Compensation Foundations: Designing an Effective Incentive Plan

This week’s column is the second in a series that I co-author with Ray Everett, the chief executive of Aon Hewitt in the Middle East. In the first article we discussed job identification, job grading and linking it to pay.

While people are paid salaries to do their job, incentives encourage them to do their job well. Nothing is more emotive in people management than communicating incentive numbers – people can be upset, happy or (as is often the case) neutral.

At least three questions need to be answered when designing an effective incentive plan:

What performance criteria will be used to determine incentives?

  1. Financial metrics, eg profit or revenue. These can be based on absolute indicators such as a profit target or relative indicators such as growth versus the previous year, or versus the budget.

  2. Non-financial performance metrics, such as the number of products manufactured or sold, number of defects, etc.

Next, at which organisational level will incentives be determined?

  1. On a company-wide basis;
  2. On a unit or divisional basis;

  3. On a team-based basis;

  4. On an individual basis.

And how will the value of incentive payments be determined?

  1. On a formulaic basis, where the individual has a clear line of sight of how incentives are determined
  2. On a discretionary basis, where the management assesses the performance of a number of metrics and determines incentives for the company, team or individual, with no predetermined linkage to performance.

Let’s look at each of these in more detail.

Ultimately, financial performance pays for incentives either directly or indirectly. Having incentives that are delinked from the firm’s overall financial performance can become a challenge and open the door for mistakes or even abuse. When people are not clear on the link between their work and their incentive, suspicion can raise its ugly head, even if unfounded.

The more that individuals understand how incentives are determined and that there is a direct correlation between individual performance and incentive payout, the more they will be motivated and aligned. There is nothing worse than telling an employee that they performed well but that the company’s results were not good and therefore they won’t be paid an incentive that year. The most successful incentive plans have a level of predictability in them. Formulaic or commission plans work best but have some inherent risks. Discretionary incentives can still work, but it takes time and commitment to consistency to achieve the requisite level of predictability.

Tying all of this together is a well-designed performance-management system. Employees need to know what they are being measured on and how their key performance indicators are calculated.

The final thing to determine is whether some of the incentives will be deferred. The point is that the total measure of performance of an employee in a single fiscal year can usually not be measured solely in that fiscal year.

In financial services this is very common and makes sense for a number of reasons. Before the global financial crisis banks deferred a portion of annual incentive to prevent staff from leaving the company. Since the crisis, regulators around the globe have said that deferral should be linked to the long-term performance of the individual and company.

The case for deferred incentives is not restricted to the financial services sector. Faulty or fraudulent design and manufacturing after initial deployment of a product can have a big effect on not only profits, but even the survival of the company. For recent examples look at Samsung and its phone batteries, or Volkswagen and the emissions scandal. Latent performance issues are not restricted to faults and fraud – consider Coke II.

For these reasons it is important to find a balance that matches the payout of the incentive and the life of the work’s effect on the company. This is never exact but it does not need to be, it just needs to be effective. A well-designed incentive plan allows you to reward staff for annual performance, matching their compensation to their results. This not only improves the effectiveness and efficiency of the workforce, but it is also an important tool in the retention of top talent.

In our next article, we will look at how firms should be thinking in terms of aligning senior team members to the long-term performance of the company.

This article was originally published in The National.