Frequently asked questions about pay-for-performance compensation plans Featured

11:23am EDT February 21, 2011
Ted R. Ginsburg, CPA, JD, Principal, Skoda Minotti Ted R. Ginsburg, CPA, JD, Principal, Skoda Minotti

In the past, many employers have used a discretionary bonus system. However, the use of pay-for-performance compensation plans has become increasingly popular.

“The process is changing because boards of directors are getting more involved in setting corporate goals and want a mechanism by which those goals can be reinforced,” says Ted R. Ginsburg, CPA, JD, a principal with Skoda Minotti.

“The boards want to guide executive behavior. In that process, companies are tying the payment of bonuses to the achievement of distinct goals.”

Smart Business spoke with Ginsburg about how pay-for-performance plans work, and how to properly implement one.

What defines a pay-for-performance compensation plan?

A pay-for-performance compensation plan is a system by which annual and long-term bonuses are directly tied to the satisfaction of goals. If the executive does not satisfy the goals, then no bonus is awarded.

Pay-for-performance plans typically contain between three and five key milestones or tasks to be attained or completed throughout the year. These goals are typically measurable, quantifiable, and quite black and white so executives can see whether or not they met the goal and will receive the payment.

How does this system benefit employers?

This system benefits employers in three main ways:

No. 1: Clarity in explaining a bonus.

No. 2: Unless desired, the CEO/board doesn’t have to listen to other executives complaining about how they didn’t meet their goals but they still deserve a bonus. It’s not necessary, because all the goals are set in advance and are clearly explained.

No. 3: If the system works properly, the goals pay for themselves. If the company attains the goal — for example, stated earnings per share — it can afford to pay the bonus. The bonus is justified by the action.

The board of directors should be going to the company with input from management and saying, ‘Here are the goals we want to attain during the year.’ Of course, you should have long-term company goals, but usually these short-term goals fit into the long-term goals.

A pay-for-performance plan focuses the executive’s attention on attaining these short-term goals. So the company can tell its shareholders that it set these goals and attained them, so payment of the bonuses is justified.

Often, the perception of shareholders regarding discretionary bonuses is that the board just ‘rubberstamps’ them because they want to make sure their buddies are taken care of. Pay-for-performance eliminates that skepticism.

How does the system benefit executives?

To the executives, the main benefit is clarity. They know exactly what to do to earn the bonus. They know exactly what the board of directors wants from them. They don’t have to worry that if the boss is grumpy on bonus day, they won’t get anything.

The other issue that benefits executives and employers alike is clarity in the pay package. An executive looking for another job knows he or she might be giving up this bonus. An employer hiring an executive could say, ‘Here is your base pay, and you will get a bonus of this amount if you reach these specific goals.’ It adds clarity to the rules of the game in the job-seeking process.

What steps need to be taken to create a successful pay-for-performance program?

The first step is to get input from senior management. Determine short-term goals that are attainable, but that people have to stretch to reach. You should set up a series of three to five goals for the executives covered by the program. The goals have to be somewhat adjusted to make sure the person who will be striving to reach them has some impact in that process.

For example, you wouldn’t want to set a goal for the VP of sales to reduce waste in the manufacturing process. You want to set up goals that fit the executive’s role. If profitability is a goal, though, a goal for the VP of sales’ could be sales with an X percent margin. Or the VP of production’s goal could be keeping production costs low enough that the company makes money.

Once you have the goals, you conduct research to determine what the overall amount of the bonus should be. You can do that through market compensation data. Then, you should allocate that total amount of bonus between the goals. Are all goals rewarded in the same amount, or are some worth more than others? This gives the executives more guidance on the importance of their tasks.

Once that’s done, communicate with the executive to track his or her progress during the year, if possible. That’s motivational. We all want to know how we are doing.

How do employees react when the annual bonus program becomes pay-for-performance based?

Surprisingly, in my experience, the employees like this type of program because it does bring clarity. It eliminates the necessity to spend a lot of time praising oneself to generate payment.

You have to involve them in the process, because if they aren’t on board with the reasonableness of the goals, the program won’t work. If you set a goal of increasing profits by 40 percent this year and, over the last 10 years, you’ve never increased profits by more than three percent, the executives will say this goal is unattainable. That would serve to be a demotivator. But if you set a goal the board and the executives feel is reasonable and a bit of a stretch, it should be very well received.

Ted R. Ginsburg, CPA, JD, is a principal with Skoda Minotti. Reach him at (440) 449-6800 or tginsburg@skodaminotti.com.