Incentive Compensation?

Determining the purpose of an incentive plan seems simple enough, does it not? And yet, depending on who you ask about why they pay incentives, you will receive a range of responses. Some business leaders view incentive compensation as a tool for impacting employee behavior. Others view it as a way to reward extra effort or to recognize and celebrate a good year. Many organizations have plans that are completely discretionary while others pay a benefit tied to the achievement of specific metrics. All will tell you their incentive plans are intended to drive higher employee performance. However, few are confident they actually do.

The truth is that the purpose of incentive plans has evolved in recent years. Some of this is the result of research that has been published regarding the impact of incentives on employee performance. Much of the change is based on “real life” experiences company leaders have had with various rewards approaches they have tried. In addition, the negative impact of incentive compensation makes news when a company’s approach to performance rewards goes bad (Wells Fargo comes to mind), which effects public perception of these plans. Such cases do not help the reputation of incentive plans. (The organizations that are having success with their plans do not usually end up on the front page of the newspaper or as breaking news on cable broadcasts.)

All of this has brought us to a point where leaders are in search of the right approach to incentive compensation and how best to tie rewards to the outcomes their employees produce. It has become a critical issue for a host of reasons. Chief among them is that a significant amount of money is invested every year in rewards plans for employees and organizational leaders want to know what they should expect to get for that investment. Compensation design is (or at least should be) an outcome-based endeavor—and if those who lead enterprises don’t know what results they are impacting through their incentive plans, they will not be able to determine whether their plans are succeeding or failing.

So, let’s solve this problem, shall we?

In this report, we will seek to define the purpose of incentive rewards by:

1. Introducing the 21st century view of incentive compensation.
2. Identifying three purposes incentive compensation should fulfill.
3. Clarifying the distinct performance periods incentive compensation should reward.
4. Defining the core philosophy that should guide how incentive plans are constructed and funded.

In the modern era of business, employees have more leverage in establishing the terms of their relationship with the company for whom they work. This is especially true of top talent—those strategic leaders who can significantly impact the growth trajectory of a company because of their unique abilities. We live in a time when there has been a shift in the employment power structure. There is a scarcity of this kind of talent in the market place. As a result, they are “holding all the cards” in the highly competitive recruitment environment that now exists.

Added to the mix of issues impacting compensation in general and incentive plans specifically is the speed at which change is occurring in business at all levels. These changes have led companies to abandon old, irrelevant performance management systems and the rewards constructs that accompanied them. Things have become much more fluid and organizations have had to adopt a greater measure of agility in their approach to pay. Instead of people being hired to fill a position they are now being recruited to perform a role. The natural extension of that mindset and approach is that people are being hired with the expectation they will become stewards of certain outcomes the company needs them to own. Therefore, they are not being paid for their behavior (time spent, duties fulfilled, actions accomplished). They are being paid for achieving a desired result—for producing a targeted outcome.

This has led to a shift away from the idea of “incentivizing” employees and towards a philosophy of value-sharing. The difference is that the term “incentive” implies employees are rewarded for behaving a certain way. It carries with it a sense of manipulation (“If you do this, you’ll earn that”). Incentives lead people to behave in their own interests instead of the interests of shareholders and all other company stake holders.

Value-sharing, on the other hand, is linked to value creation. The philosophy is that company leadership views its employees as growth partners. As such, they want them to understand how value creation is defined for the business and what their role is in creating and sustaining it. The extension of that kind of thinking is that employees will receive value only if they contribute to its creation. And the more they create, the more they share in the growth they help produce.

So, before we can accurately define the purpose of incentive compensation, we must first understand that there has been a shift away from paying “incentives” as traditionally thought of and towards sharing value.

Once value-sharing becomes the premise upon which a variable compensation strategy is built, there are three core outcomes incentive compensation should help fulfill. They are interrelated and it is impossible to fulfill one without also achieving the others.

Purpose #1: Create a Unified Financial Vision for Growing a Business

Enterprise leaders want to be surrounded by people who think about the future company the same way they do. Among other things, this means individuals working within the business have the same sense of urgency about getting results and managing priorities as owners do. They have a sense of stewardship about protecting shareholder interests and apply an ownership mindset towards decision-making.

This can only happen when employees are viewed and treated as growth partners in the business. And their compensation needs to reflect that kind of relationship. Incentive compensation is the mechanism that codifies the financial nature of the partnership companies want to have with their employees. It aligns the interests of all stakeholders within the organization so there is “line of sight” in the way all company associates approach their work. When incentive (value-sharing) plans are constructed properly, and are effectively integrated with the total rewards offering an enterprise makes, employees have a clearer understanding of the relationship between the company vision, its business model and strategy, their roles and what is expected of them, and how they will be rewarded for fulfilling those expectations.

This kind of aligned financial vision makes compensation a powerful tool in fueling business growth. It ensures that the way people are paid is consistent with the financial goals organizational leaders want them to help the company achieve. It reflects operational congruity and functional integrity in the way the organization goes about trying to fulfill its vision.

Purpose #2: Reinforce Roles, Outcomes and Strategic Priorities

As mentioned in purpose #1, company leaders want employees that adopt a stewardship approach to their responsibilities. This is why the sense of partnership mentioned earlier is so important. When workforce members feel like they are critical contributors to the growth trajectory of the business, they perform differently. They more fully engage.

One of the implications of this philosophy is that employees end up feeling like they have been brought into the company to fulfill a strategic role, not just to fill a position. They are given responsibility for achieving clearly defined outcomes and provided the resources necessary to achieve them. They are tutored and coached, not supervised and managed.

In this kind of environment, value-sharing becomes one the of the means by which role clarity is realized. Effectively designed incentive plans make the desired results associated with employee roles clear to the growth partners in the business. It helps them understand the balance they need to strike between maintaining revenues and profits and growing them. By extension, value-sharing, done correctly, removes ambiguity about priorities and performance standards.

Purpose #3: Reward Value Creation

A central function of incentive compensation is to share value with those who help create it. The idea is that people are more likely to focus their efforts on driving business growth if they know they will benefit financially from their efforts. This is why it is so important to frame the rewards you offer as value-sharing rather than incentives. You are rewarding the achievement of well-defined financial outcomes that are tied to the roles and stewardships of your growth partner employees.

Given this intent, companies must be able to clearly define what value creation means in their organizations. On a macro level, businesses should aim to reward profit growth and the things that drive it (revenue increase, improved margins, etc.). However, there should be an overriding standard of profit performance that is reached before any value-sharing occurs within a company. At VisionLink, we suggest that threshold be something we call productivity profit.

Productivity profit is value that is created or added through the efforts of employees at work; as opposed to value attributable to existing shareholder assets at work. Another way of looking at it is in terms of the return on capital shareholders are entitled to receive before they start sharing value with the workforce. For example, let’s assume owner capital assets in a business amount to $20 million (stock, debt, etc.). Shareholders might enforce something called a capital “charge” on those assets that is assessed against profits before value-sharing occurs. Let’s say shareholders peg that capital charge at 12%. This would mean that the first $2.4 million in net operating income would be considered return on owner capital and remain in the business instead of being paid out in incentive compensation. After that threshold is met, the business determines how much of the excess value is available for incentive payments. That excess value is considered productivity profit.

Here’s what that calculation would look like:

Net Operating Income: $10,000,000
Capital Charge: $2,400,000
Productivity Profit: $7,600,000

In a properly designed incentive compensation plan, benefits are only paid out of productivity profit. And if no productivity profit is generated, then no value-sharing occurs. This ensures that incentive plans remain “self-financing” and employees understand the relationship between their earnings potential and their ability to drive up productivity profit.

One of the results that should emerge from an effectively designed and executed incentive strategy is that employees have a balanced focus on the fulfillment of short and long-term outcomes. This can only happen if people are properly rewarded for both annual and sustained value creation. A balanced approach helps create the alignment spoken of earlier between owner and employee vision and priorities. In an article for Strategy+Business, Ken Favaro offered the following perspective about organizational growth:

Peter Drucker once wrote that the manager’s job is to keep his nose to the grindstone while lifting his eyes to the hills. He meant that every business has to operate in two modes at the same time: producing results today and preparing for tomorrow.

But “preparing for tomorrow” really means investing in the future, an expensive and uncertain proposition. It demands taking an incremental hit to today’s performance in exchange for an unguaranteed payoff. Meanwhile, you have to meet your previous promises of big gains to have the wherewithal to continue investing. But that wherewithal will soon be lost if meeting those promises means forgoing new investments that are essential to future results. Drucker’s dictum is not only an acrobatic feat, but a managerial one as well.

Certainly, it will be difficult if not impossible to create the dual focus Peter Drucker espouses if an organization has a compensation strategy that is at odds with it. And the only part of compensation that is tied to the fulfillment of financial targets is incentive compensation. So, it is critical that organizations learn how to blend short and long-term value sharing in a way that reinforces the overall financial effect the company is trying to drive.

This split approach to designing incentives requires that organizations home in on the right metrics for each performance period. Businesses run into problems when they complicate this issue by building too many measures that must be achieved for incentives (value-sharing) to be earned. Once foundational metrics are determined, organizations can certainly add others as long as they facilitate and not sabotage the core outcomes that must be achieved.

For annual performance periods, rewards should be tied primarily to profit. This is the value that aligns everyone’s efforts with the most important issue to shareholders. Without profits, companies cannot fuel growth.

For long-term performance periods (more than 12 months), rewards should be primarily tied to company growth. This ensures that at least part of an employee’s compensation mirrors how owners are paid for their contributions. Shareholders are rewarded primarily by growing the company and so should employees—at least those in a position to impact the business’s growth trajectory.

One of the key decisions facing business leaders is which incentive plan types will drive annual profits and sustained increases in business value. For short-term incentives, the primary choices are plans that are tied to key performance indicators or profit allocation. If the former is elected, then the measures chosen must be those that will directly impact profit (and productivity profit) growth.

There are nine different incentive plan types that company leaders can employ to reward long-term value creation. Three of them are ways to share equity, three are different types of phantom stock plans and three are rewards approaches that are tied to other financial measures (which impact business value). Many organizations need help determining which type of plan is suitable for their companies. That is the role of a compensation professional or consultant.

The essential driver of any pay strategy is a compensation philosophy that defines what a company is willing “to pay for”; how it rewards value creation. And when it comes to the design of incentive compensation, 21st century enterprises should be moving towards a Wealth Multiplier philosophy in their rewards approach.

This philosophy is rooted in the belief that it is both fair and financially prudent to pay people well for creating significant financial value. It is fair because business leaders do not and cannot drive growth by themselves. They need the contributions of growth partners who are as committed to and passionate about the vision of the company as they are. So, when those people devote themselves to doing what’s necessary to drive that growth, they should be compensated for it.

It is smart to pay employees well for significant value-creation because stakeholders are more likely to fully engage and pursue higher levels of performance if their earnings are tied to the wealth multiple they help create. Hence, the term Wealth Multiplier philosophy. Successful enterprises have an intuitive sense for this principle. They recognize that in a competitive talent environment, high performers will be drawn to those businesses that offer them the opportunity to control their earnings through their performance. This kind of philosophy makes sense to them.

Great compensation design is created through the proper blend of art and economics. Organizations need to understand that offering pay incentives rooted in value-creation puts employees in control of their earnings while simultaneously protecting the financial interests of shareholders. The art in that equation is in determining the right balance between guaranteed and incentive compensation and between short and long-term value-sharing. Economic considerations provide guardrails to pay designs so the organization does not end up “giving away the farm” through value-sharing. This is achieved by ensuring that all incentives are paid out of productivity profit.

Incentive compensation is a critical pay element in developing an employee value proposition that is compelling. And during a time when competition for top talent is at a zenith, the pay offerings companies make must not only be compelling, they must be irresistible. As a result, making the shift from incentives to value-sharing not only makes sense, it is strategically urgent.

So, as you consider plan designs that match the growth ambitions you have for your company, remember the purpose of incentive compensation is to create a unified financial vision, reinforce roles, outcomes and strategic priorities, and to reward value creation. Achieve those three things and you will be able to declare pay strategy success.