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Do variable-compensation plans for employees really work?

Published in the Rochester Business Journal

Compensation is both an intriguing and emotional subject. Depending upon the size of a company, it also may be the single largest expense in the form of payroll. So it’s not surprising that organizations continually strive to find the ideal balance between compensation and productivity.

Professional sports teams are well-known for negotiating a sophisticated blend of guaranteed and incentive compensation as a way of encouraging superior performance by their promising stars. In highly visible and oft-controversial moves, corporations like Walt Disney Co. award CEOs like Michael Eisner effusively, even as profits and shareholder values decline.

Out of the limelight, however, the issue of compensation is just as timely for every company focused on profits and growth. Our clients frequently ask us: How can we get the performance we’re paying for? Should we be doing something else? How might we tie pay to performance in order to achieve maximum benefit?

Once the domain of executives and key employees, variable-pay plans are now being designed to work at lower levels, as organizations seek to motivate their staffs to produce better bottom-line results in tough times.

Variable pay, also known as incentive pay, refers to pay earned beyond an employee’s normal weekly, monthly or annual salary. Not a guarantee, it is paid out only if an individual or team achieves a goal. Typically these goals relate to profit, sales growth, productivity or customer service improvement.

But does variable pay work? It depends on several factors, including the company’s culture and the plan’s design. When properly structured, variable pay allows a company to reward employees for attaining successful results, but also controls compensation expenses during periods when results are not attained.

Many high achievers, eager to be part of a dynamic work environment, view variable pay as an important factor when choosing an employer. However, variable pay cannot fix poor management or employees’ problems related to mistrust or low morale.

So what can an organization do to ensure its pay programs are as effective as possible? First, the organization should determine why a variable-pay plan is necessary or desirable. Just because some employees have variable pay doesn’t mean they all should. Before beginning or continuing a variable plan, the employer should ask the following:

  • Do we know precisely what performance criteria create measurable success? Does the performance of the targeted employees relate directly to the bottom line, or at least contribute to it? If not, the incentive compensation won’t work.
  • In the competitive marketplace, how are employees at this level compensated? If similar employees at rival companies typically have 20 percent of their compensation at risk in a variable plan, failure to provide such a plan leaves your organization at a disadvantage. But if such plans are uncommon at this level, employees are unlikely to expect it.
  • Does variable compensation fit with our corporate culture?Companies that implement successful plans have a well-established culture where employees have been trained to focus on results. Variable pay won’t work in a culture where employees have never been expected to perform based on measured results. In addition – except for broad profit-sharing plans -- not all positions make a credible case for variable pay. Incentive pay isn’t likely to work well for credit analysts, for example, or administrative staffers. And simply offering variable pay won’t shift a culture; organizations first must develop some acceptance for compensation practices targeted to achieving specific results.
  • How will variable pay be accrued for and funded? It sounds obvious, but this question is often overlooked. Once these issues are addressed and an organization decides to propose a variable-compensation plan, the following guidelines should be considered:
  • Good variable-pay plans work. If you financially motivate executives and employees to focus on certain activities or results, they will do that. While many studies have shown that pay is not a perfect motivator or, for some, the best motivator, financial incentives do shape behavior. Without well-chosen goals, employees will focus on and accomplish the wrong things.
  • Good variable-pay plans are not complex. Because layering in multi-factor goals is possible and tempting, some plans become monuments to spreadsheets and financial analysis wizards – and therefore are doomed to failure. Plans should be pragmatic – measurable, easily understandable and applicable to a broad number of participants. Plans should focus on the few absolutely key measures of performance. Omit behavioral and ancillary goals that can be reported through annual goal-setting or performance-appraisal activities.
  • Good variable-pay plans don’t create work. Don’t begin measuring an activity just so it can be included in a variable-pay plan. If the activity wasn’t important to measure before the plan was established, it’s not important enough to put in the plan. Use financial and other tested measures instead.
  • Good variable-pay plans are communicated and updated frequently. Unproductive as it may seem, not all organizations involve employees in setting goals – or even tell employees what the goals are -- thereby missing the point altogether. Employees will have the best shot at meeting goals if the goals are simple and understandable, and employees are given frequent feedback on how they’re doing.
  • Good variable-pay plans involve attainable goals. While pushing employees to reach for the sky may be admirable, deliberately setting goals that prove to be impossible – or failing to provide the necessary tools and resources -- is likely to sabotage most variable-pay plans.

Guidelines aside, it’s essential to remember that no compensation plan is perfect – because it can’t predict how the world may change. In 2001, many organizations awarded incentive pay even when goals were missed because of the devastating loss of business after the Sept. 11 terrorist attacks. Variable compensation should be viewed as a management tool that provides companies flexibility while sending a powerful message to employees about the importance of achieving goals. Current economic conditions make variable pay an important option to explore when looking for ways to control compensation costs.

Paula Dolan, director of the Compensation Programs Division at HR Works, assisted with this article.


© HR Works, Inc.

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HR Works, Inc., headquartered at 200 WillowBrook Office Park in Fairport (Rochester), New York, with an office in East Syracuse, is a human resource management outsourcing and consulting firm serving clients throughout the United States. HR Works provides scalable strategic human resource management and consulting services, including: affirmative action programs; benefits administration outsourcing; HRIS self-service technology; full-time, part-time and interim on-site HR managers; HR audits; legally reviewed employee handbooks and supervisor manuals; talent management and recruiting services; and training of managers and HR professionals.