What should organizations do when incentive plans misfire? The title of the classic Dire Straits song, “Money for Nothing,” comes to mind. It describes a concern that many rewards professionals and executives face when designing and managing incentive plans. Incentive plans can provide a powerful reward for performance, but they also can misfire. They may not pay out despite strong performance or pay out when overall performance is poor.
Recently, a pharmaceutical company had a bonus plan designed to pay out at an exponentially increasing rate for performance above target. Then their primary competitor dropped out of the market. By the end of the plan year, nearly every eligible plan participant had achieved maximum payouts for relatively minimal effort. While there was a “pop” in revenue, the exponential incentive payout curve eroded marginal profitability. For what, exactly, did the company pay out bonuses that in some cases amounted to multiples of base salary? Leadership was concerned they had missed an opportunity to more effectively leverage market share gains.
Another case was that of a construction company. After investing in the design of a new sales incentive plan, the company was struggling to achieve threshold performance. The CEO stepped in to secure a large sale for the company that would raise the company above the threshold. Once the deal was in place, a new member of the sales team who had not participated in the sale brought it to the company’s attention that the project fell under his role as customer relationship manager. As a result, he was entitled to a significant payout — four times his base salary.
We find that these types of situations are not unique. Often in the design of pay for performance plans there occurs a situation where an incentive plan has resulted in payouts that may not seem appropriate by any measure. Despite poor to mediocre performance, sales forces or specific individuals can earn large bonuses. It is not limited to windfalls either. Many other organizations have faced lower-than-competitive payouts because of increasing growth expectations resulting in more difficult goals.
We have outlined below recommendations to consider in ensuring a more appropriate pay-for-performance relationship when facing potential windfalls or structural changes in the business that result in potentially large (or small) incentive payouts outside the control of the employee. In other words, when does it make sense to make an exception?
When to Make a Change
Overall, we argue that common sense should always prevail; however, few things are completely clear-cut.
The first question for companies addressing plans that are not operating as intended is whether to consider a change to the goals, the plan or expected payout. Factors to consider include:
- Legal implications. First and foremost, you need to understand the legal standing of the plan. Is management free to vary the terms of the bonus plan or is there a legal obligation to operate the rules with very little discretion? As a matter of practice, we always recommend that management have complete authority to amend or terminate the plan regardless of reason within applicable laws.
- Company culture. Are there aspects to the salesforce culture, how people work together, and so on, that make it easier or harder to make changes or take action?
- Expected regularity of the event. If the environment or factors that created the event are likely not to occur again, it may make sense to keep the plan as is. On the other hand, if there has been a fundamental redefinition of the market or business processes, recasting the design of the plan is reasonable.
- Alignment with team, business unit, or company performance. High rates of achieving target or maximum payouts are not necessarily an indicator that something is amiss. If variance in performance is minimal, then high payouts may be a genuine indicator of success. In such a case, it likely does not make sense to initiate a change barring consideration of other organizational priorities, strategy, etc.
- Impact on total cash compensation. Magnitude of change in compensation is a factor to consider. It is a given that most plan changes will likely generate ill will or anxiety from employees. If the proposed change makes a difference of less than a percentage point or two in payouts, for example, it may not be worth it. This also holds true if there is minimal pay at risk.
- Impact on top performers. A fundamental question is whether top performers fared better than average or poor performers. In a typical windfall situation, it is very often the least effective performers who benefit most. This can create a secondary, longer-term loss of competitiveness. In addition to the flat cost of a high payout, top performers become more vulnerable to being picked off by competitors.
Addressing Environmental Changes
Leadership must balance these concerns when debating whether to intervene on changing an incentive plan. Most organizations do not provide for exceptions based on:
- Lack of market demand
- Poor economic performance
- Product changes or redesigns.
If the plan document and organization culture provides opportunities for discretion, management may consider the following:
- Determine the critical jobs or incumbents that need to be retained and set aside additional funds for bonus awards to this group. Identify high performers whose contribution impacts results and set aside some money for them. Identify key qualitative and quantitative criteria to achieve any payout.
- Plan a detailed communications campaign to explain to people how the business is performing in the market, what this will mean in terms of bonus awards (set expectations), and what management is doing to drive performance. This needs to be urgent and combined with additional communication mediums (e.g. face-to-face briefings, e-mails, letters, etc). It is also important to sustain these communications as opposed to a ‘one and done’ mentality.
- Decide whether the plan (despite having some flexibility) needs to be redesigned to better meet the needs of the business in future.
Variance Across Divisions
In a situation where a group or division is successful while corporate performance flags, a key issue for the organization to consider is the balance between corporate, divisional and individual performance. It is important to ask how the organization would tolerate a situation where the company did well but a division lost money. A true incentive should be less. The question is how much should the divisional executives receive? How much overlap or integration is there between divisions? What’s the role of the corporate head office? These are all key questions in developing the overall variable pay plan strategy and plan architecture when there is variance in performance.
Incentive plans should be an extension of common sense and leadership, not a substitute.
Windfalls can be difficult to manage, but are most often controlled using caps. Korn Ferry research with WorldatWork indicate that 92% of broad-based plans have caps. Sales incentive plans are less likely to have caps, but they are still predominant, even though it is not always a best practice (as opposed to per deals and decelerators). As a result, windfalls tend to be more associated with sales incentive plans; however, they can happen to any incentive plan.
In situations where the incumbent receives a significant payout for reasons beyond his/her control, some organizations limit payouts. A windfall situation may be occurring if
- The projected payout(s) are significantly above the stretch goals.
- There is a clear reason for the excess — and it is not performance-related.
- Top performers are not the ones benefiting from the excess.
- Goals are inconsistent due to lack of historical context.
In these types of situations, companies tend to:
- Require some additional performance to the payout
- Develop specific protocols for dealing with windfalls
- Recalibrate performance measures.
Typically, this determination is sensitive because it “changes the deal.” It is important to consider the degree to which the windfall is expected in the future as well as the magnitude of the impact. In many cases, organizations redesign or reset the plan going forward rather than retroactively change the plan. Instituting or resetting caps is a common and basic approach for addressing this.
Tips to Avoid Problems in the Future
Avoid problems by implementing the following action steps in plan design and communication.
- Clearly include management discretion language in plan design documents and employee communications that reiterates the company’s ability to change or cancel the plan at any time for any reason.
- Include corporate triggers (or hurdles) that specify that a threshold of corporate performance must be met.
- Establish the expectation that the plan will be reviewed and updated every year: “This is the game plan for this year.”
- Step away from a plan design and consider the source of instability if there is a history of exceptions being made. It may be that a permanent plan may not be appropriate, or that the measures used are not reliable enough to gauge success.
- Establish an “exception committee” that is crossfunctional (Finance, HR, Line, Risk, etc.) to review requests.
There are no “right” answers. The best course of action depends on the philosophy that the company wishes to follow, the organization’s culture and the business model. It is important to balance performance impact and pay when having to make midcourse adjustments to incentive plans. It is important and appropriate for management to consider changes to plans and they should be reviewed for appropriateness annually.
Incentive plans should be an extension of common sense and leadership, not a substitute. If that ceases to be the case, it is time for executives to take action.
Marc Wallace is senior client partner at Korn Ferry.