A Frank Discussion About Incentives

05/01/12
By: Paul R. Dorf, APD, CRI

Introduction

During the recent economic downturn, many companies suspended the use of variable compensation in order to conserve cash and to focus their resources on survival.  Now that the business environment is improving, many companies are reintroducing incentive compensation to motivate employees to achieve key strategic objectives aimed at business growth.  Unfortunately, we often find that many companies do not take adequate time or expend sufficient effort to research, plan, and model their incentive opportunities in order to understand how these plans will impact their bottom line and the employees’ motivation.  This lack of a systematic and well-though out process can turn a good concept into a poor plan, which leads to negative outcomes, including decreased morale, unforeseen consequences, and the company’s failure to achieve its key business objectives.  This white paper is intended to provide some cogent thoughts on the subject, as companies consider the design and implementation of a new variable pay plan.

Why are incentives important now?

Before we examine incentives in general, it is important to understand that there are a considerable number of reasons why it is particularly appropriate to consider them in the current business environment.  Among these reasons, the most relevant are as follows:

  1. Almost everyone is using incentives – We don’t believe that companies should be bullied into adopting incentives just because of everyone else; however, without incentives they are at a serious disadvantage when it comes to their ability to attractive new staff and to keep their current employees.
  1. Reaching for the stars – An important function of incentives is to focus attention on specific desired goals and provide the motivation which will assist in achievement of those objectives.
  1. Reducing fixed costs – Increasing salaries raises fixed costs for pay and benefits, which will continue to pyramid in the future; whereas incentives, when earned, still have to be earned again each year.
  1. Most incentives are self-funding – Whereas salary increases are an added expense, incentives must be earned, and if those plans are properly designed, the achievement of the performance metrics should generate the necessary funding.
  1. Being competitive with peers – Providing employees the opportunity to earn incentives, tied to meeting or exceeding performance goals, results in the company’s ability to be competitive with other employers, while at the same time meeting its business objectives.
  1. Supporting the pay for performance concept – Incentive plans provide an identifiable relationship between pay and results, which in turn should drive desired activities.
  1. An additional benefit – Establishing incentives requires that the company establishes and clarifies its expectations, which in turns requires that it actually develops a business strategy and plan.

We strongly believe that incentive plans will focus attention on desired goals and greatly enhance a company’s ability to achieve impressive results, and thereby provide highly competitive pay packages based on those results; however, they are not a panacea for fixing all of a company’s ills.  Another cautionary note is that they are not foolproof, as will be discussed later in this paper.  However, by taking the time and effort necessary to properly analyze their possible use in any given situation and following the seven (7) steps we identify below, there is a strong probability that introducing incentives will make a positive contribution towards achieving a company’s business objectives.

What to consider in incentive plan design

When considering the design of a specific incentive plan, the metaphor is that there can be as many types of incentive plans as there are trees in a forest.  Like a tree, the features of each incentive can vary and be individualized based on its intended purpose and the environment in which it grows.  In addition, if it is not monitored and occasionally refreshed, similar to the nurturing of trees, the incentive plan will become ineffectual and die.

We believe that understanding what the inherent problems are, and where incentive plans can go wrong, is a crucial part of designing any new incentive so as to avoid those pitfalls in order to end up with a successful and problem-free program.

The following seven (7) steps offer a systematic approach to the design and implementation of incentives; these are:

  1. Determine the business functions in which the incentive will operate, along with a clear identification of what the plan is expected to accomplish – what is the purpose of the incentive?
  2. Identify the potential positions to be included in the plan.  It is important to also determine those functions which will be excluded from the plan, and why.
  3. Clarify the main goals to be achieved, and consider the following questions:

Are they worth paying for?

Can the performance be tracked accurately and on a consistent basis?

Can the related activities be associated to individuals or groups of employee

  1. Establish the performance metrics which will be used to trackactivities and determine the level of accomplishment.  This includes setting the target performance level, as well as the threshold or minimum level, below which awards cannot be earned, and the outstanding or maximum level above which further awards will not accrue, to prevent “windfalls”.
  2. Determine the award amounts at various performance levels and calculate the funding required based on the metrics, and identify whether the perfprmace levels are potentially attainable and realistic.
  3. Model the plan based on historic and forecasted performance data and determine if the award levels are consistent with competitive practices, the company’s desired compensation levels, and necessary net performance requirements.  In some instances, it may be advisable to “test drive” the new plan before the formal launch.  This involves conducting a pilot study with a limited and representative group of locations or participants.  Obviously, the main concern is to see if the new incentive will actually attain the desired performance results; however, there are two additional items to consider.  The first is if the company has the administrative capability to track and assign performance appropriately; while the second is if they can simplify and communicate the plan details so as to motivate the participants.
  4. Create and execute a strategic implementation plan which addresses all documentation, communication, training, and transitional issues.  Then “Go for the Gold”.

Although not part of the development and implementation steps, it is critical to periodically review the new incentive plan’s effectiveness to ensure that it is achieving the desired results and has not caused any unexpected issues.

Bonuses versus incentives

In considering the potential applicability of incentive plans within your company, it is important to clarify the difference between the definitions of bonuses and incentives.  These terms are often used interchangeable; however, there are significant differences that need to be recognized since each one has its specific use.

Bonuses typically refer to discretionary awards that are determined after-the-fact based on the year-end profits, significant monetizing events, or similar funding.  Bonuses usually provide a substantial amount of subjectivity as to the amount of the award, as well as discretion as to when and who will receive the awards.  It is important to recognize that with bonuses, the key linkage between specific activities, performance and results, and the payment are not well understood.  Because of the vagaries typically associated with bonuses, they tend to be less motivational than incentives.

On the other hand, incentives require a more formalized process in which the performance expectations, consisting of specific measurements and targets, must be identified up front.  This assumes that the organization is willing to and capable of determining those expectations at the outset of the performance period.  If a company does not have a strategic plan, and, in effect, operates in a more “catch as catch can” manner, the ability to set clear and meaningful expectations may be extremely problematic.  In addition to establishing the performance requirements, incentives also indicate the potential awards that relate to each level of performance achieved.  Since key expectations are determined and communicated in advance of the required activities, incentive plans tend to be much more motivational.  However, if the company is unable or unwilling to establish firm annual goals, maybe they are not ready for incentives, and should concentrate on more defined bonus plans initially.

One of the most troublesome aspects of some incentive plans is their inherent complexity due mainly to the attachment of too many “bells and whistles”.  When an incentive plan is trying to do too many things, the plan runs the risk of being difficult to understand and communicate, resulting in difficulty in the plan’s administration and confusion of the participants.  In most instances, if the incentives are constructed so as to avoid the previously mentioned pitfalls, they will tend to be more motivational, as well as being far more successful at achieving their intended goals.

Types of incentive plans

The flexibility built in to the design of incentive plans offers each company the opportunity to tailor the plans to meet its unique requirements, management styles, performance expectations, and administrative capabilities.  There are a limited number of rules that must be followed, and the majority of these relate to plans in which the performance period extends past one year.  Recently, the enactment of the Dodd Frank Act placed restrictions on payment of incentive awards that affect a limited number of large financial institutions.  There have also been a number of court decisions which have placed limitations on some plan design features, but again these are very limited in nature.

The key limitations affecting plan design include:

  1. Recognize that the plan normally doesn’t permit bad business expenses and/or decisions to be transferred to the employees.
  2. Changes can usually be made in plan design, performance measures, and targets, award sizes, etc., as long as they go into effect prospectively.
  3. A promise to pay is an enforceable contract, as long as the terms of the arrangement are met.
  4. Clear and unambiguous language is crucial, since courts have held that the drafter (company) is responsible for the language; if it can’t be understood, it may be interpreted against the company.
  5. A myriad of confusing, arbitrary, and conflicting government regulations often makes it difficult for companies to design an appropriate plan.

While incentive plan design is very flexible, they tend to fall into a number of categories based on how they will be used, the types of participants, the specific performance measures, and the length of the performance period; these are as follows:

Short-Term or Annual Plans – These are incentives in which the performance period is 12 months or less.  This includes monthly and quarterly time periods, as well as 12 month rolling periods.

Commission Programs – Commission plans are those that offer a percentage of the sale (or profit dollars) resulting from a sale to the sales person or sales team.  Although there is no standard for these plans, they typically tier the award levels based on the value of the specific sale, and often incorporate a minimum level before the sales are commissionable.  These features allow the percentage of the awards to increase as sales increases, once specific goals are met.

Overrides – These plans are usually associated with sales plans, in which management’s awards are a direct tied to a portion of their immediate sales or location (branch, store, etc.) staff.

SPIFFs – Are a form of commission plan in which personnel are given a small award tied to the sale of specific products or services, as an extra inducement, over and above the regular incentive program.  These are typically short-term special awards that are paid out consistent with pay periods or monthly.

Transactional Bonuses – Regardless of the name, these are not really bonuses, but rather incentives designed to achieve one or more specific goals, such as meeting completion dates, saying under budget, etc.  The awards can be scaled up or down, based on the level achieved in relationship to the target.

Long-Term Incentives – Included in the concept of long-term incentive plans (LTIPs) are all plans in which the performance period is in excess of 12 months; this includes most plans that are tied to strategic goals with longer-range payouts.  Some of these plans are tied to increases in the value of the company, in which its stock or phantom stock is used strictly as the yardstick for measurement purposes (e.g., Stock Appreciation Rights). Since most of these plans involve some form of deferred compensation, it is critical that they are carefully written in order to comply with IRC Section 409A regulations.

Equity-Based Incentives – Similar to LTIPs, these plans cover a number of years or the participant’s entire career; however, both the measurement and the actual award are made in actual company equity.  Since real stock is used, these plans must take into consideration applicable Securities and Exchange Commission (SEC) regulations, and require shareholder agreements and more complicated documentation.

Why incentives fail

The use of incentives has been subjected to a varied and almost cyclical nature of attention over the last couple of hundred years.  Part of the reason for this love – hate relationship is in the misunderstanding of what incentives can and can’t do, which is exacerbated by poor design features and lack of follow-through on the part of the companies who have adopted them.  There are many examples of “incentives gone wrong”, but unfortunately, there has been insufficient research and publicity as to why or where they failed, and too often a rush to judgment on how to fix them, often resulting in a syndrome known as “throwing the baby out with the bathwater”.

Based on our own experience covering years of analyzing and developing a multitude of different incentive plans, we have identified nine (9) most common reasons that plans fall short of their expectations, or fail in their entirety.  These problem areas can be summed up as follows:

  1. Overly complex – participants, management and administrators don’t understand the plan.
  1. Poorly conceived – insufficient and erroneous background data.
  1. Not a Win/Win – lack of cost/benefit analysis modeling, so that benefits are equally shared between the company and the participant.
  1. Poorly implemented – more time spent on design than on the plan’s implementation.
  1. Insufficient communications – lack of motivation since participants don’t value the plan.
  1. Too many objectives – lack of sufficient focus, with each goal having little value.
  1. Arbitrary changes – constant changes resulting in cynicism and a lack of trust.
  1. Law of Unintended Consequences – unexpected problems due to poor planning and lack of foresight.
  1. Lack of follow up – even the best plans need to be monitored and occasionally refreshed.

Summary

Incentive compensation design is a fluid process that requires a company to continually monitor its processes, and make refinements, where needed, to continue to allow the plan to meet the intended objecitves tied to motivating and focusing employee performance.  These guidelines are meant to assist companies in identifying their needs with respect to their incentive compensation plans, and redefining their processes so they meet the company’s strategic goals and reward plan participants commensurate with their performance.