Do Incentive Plans Really Work?
An Interesting Debate
Business leaders that are trying to drive sustained performance inevitably come face to face with this question: "Will incentive plans help?" The issue becomes one of ROI. "If we allocate these financial resources to incentives, will we build enough additional shareholder value to merit that investment? Will performance improve?" Over the years, much has been written on both sides of this argument. Given what's at stake, every CEO has to make a determination about how he or she will address performance factors for which incentives are often seen as a solution.
This subject has received some recent buzz due to the publication of the book Drive (Publisher: Riverhead Hardcover), by author Daniel Pink. In his treatment of the subject, Pink indicates that studies show the following:
- Rewards narrow our focus, concentrate the mind, and restrict our possibilities
- When a task requires creative thinking, offering a reward extends the time it takes to solve the problem
- Extrinsic rewards should not be applied to tasks that require creativity
In reality, Pink's conclusions are not new, nor are they "wrong." Studies have been researching this conclusion for 30 years. Indeed, rewards can distract from results by focusing people on such issues as "how do I get this quarter's bonus?" Similarly, incentive awards can buy temporary compliance but do not change intrinsic motivation. They can likewise discourage innovation.
Instead of using incentives, Drive suggests that the focus should be on intrinsic rewards. Give people autonomy so they feel more in control of the direction of their lives. Provide opportunities for mastery so individuals feel they are improving and getting better. Establish purpose in their work so employees feel they are in the service of something larger than themselves.
For VisionLink, there is no real argument here. Given we are a compensation firm that designs a lot of incentive plans, that may seem surprising to some. But it's true; incentive plans can backfire. However......
We're not sure we agree with the foundational premise about compensation upon which Pink bases most of his arguments: "Pay people adequately and fairly, get the issue of money off the table, them give them lots of autonomy."
Our observation and experience is that this is not so easy in real life. In response to that statement, consider how you would answer the following questions if you were to adopt the "Drive" philosophy:
- Do you set salaries at the same level that formerly reflected total pay?
- How do you handle pay strategies for people of clearly different skill levels?
- How do you budget for total compensation without anticipating self-financing elements?
- How do you tell people, "don't worry about pay; just enjoy the 'intrinsic awards'?"
If you lead a business, you know these are real issues that have to be confronted. So, the obvious question is: can a business develop a culture that supports intrinsic motivation while still offering extrinsic rewards?
Perhaps it will not surprise you that our answer to that question is yes. How? It begins with a foundational understanding of what it means to address "total rewards" needs within an organization. At the core, every company must effectively address and align four key elements if they want to attract premier talent, keep them and have them perform well.
- Compelling Future - do employees find the mission and vision of the company compelling and do they see themselves as an integral part of its fulfillment?
- Positive Work Environment - do employees like the nature of their work, the team of people with whom they work, and do they have access to leadership to solve problems and communicate about important issues?
- Opportunities for Personal & Professional Growth Opportunities - do employees see a career path, and that their unique abilities will not only be utilized but maximized within the organization.
- Financial Rewards - will employee cash and security needs be met, and will they have an opportunity to participate in the value they help create (wealth creation).
When you look at the issues that Drive and other studies have raised, it becomes apparent that there is an incomplete picture of the rewards picture being evaluated. They are addressing just two of the four elements: Compelling Future (Purpose) and Opportunities (Autonomy and Mastery). What is needed is a total rewards philosophy that addresses all four components in a way that also creates a unified financial vision for growing the business.
Reinforce, Don't Force
When a company approaches strategic compensation plan design, it must start with a correct understanding of the purpose of incentives. To bring this concept into focus, let's start with the traditional view of these kinds of rewards. Most companies are disappointed in the results they get from their incentive plans because they use them in one or more of the following ways:
- "Carrot and Stick" approach to motivation
- Means of changing behavior
- Getting people to do things they don't want to do
- Motivating people to "do the right thing"
Conversely, a healthy view of incentives would have a company view their purpose as follows:
- Demonstrate a financial partnership with employees
- Communicate the outcomes and results most valued by the organization
- Create a flexible means of rewarding high performers as well as special circumstances and achievements
This latter approach to incentives is one of reinforcement, validation, alignment and unity. It conveys to employees that ownership sees them as key partners and that the desire is to build a unified financial vision for growing the business. It is in such an environment that confidence is conveyed, engagement is increased and, as a result, productivity improves.
See the chart and illustration below that shows the contrast between the "force" and "reinforce" approaches to incentive design, and the outcomes each produces.
Bad profits are those that come at the expense of the customer or client and erode shareholder value over time. Conversely, good profits build long-term value for the market, for shareholders and for employees.
Effective incentive plan design is fundamentally about fulfilling a commitment to reward people fairly (even generously) for helping fulfill the mission of the organization. When quality people understand and believe in this commitment, you reinforce their intrinsic desire to deliver on your business plan.
Sustained growth in a business comes about primarily because key employees are focused on performance factors they can impact - and they feel motivated to do so. That focus leads to execution. When sustained, such a productivity pattern brings about the results and success the business plan is seeking.
So they question is, what performance factors should become the focus of employees - especially key employees? It would make sense, at least in general terms, that they be the same factors to which the CEO and shareholders devote their attention. There needs to be alignment between what the business needs to achieve next, how employee roles and expectations are defined, and what rewards will flow to those who fulfill and/or exceed those expectations.
In our work with clients, we suggest the performance factor discussion begin with what might be referred to as the "CEO Worry List." That list is broken into certain categories as listed in the graphic below.
As the CEO of a company looks at such issues, what crosses his or her mind? Likely, it's something like the following.
- We are not hitting our sales targets
- Sales are not growing at the right pace - or at all
- Our sales cost is too high
- Our gross profit per employee is too low
- Our gross profit is not improving
- Our headcount is too high
- Our market share is not improving
- Our return on equity is unsatisfactory
- We are not growing our market value
- Our employees lack a sense of urgency
- Our innovation cycle is too long
- We are falling short of critical KPIs
- We are not yet considered an "employer of choice"
- Our turnover is too high
- Our talent level is below the desired standard
- New value is created
- Competitive advantage is enhanced
- Employer of choice status is attained
- A culture of execution and confidence emerges
The source of superior value being generated through these results allow the paying of incentives to be a "self-financed." Value (incentives) is paid out of additional value that has been created. If that value isn't created then rewards aren't released - or at least they are diminished.
Such an approach communicates the sense of partnership alluded to earlier. Until and unless this financial component is introduced in an incentive context, a business is really not positioning employees to have an ownership mentality. How could they?
Connecting the Dots
Something called "line of sight" is created in an organization when a connection is made between vision and strategy, roles and expectations and rewards. In such a context, incentives become the thread of continuity that connects those interdependent elements creating a unified effect. The following two graphics illustrate the outcomes and mindsets that should emerge from such an approach.
As illustrated in the graphics above, incentives become the lens through which an employee is better able to see and understand what responsibility he or she has for the (hopefully clearly) defined outcomes the business is trying to achieve. This is what it means to achieve "line of sight." If the reward is tied to factors the employee can impact, and it provides a meaningful benefit, that incentive is much more likely to impact execution and results.
Don't Follow the Trend
One of the reasons many companies start questioning the value of incentive plans is because they get stuck in an unproductive mindset. They typically get stuck in annual bonus mode and their whole incentive focus is myopic. The trend they follow goes something like this:
- Develop and redevelop the short-term incentive plan - sometime using a profit-based approach, other times making it target-based
- "Some day" we need to develop a long-term incentive plans for senior executives
If companies are going to develop world-class compensation strategies and incentives that play a meaningful and strategic role in their overall business, then they must become trend breakers. Or better yet, they start a new trend. What is needed is a balanced approach to incentives that addresses the need for generating short-term results that drive long-term value. How does a company do that?
Here is an example of how such a trend breaking process might be approached.
Create a short-term productivity incentive that accomplishes the following:
- Recognizes both human and financial capital
- Creates a rewards pool for producing profits in excess of a "return on capital" threshold
- Allocates the pool to employees based on an evaluation process that recognizes contributions to "good profits"
Create a long-term incentive plan tied to growth and value creation goals that accomplishes the following:
- Estimates a potential "new future value"
- Determines the portion that will be shared
- Determines the best way to assign, measure, distribute, etc. the allocated value
The graphics below illustrate the impact of these two approaches.
Again, as ownership looks to build the future company, it must create the right balance in the mind of employees between the need to generate results (this year) and build long-term value. Incentives, when engineered properly, allow employees to have more of an ownership view of the "tension" between those two elements and the personal financial impact of the company achieving or surpassing its targets.
Why would a company adopt such an approach to compensation? Because the following results emerge, all of which promote business growth:
- Employees are treated like true partners, therefore there is a unified financial vision for growing the business
- Values that employees participate in mature and grow, creating both a retention and performance outcome
- An ownership mentality emerges
- Recruiting and retention of premier talent is strengthened
- Incentive become self-financing, not entitlements or unattainable payouts
We pay fair salaries (at approximately the 50th percentile of market pay) with great upside earning potential for short and long-term growth and profitability. We share the economic value our employees create.
Do incentive plans work? What conclusions can we draw from the things just reviewed?
- No, if "work" means you can positively improve results by tying incentives to targeted KPIs only
- Yes, if "work" means you can forge a stronger relationship with employees and engage them in a unified financial vision for growing the business
- Don't expect a traditional incentive plan to improve productivity (if anything it might make it worse)
- Employee perception of the plan is more important than the plan itself ("Is this a game or is this for real?")
- The lack of an incentive plan can make it difficult to:
- Provide competitive pay structures without straining the budget
- Fulfill the commitment to support long-term wealth accumulation opportunities for top performers
- Consider developing an approach to short-term incentives that shares profits above a productivity threshold
- Utilize a long-term plan that shares an appropriate part of the created wealth with those that help create it
- Build on a philosophy that treats employees as partners and your most important asset