers need to undertake a comprehensive (and holistic) review and evaluation of their compensation and benefits programs. Such a review might uncover surprises as to whether the program is effectively motivating employees and how the various components of the employer’s program coordinate with each other and shine a light on how to get the most out of this investment.