Variable Pay: Understanding Plan Types and Objectives By Jerry McAdams, CCP
A compensation manager of a major financial institution recently spoke about the all-employee variable pay plans the organization has been running for years. His comments included the objective of the plans.
“It's really pretty simple,” he said. “We wanted to get all the employees that weren’t on the executive compensation plan to focus on what’s really important to the organization. We wanted them to make a contribution or at least influence the measurements for each organizational unit. If we improved, they got rewarded and the bank got rewarded. We learned a lot through regular reviews of the plans. The most active ones, performance sharing and recognition, were most effective when they were considered management tools, rather than comp plans. The primary objectives of improving performance and creating a culture of positive reinforcement, respectively, had to be constantly refreshed to everyone in management and supervision. If we didn’t do that, the plans became passive — that is, entitlements.”
Effective variable pay plans are those whose design, communication, measurement and, most importantly, management disciplines clearly reflect plan objectives. To that end, it is helpful to remember what the basic types of variable pay plans can do. Following are some highlights.
Recognition, Bonus and Incentive Plans
The most common plans in the United States are recognition plans. The objective of recognition plans is to create an environment of positive reinforcement of those employees who contributed something valuable to the organization. The type of award can be cash, noncash or simple “thanks.” Recognition plans require constant refurbishment. They are discretionary, subjective and after the fact, and are best run by an employee committee. The awards can be big or small. They can be made by management or by fellow employees with a minimum of bureaucracy. If your goal is to keep particularly valuable employees, spot awards can be very effective. (Plans that management uses to deliver purely discretionary annual payments to employees are improperly referred to as “bonus” plans. Because the connection to performance is subjective, these are better defined as recognition plans.)
Bonus plans are another type of variable pay plans. WorldatWork defines bonus plans as those that reward for specific activities: referrals, hiring (sign-on), retention (staying on) and project completion. The objectives of these plans are very clear and are rarely confused. The key is to make sure that the organization still needs these plans. An example would be employee referral plans that continue after the need for those positions is over. These plans should be regularly reviewed to ensure they meet a current need.
One of the biggest challenges with variable pay lies with incentive plans for nonsales nonexecutive employees. These can be short-term plans (announced for one year or less) or long-term plans (announced for longer than one year and usually for management). They are announced before the plan’s measurement period begins, have a performance-reward schedule and are not discretionary.
Whether designing a new incentive plan or redesigning an existing one, it is important to ask the fundamental question: “Why do it?” The reasons are many and varied. An incentive plan’s primary objective is to improve performance on a few measures that are considered critical to the organization. Profit (or some other financial measure), productivity, customer service, quality, operating return on sales, return on shareholder equity, turnaround time, cost reduction and new product introduction are all possibilities for objective measures, though there are many more.
Incentive plans are extremely difficult to compare between organizations. They are organization-specific. Every organizational unit (company, strategic business unit, division, department or work group) has its own culture, business objectives and measurements.
Whether they have a single measure of financial performance or a number of financial and operational measures, WorldatWork research has shown that the key to success for incentive pay plans is the management and supervisory discipline to “work” the plan. One way to ensure working the plan is to introduce it through the normal management chain, rather than to every participant at the same time. Each manager and supervisor introduces the plan to his or her direct reports; compensation departments do not need to be involved. If supervisors, managers and executives can explain the plan(s) clearly and effectively in less than a few minutes, then they understand it. If they understand it, then they can own it. If they own it, they will work it.
“Working it” also requires constantly engaging teams of employees (functional and cross-functional) in improving performance in areas the company has deemed critical. Constant communication, performance feedback and reinforcement are also a must.
When considering types of variable pay plans for your organization, remember:
If you want to create a positive atmosphere that reinforces employees based on subjective criteria, use a recognition plan.
If you want to reinforce specific activities (referrals, hiring, retention, project competition), use a bonus plan.
If you want to improve performance of the whole organization, a business unit, a department or a work group, use an incentive plan.
Matching the plan to your organization’s objectives will ensure it is cost and culturally effective.
About the Author Jerry McAdams, CCP, has worked in the variable pay arena for 25 years and on the faculty of Variable Pay — Improving Performance with Variable Pay (C12). He is the author of “The Reward Plan Advantage, Rewarding Teams” (with Glenn Parker), “People, Performance, and Pay” (with Elizabeth Hawk) and “Organizational Performance and Pay” (with Elizabeth Hawk). He can be reached at email@example.com.