Pay for Performance Principles
Most companies instinctively understand that at least part of their employees' remuneration should be performance based. As a result, building an effective incentive plan assumes an employer has determined to establish a "pay for performance" philosophy and structure upon, and within which, he will construct his rewards programs. The objectives typically associated with such a philosophy and framework are as follows:
To accomplish those objectives, a compensation plan that is centered on pay for performance must meet the following five essential criteria:
- Must tie performance awards to shareholder financial objectives
- Must employ the proper mix of compensation elements
- Must result in meaningful dollars
- Must embrace performance that employees can impact
- Must be effectively communicated and reinforced
Obstacles
In an attempt to turn a Pay for Performance philosophy into living and breathing compensation strategies and incentive plans, many companies run into road blocks. These obstacles are typically centered on these key questions:
These queries reveal the need for an effective process to guide a business in developing compensation strategies that can drive productivity while increasing the economic value that inures to the company AND to the plan participants. That process should address and connect 10 related components: purpose, people, potential, share, standardization, tiers, weighting, indicators, allocation and measurement.
These components can be thought of as steps in developing an effective incentive plan. Let's look at each one of these individually.
Define the Purpose
The starting point in the building of any incentive plan is to determine the result you are seeking. This is the strategic step in the process.
At this stage, you are identifying the specific goals that should be achieved as a result of the strategy. For example, are you looking for increased sales, specific margins, higher profits, improved customer retention or a combination of those factors? Understanding the performance you want to impact has to be determined before any other step in the process can be navigated.
Many companies try to engineer or reconstruct an incentive arrangement without first determining clearly what outcomes they seek in doing so. The result of such an approach is to create a rewards strategy that is at a minimum unclear in what it is trying to communicate. Worse, it does not create any "line of sight" for the employee between his performance, his role in the organization and how that is tied to the vision and strategy of the company.
Identify the People
With the key result areas identified, you are ready to determine who in the company is best positioned to fulfill the plan purpose. In doing so, you will want to think through the layers of people within the business and identify those that will have direct impact on the achievement of the strategic objectives.
Not every employee will have an equal impact on the outcome of the business. You must examine the results you indicated you wanted to fulfill as well as the initiatives that will need to be executed to achieve them. Those execution elements should then be assigned to individuals that are best positioned to impact them either individually or in teams.
Further on we will address the issue of "tiers" - dividing employees into groups and then "weighting" performance elements that will drive their performance.
Quantify the Value
The next step in our process is to determine the economic value that will be created for shareholders if the incentive plan objectives are achieved. In other words, the results identified in our purpose step are intended to produce a certain financial outcome. That outcome needs to be quantified. (For example, if we double revenue over the next five years, we will increase the equity value of shareholders by $20 million.)
Consequently, you will want to identify a way of projecting the potential and subsequently measure the value that will be created if the plan produces the desired result. This will typically require a spreadsheet projection that allows you to ability to alter and simulate different levels of performance.
As VisionLink gets involved with this process, we usually construct models that project base, target and superior result thresholds. Each of these models should include assumptions about expenses, staff additions, revenue increases, etc. so that an accurate picture can be attained of what the business will look like under certain growth assumptions. As a plan design evolves, they can then be plugged into this model so we can maintain a view of how a given rewards strategy will impact shareholder value.
Share the Value
Once an economic value has been determined and modeled to your satisfaction, the next step is to determine what amount of the increased value should be shared with the people who created it. The concept here has to do with treating compensation as an investment. Under the last step, you will have made certain assumptions about what the growth of the business will look like in terms of increased shareholder value if the plan purpose is fulfilled. Now you are determining how much of that value has to be shared to generate that result.
In a pay for performance environment, excellent results are shared with the (people/talent) asset that creates them. Therefore, this step asks you to evaluate what is an acceptable, "expected" return for your company over the period you are measuring and what would be considered an attainable, "superior" return. Once those two measures are determined, the incentive will come from that portion of the superior return you want to share with your employees. You are determining how much of the "new" value should be shared with the people who help generate it. This should be reduced to a percentage of the total potential value (e.g. up to 10%). This percentage then becomes a target goal for planning purposes.
Base level performance does not typically result in incentive awards. Sometimes incentives are paid at target level performance, but on a much smaller scale. You are trying to build incentives for a superior return, not an average ROI. This needs to be done in a way that respects shareholder value but crosses the motivation threshold employees need to experience for execution and performance to improve.
Standardize the Benefit
With the just mentioned targets in mind, the next step is to determine a standard that can be used to express the potential value of the award in current terms. Employees will relate to the future only if it is presented to them in terms that have an orientation to the "here and now".
For this reason, typically the potential award will be stated as a percentage of each participant's current salary. This creates a finite measure that allows participants to translate a result into an economic benefit that can be easily calculated.
How much of a person's salary should be paid as an incentive? It is going to be a little different in every company - however, here are some rules of thumb.
Incentive Plan Targets (combination of short-term and long-term incentives)
Keep in mind that a company will not typically go from having no incentives to these levels. A transition period is usually followed.
Establish Tiers
At this point, the question that naturally emerges is whether all the people who help create value should benefit equally. If not, how do you address the differences?
Most incentive plans are not uniform in this regard because not everyone is in an equal position to impact the same outcomes. To address this, customarily, a business will define "tier" levels that each participating employee is assigned to. Establishing different tiers for participants allows you to assign greater potential value to those who are likely to have the greatest impact.
For example, under this approach, the highest tier (executive management) might have a target incentive of 80% of salary. The next tier of management might have a target of 60%. And so on.
It should be kept in mind that we are defining standards and tiers for the "total" incentive for which an employee is eligible. Later, we will determine how much of that should be paid in the short term and how much of it will have a longer term distribution period.
Use Weighting
Weighting is a companion to and grows out of the tier concept. To weight an incentive is to determine how much of the reward should be assigned to the achievement of various categories of expectations. It is answering the question, what percentage of the reward should be earned for achieving the company goals, the department/team goals and individual goals?
The weighting assigned should be based on how much of an employee's role allows him to impact each of those categories. For example, an executive level tier might have its incentive weighted at 75% for company performance and 25% for individual achievements with no team requirements. However, a manager tier might have a weighting that assigns 25% to the company performance, 50% to the team and 25% to achieving individual milestones.
Define Indicators
With the previous measures determined, you now have a general sense of the economic benefit that can be earned by your key employees and what weight you want to give to the areas of focus they have within their stewardships. You now need to go from the general to the specific. What specific and measurable indicators will best reflect the improvements desired? Identify the indicators that will be used to measure performance in each area. Here are some examples for each of the categories outlined in the weighting step.
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Company: revenue growth and net income
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Department: improvement in customer retention; collections rate; employee productivity factor
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Individual: performance goal achievement
For each of these indicators, a base, target and superior goal can be set. Incentive payouts can then vary depending on the threshold of performance achieved.
Determine Your Allocation
To allocate the incentive means to determine when it will be paid to participants. You will need to determine if the awards, once earned, will be paid at the end of the quarter, end of the year or at a future date. Typically, a percentage of total incentives are paid annually and a percentage will be paid in the future. This can also vary by tier. For example, tier one might have 50% of its incentive paid in the short-term (a year or less) and 50% long-term (typically 3-7 years). On the other hand, tier 2 might have 70% of its total incentive paid in the short-term with 30% allocated to the long-term.
Usually, companies that do not have a pay for performance rewards philosophy and structure will need to transition into the long-term incentive piece. They way many companies do this is by starting out the first year with, perhaps, a 70/30 split between short and long-term, then move to 60/40 the second year and finally 50/50 by the third or fourth year. Whatever transition period is used, it is critical to understand that a rewards strategy without a long-term component is not really a pay for performance plan in the truest sense. How can a company have a long-term plan for growth, but not have a compensation component that corresponds with it?
Prescribe the Measurement
This last step has to do with the long-term portion of the incentive. It asks you to determine how the long-term portion will be measure over time. You should establish the form and shape the long-term incentive will take by determining if it should be" a) held in a pool; b) credited with interest or investment earnings, or; c) treated as a stock or phantom stock incentive. Ultimately, this step leads to an evaluation of about nine different long-term plans (and combinations) that can be considered for the percentage of the total incentive that will be paid out sometime in the future (longer than a year).
VisionLink recommends that companies work through a decision tree process to determine which plan is right for your company. This mechanism helps to sort through the various types of plans based on a process of elimination to arrive at a plan that is consistent with the results you are trying to drive and will match the needs of the employees that can impact those outcomes.
See the same decision tree sample below.
In Conclusion
Without a process like the one described here, shareholders in a business are reluctant to approve plans that pay out significant value - because they view those payouts as added expense. Without a system of targets, metrics and measures, they will not achieve an efficient return on their compensation investment and frustration levels will increase between them and their workforce. Likewise, they don't end up attracting and retaining the highest quality talent.
Conversely, by following this kind of process, key employees know at the beginning of the year exactly what their target incentive is. They know what has to happen to achieve the optimum incentive. They know when it will be paid and they know how it will be measured.
With this kind of process, shareholders know exactly what value they will accrue before the managers earn their incentives. They know precisely what percentage of future growth will be shared with the management team. And finally, they know that the managers are going to be rewarded for achieving specific, measurable results.
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