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Key Compensation Trends

Bonus Plan Rx: First Aid for Short-Term Incentive Plans
Arden Dalik, Jackie Goldman

October 1, 2003

Is your bonus plan feeling tired and run down? Is it stuck in a rut? If it’s any consolation, your plan is not alone. There appears to be an epidemic of company short-term incentive plans desperately in need of some first aid (and in some cases, major surgery). In this article we explore some of the common bonus plan ailments and how to diagnose them. Then we look at a number of steps you can take, depending on the condition of your plan, to get it back on its feet —or more importantly, back to helping drive and reinforce your business strategy.

Identify the Symptoms: Is Your Bonus Plan Sick?

While there are many different types and designs of short-term bonus plans, or annual incentives (STIPs), the symptoms of an ineffective plan are generally very similar. The signs that your STIP is performing sub-optimally include:

  • Lack of support or challenges from the Board or other key stakeholders;
  • The formula results in a proposed payout that the company cannot afford;
  • Tremendous “push-back” and surprise from employees upon distribution;
  • “Windfall” bonuses and/or “no bonus” situations resulting from environmental factors that the employees could not influence;
  • Perception by employees that bonuses are “just a part of base pay” (i.e. entitlement);
  • Failure of employees to shift their efforts to align with new business strategy;
  • Inordinate focus on a few, but not all, of your key business metrics;
  • Poor performers receiving too much and outstanding performers too little;
  • Employees not understanding the connection between their bonus payout and their individual performance;
  • Multiple or exclusive programs alienating some key groups of employees and/or reinforcing inappropriate hierarchical distinctions.

Diagnose the Severity of the Problem

There are seven key design features which determine, in large part, the potential effectiveness of the bonus plan.

1. Alignment with Business Strategy and Culture

Does your bonus plan support your current business strategy?

  • As obvious as this may seem, it is amazing how often STIPs can be reinforcing an “old message” to employees.

Is the incentive plan viewed as ONE driver of business strategy versus the cure for all organizational evils?

  • Oftentimes, executives believe that all they need to do is implement the incentive plan and business performance will take care of itself. In practice, quite the opposite situation can occur. Employees quickly realize that they are not able to earn their incentive awards because other critical strategies and processes haven’t been designed or implemented. The result can be frustration and deteriorating performance.

Has the culture of the organization been reflected in the STIP design?

  • A company that demonstrates trustworthiness, openness, and respect for employees stands a much better chance of reaping the organizational rewards of an effective incentive plan.

2. Economics of the Plan: Can You Afford It?

Has the plan funding been carefully calibrated?

  • Many incentive plan designers without a solid grounding in finance neglect to do the proper analysis to ensure the design can stand up to rigorous financial tests, such as self-funding. While often incentive plans are not self-funding “out of the gate,” all should aim to be after a certain length of time (usually two to three years)

3. Performance Metrics: Figuring Out What to Measure

There are many considerations when it comes to selecting performance measures for your plan. Are the following considerations reflected in the design of your program?

  • The use of a “balanced” group of performance measures: Regardless of whether a company uses a “balanced scorecard” or a more formula-based approach, it is critical that the incentive plan incorporate a variety of measures. Measures which encourage short-term profit (e.g., increased production volume) need to be “balanced” with those that ensure future value is simultaneously created (e.g., property rationalization).
  • Cascaded performance measures: Corporate goals are aligned to business unit goals, which are then linked to team goals, and are finally linked to individual goals. This way, employees at all levels of the organization are able to see how their job and their performance help to drive business strategy.
  • “Line of sight” Employees should be able to have some impact on the performance measures used in the bonus plan. While simplicity in design helps to illustrate “line of sight,” rather than targeting the bonus plan measures “down” to the lowest level of understanding, employees should be educated in the performance metrics and shown how their role can have an influence on the outcomes.

4. Formula/Scorecard: Keep it Simple

How complex is your current bonus formula?

  • The rule of thumb is to keep the plan design as simple as possible. Typically, everyone involved in the initial design process starts out with the objective to keep it simple. However, as the design process unfolds and details about the business strategy and objectives come to light, a desire to capture everything the business needs to accomplish emerges.
  • Using the balanced scorecard methodology as the foundation for incentive plan design can facilitate this process. The strategy map (or “story”) makes the linkages between performance measures much more clear to employees. Then, the incentive plan isn’t merely a compilation of measures, but rather another powerful vehicle for communicating business strategy.

Is there a high level of award differentiation between strong and weak performers?

  • Many managers continue to be uncomfortable with the concept of differentiating pay based on performance. Typically, this is because managers are not equipped with the skills or training required to coach an employee through the performance improvement process.
  • This situation is often exacerbated by the incentive plan design as many plans do not provide sufficient reward differentiation for superior versus poor performers. Even when incentive plans do incorporate the ability to differentiate rewards, many managers gravitate to the middle when assessing individual and/or team performance.
  • Research has shown that this reluctance to differentiate rewards based on performance can have an extremely negative impact on the ultimate success of the incentive plan.

5. Participation

Plan participation is an important consideration. Companies have been pushing their bonus plan participation further down into the organization. You will need to examine marketplace practices as well as organizational culture to determine whether your bonus plan participation or eligibility is appropriate. The degree of risk that employees can tolerate or desire is an important consideration when determining the organizational levels to include in the plan.

6. Leadership Commitment: Walk the Talk

Have your leaders “bought in” to the bonus plan measures and objectives?

  • Often, bonus plans end up being driven by the Human Resources department (or blamed on HR when they are not working). In order to utilize the bonus plan as a strategic business tool, it must be universally seen as ‘owned and valued’ by the leaders of the organization.

7. Communication and On-going Monitoring: Transparency is Important

Did employees receive communication before, during and after the incentive plan was implemented?

  • Many organizations employ a “black-box” approach to incentive plan design and then wonder why employees are not enthusiastic about the program when it is rolled out. By opening up the bonus plan process (e.g., measures, distribution process, link to individual performance) to employees, trust and support is built for the program.
  • Even if the STIP was not well communicated initially, there is still an opportunity to enhance the effectiveness of the program by establishing a communication process for tracking progress or illustrating the link to the business strategy. employees 0.6% shares financial information with employees 0.5%

Were challenges associated with gathering, tracking, and reporting potential performance measures recognized and addressed early in the implementation process?

  • Finance and systems people should be engaged early in the project so that they had sufficient time to put the necessary processes in place. Otherwise, the result may be disappointment, frustration, and failure of the plan rollout.

Prescribe a Treatment Plan Rx

Once you have completed your diagnosis and have identified the incentive plan design features that require attention, it is time to put the treatment plan in place. An effective design process encompasses four key features:

1. Use a bonus review committee comprised of managers and employees (where appropriate). This committee should:

  • Collect input on the effectiveness of the current program;
  • Retest the role of the bonus plan within the Total Compensation Strategy;
  • Review market data for competitive positioning;
  • Articulate how the incentive plan is changing to provide alignment with the business strategy;
  • Generate interest and excitement for the revised incentive plan;
  • Define the plan’s guiding principles;
  • Oversee and guide analysis, redesign and implementation; and
  • Review the ongoing effectiveness of the revised plan.

2. Involve employees in the process

Typically, one of the most important objectives in revising an incentive plan is to realign employee behaviour. Conducting employee focus groups as part of the redesign process can accomplish a number of important objectives, including gathering insight on employees’ understanding of business strategy and objectives, and gauging the likely impact of the updated incentive plan on employee behaviour and performance.

3. Develop a realistic roadmap for redesign and implementation of the revised incentive plan

The roadmap should identify the sequence of the redesign and implementation activities. There are a number of “moving parts” in any incentive plan design project, and a detailed project plan is critical to successful project completion.

4. Avoid getting “sent back to the drawing board”

Check in frequently with the group that will ultimately be responsible for approving the revised plan design. Too often, the redesign team proceeds on the assumption that the executive team and/or Board is “on the same page,” only to find out at the eleventh hour that there is disagreement on something as fundamental as the plan’s guiding principles.

Post-Mortem: How to Avoid a DaVinci’s Inquest

If your plan is exhibiting some of the symptoms outlined above, it is critically important to diagnose the severity of the situation. Whether your plan needs only a band-aid or a multiple bypass, it should be addressed as soon as possible. Overlooking bonus plan issues will not only minimize the return on your compensation investment but, more importantly, can work against the attainment of your business goals. Your plan may be reinforcing, or even rewarding, business efforts that are counter to your new business strategy and cultural change efforts. So “scrub up” and begin to diagnose your bonus plan to ensure that it operates as a strategic tool as a well-designed bonus plan should.

Jackie Goldman is senior consultant with Buck Consultants in Toronto. Jackie specializes in the design and implementation of reward strategies and programs.

Arden Dalik is a founding partner of RainTree Consulting in Calgary. Her areas of expertise include executive compensation, compensation strategy and design, and competency-based system development.

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