Annual incentive efficacy Featured

8:00pm EDT August 26, 2008

Is your company’s annual bonus expense in line with its recent financial performance? Do top performers receive a larger bonus than their lower-performing peers? The current economic climate is the perfect reason to review your company’s bonus and incentive plans.

During prosperous times, employees come to expect bonuses, and the company has less trouble justifying the expense. So bonuses lose their meaning and become automatic or entitlements. If there’s little to no growth in your company’s 2009 forecast, now’s the time to revisit those incentive plan fundamentals and make the necessary adjustments.

“Now that executive compensation is subject to new SEC disclosure rules, CEOs are realizing that the same philosophies around executive bonus and incentives must cascade down through the organization,” says Ann Costelloe, San Francisco office practice leader of executive compensation for Watson Wyatt Worldwide. “They’re wondering how they can justify paying employees profit sharing or incentives if the company’s financial results are lower than the prior year, yet still incent employees to achieve stretch goals.”

Smart Business spoke with Costelloe about how executives can calibrate employee bonuses and incentives to mesh with 2009 forecasts and still maintain motivation.

What’s the first step to calibrate annual bonus and incentive plans with results?

Executives should start at the macro level by revisiting the philosophy behind the plan to make certain it’s still appropriate. Next, make certain the plan is motivating employees toward the main business drivers. At all times, a plan should be self-funding in that the incremental gain to the company should more than pay for the bonuses to employees. If it’s a profit-sharing plan, where all employees share in the overall company results, should you pay employees the same percentage if the company doesn’t achieve a profit increase? Or is the percent of profit shared appropriate and affordable given the financial performance of the company?

The questions are: What results should we be rewarding? Are there specific business drivers and return (e.g. return to shareholders) that we must achieve and exceed before we can afford to pay a bonus? Should employees still have an opportunity to earn the same bonus if they meet individual goals, but the company misses its broader target?

What’s the next step?

Establish companywide financial goals that include the appropriate amount of growth that is both achievable and affordable but by no means a given. This is the first step to assuring that the employees’ collective performance will fund the bonus expense. Then cascade the goals down through management to each division, group and individual. Understanding the extent to which company performance versus individual performance will impact an employee’s personal reward is critical. I advocate giving employees no more than three goals, so that an individual isn’t juggling too many targets. A goal that impacts only a small fraction of an employee’s ultimate reward (e.g. 10 to 15 percent) will likely receive no attention versus goals that impact a significant portion of the reward. Bonuses and incentives should be earned for achieving results, not completing activities, and if it’s a true incentive plan, those who achieve at higher levels should earn larger bonuses than their lower-performing counterparts.

When determining the bonus amount that will motivate employees, there’s no one-size-fits-all number. Instead, the percentage must coincide with the company’s philosophy, the industry, the maturity level of the company and the targeted return to shareholders.

How should plan changes be communicated?

Initially, the CEO should communicate the plan change, including the reasons behind it, because employees are much more likely to embrace change if they understand why it’s necessary. Employees need to understand how bonuses payments are calibrated to company-expected results and to what extent the bar for performance measurement has changed. CEOs should then provide periodic updates, detailing how the company is tracking toward those goals. This strategy creates line of sight between the employees and the company’s mission, and it also keeps the employees focused and motivated, especially if they’re working toward stretch goals.

Which plan structures are the most effective?

I don’t favor all-or-nothing plans because they can be a little scary, and they often fail to motivate employees. A scaled system, which financially rewards employees at a level that’s commensurate with their performance, is fair and the expense is calibrated to the achievement. The key here is to ensure that employees at all levels know what performance, outcomes and results are expected and how they will be measured so that rewards line up with results delivered.

I also encourage employers to set aside a pool of funds to reward and retain top performers. It’s best if the opportunity is embedded within the plan structure because you don’t always want to be managing by exception. If your company is hitting or exceeding its bonus plan targets every year, there’s a good chance the plan isn’t working properly because the bar is set too low. When a plan is structured correctly, you won’t hit the goal every year, nor will you consistently miss or overachieve.

ANN COSTELLOE is the San Francisco office practice leader of executive compensation for Watson Wyatt Worldwide. Reach her at (415) 733-4244 or ann.costelloe@watsonwyatt.com.