Managing reward: Variable pay
Section four of the Personnel Today Management Resources one stop guide on managing reward, covering variable pay, including: annual bonuses and bonus plan design; profit-sharing plans; sales commission schemes; allowances; and deferred bonus plans. Other sections .
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Variable pay can take many different forms but the most straightforward classification is to define and differentiate based on time frame and purpose. For the sake of clarity, this section identifies the following forms of variable pay which may be applied on either a team or individual basis:
Annual bonus or 'incentive'
Profit sharing schemes
Sales commission
Allowances and premia (eg, overtime)
Deferred bonus
With the perceived decline in organisational certainties, ever present change and the ups and downs of the business cycle, variable pay systems have attracted greater management interest in recent years. The attraction of being able to 'flex' employment spend in line with the fortunes of the business has become a holy grail for business leaders to pursue, especially in highly cyclical sectors, such as airlines, financial services or the hospitality sector.
Annual bonus
An annual bonus (or short-term incentive as sometimes called) is an opportunity for employees to earn additional annual pay contingent on the achievement of (usually) predetermined financial and/or personal goals. While annual bonus opportunities remain predominantly a feature of management job roles, bonus payments are being cascaded down the organisational hierarchy (at a fairly rapid pace in some sectors) such that more and more organisations are establishing all-employee variable pay schemes. Where these all-employee schemes cross the line into profit sharing plans (see below) is a debatable point and depends in large part on the internal branding of variable pay schemes.
An example of a typical management bonus plan is illustrated below. In this example it is a management bonus which creates a maximum opportunity of 50 per cent of base salary with two-thirds of the bonus opportunity driven by financial attainment, the balance determined by personal contributions:
Key considerations in designing a bonus plan include:
Which categories of employee does the organisation wish/need to be eligible to participate in the bonus plan?
What proportion of bonus earnings should be determined by financial versus personal objectives?
What dependencies should exist, eg, to ensure ability to pay, should personal objectives pay out only if a certain financial attainment threshold is reached?
Are the bonus plan rules and contracts of employment written in a manner which minimises the likelihood of the bonus being regarded as contractual?
Which financial measures are appropriate (eg, profit, cash flow, EVA, sales) and how should these differ by different parts of the business or job level?
What can the business afford to assign to bonus relative to other stakeholders (eg, shareholder dividends or investment requirements)?
Does the plan deliver 'line of sight' ie, can the plan participant clearly make the connection between their behaviour and contribution and the pay out from the plan?
Are the performance goals SMART (Specific, Measurable, Achievable, Realisable and Time-based)?
How will the bonus budget or pool be calculated and accrued?
Is this plan truly able to incentivise future behaviour or is it paying out 'after the fact'?
How objective are the performance criteria and assessment mechanisms? (The more quantitative and/or objective the plan formula the lower the organisation's exposure to discrimination or equal pay claims)
Has the plan been designed to optimise tax planning opportunities for both the organisation and the employee?
Should the calibration of payout against performance be subject to a cap, or is the organisation prepared to make bonus payments without limitation in times of exceptional financial performance?
What is the most appropriate timing (and frequency) of bonus payments, eg, against alignment with the financial year?
How frequent should bonus payments be made?
Is the performance management system good enough to reliably and consistently assess individual or team based contribution?
How straight-forward is the bonus plan to explain and administer?
In comparison to market practice, is this a competitive bonus opportunity?
Is there broad based agreement (eg, finance function, line and HR) about the performance metrics to be used in this bonus plan?
How challenging or realistic is the budget compared to the proposed bonus targets?
Do the plan rules deal adequately with contingencies or foreseeable events? (eg, disputes over the true level of performance, transfers between business units, payment entitlement during maternity leave, long-term sickness or in the event of redundancy or retirement)
Profit-sharing plans
In their simplest form a profit-sharing plan distributes a proportion of pre-tax profit to employees. Famously, the John Lewis Partnership is an example of an organisation which distributes a proportion of its profits annually to its employees, or 'partners'.
Profit may be distributed on equal terms ie, all employees receive the same amount of cash (or shares in some cases) regardless of their level or length of service in the organisation. Alternatively, higher amounts of profit share may be paid to more senior employees because their position in the organisation enables them to significantly influence the overall profitability of the business. It could also be the case that a profit pool is determined by reference to the overall profit achieved, but the distribution of that profit share is mediated through an assessment of individual or team performance.
Although the mainstream approach is an annual distribution of cash in the form of profit sharing bonus some organisations deploy similar approaches against the achievement of a single goal or series of performance targets. For example, a fund management company might make a distribution to all employees on equal terms upon attainment of a certain target value of assets under management. The achievement of such a target may take several years to reach but the financial consequences or leaving (especially as the target level approaches) creates retention value for the organisation.
Sales commission schemes
The guiding principles of bonus plan design apply equally to sales commission or sales incentive plans. However, the issues to be addressed are often much more complex and greater skill is required in crafting effective sales incentive solutions. Design of sales incentives needs to take into consideration three essential factors, for instance, job role - sales manager incentives need to be a mixture of management and perhaps team sales targets, whereas a sales representative may be bonused on individual sales targets. The above example illustrates this point in more detail.
Market or 'channel' strategy - The different demands of different markets or sales channels will necessitate different forms of incentive plan if they are to be effective at incentivising appropriate behaviour and rewarding the right sort of results. A typical approach which shows different gearing between fixed and variable pay (dependent on market) is set out below.
Payment frequency will generally be more regular with sales incentives than management bonuses. This is because of the need to link reward closely to results and create proximity between the sale and the commission attributable to that sale. Such action tends to reinforce appropriate sales behaviour rather better than systems of deferred gratification. It is common for sales incentives to be paid monthly and/or quarterly, perhaps with a proportion retained or deferred until the end of the financial year. This latter approach assists retention of sales personnel and limits the risk of overpaying if, say, stellar success in the first quarter is not matched by high performance in the remainder of the year.
Allowances
A more traditional form of variable pay is the use of premium pay or allowances to reflect either local or regional market conditions (eg, the London Weighting Allowance) or to compensate for temporary increases in workload, required hours or availability.
Commonly used forms of allowance and premia include:
On-call allowances - to ensure the employee is available for work in emergencies or to meet operating contingencies (eg, a hospital doctor or IT support person)
Shift allowance - unsocial hours payments, often expressed as a percentage of salary with higher percentages paid for night work or rotating rosters (eg, a regular pattern of early, late and night shifts would be paid at a higher rate of allowance than that applied to permanent day workers)
Location allowance - in effect a market premium based on that location or region of the country
Attendance allowance - a form of bonus 'at risk', whereby the bonus or allowance is forfeited if the employee fails to attend work due to sickness or any other form of authorised or unauthorised absence
Piecework payments - based on the number of units produced by an individual worker or their overall team.
Deferred bonus plans
During the 1990s there was a slow, but discernible, advance in the use of deferred bonus schemes outside of their traditional heartlands of financial services and UK subsidiaries of US corporations. With most bonus schemes there is only a relatively short delay between the end of the performance period (the duration of time over which bonus is earned) and the date on which any bonus is paid. This will usually be for no more than administrative reasons, eg, a calendar year bonus is not paid until February of the year following because it requires a few weeks to finalise the performance numbers for the previous year end.
With deferred bonus schemes there is a period of 'deferral', usually of at least one year, between the time the bonus is earned and the time it is received. For example, it is common practice in the financial services sector for bonuses of more than, say, £100,000 to have the top slice deferred for 12 months. In this case, a bonus of £150,000 earned against performance in the year would result in £100,000 being paid out a month or two after the end of the performance period, the balance of £50,000 being paid out 12 months later. The logic behind this approach is that something is 'left on the table' if a key contributor resigns from the organisation. To ensure that the deferred element of the bonus does not become taxable before receipt, the deferred element remains 'at risk' until the end of the deferral period. Interest may, however, be paid on the deferred sum, or, the employee may be permitted to make their wishes known to a trustee who then invests the deferred sum in unit trusts or another asset class.The increasing popularity of deferred bonuses in executive reward is often associated with cash or share 'matching' of the bonus sum deferred. In return for deferring a cash bonus the executive is awarded a certain value of shares determined by a matching formula, such as 1:1, whereby every £1,000 of bonus deferred receives an award of shares worth £1,000 at the end of the deferral period. In those executive schemes which integrate a proportion of annual bonus into a matching vehicle the deferral period will often be three years rather than 12 months. This combination plan may be referred to as a long-term incentive plan (LTIP).
From an international perspective, deferral plans most commonly arise in the US where a (non-qualified) deferred compensation plan will be offered as an executive benefit. This permits an executive to defer bonus or sacrifice salary into a deferral vehicle from which they draw down income in retirement. The advantages of a 'deferred compensation plan' are the belief that average tax rates in retirement will be lower than those experienced during employment and the fact that investment returns are earned on the gross sum deferred. The potential disadvantages are that average tax rates may not be lower, the long-term tax risk and the fact that the executives may subsequently find they now have need of cash which is now somewhat out of reach.
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1. Remember the design is as good as your understanding of the business 2. Keep the plan simple to administer and straightforward to understand 3. Always ensure 'line of sight' (incentivise things employees can influence) 4. Make sure goals are stretching, but achievable 5. Be clear about implications of any split between personal and financial goals 6. Establish clear agreements between line, HR and finance pre-launch 7. Stress test your scenario modelling before communicating the plan |
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Bonus plan - 2005 financial year |
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Financial gateway |
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No payment will be made for the achievement of financial objectives unless cashflow is at least 95% of the budgeted target |
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Financial targets: calculation table |
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Operation profit achievement |
Incentive earnings |
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‹ 95 |
nil |
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95 |
10 |
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96 |
12 |
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97 |
14 |
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98 |
16 |
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99 |
18 |
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100 |
20 |
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101 |
25 |
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102 |
30 |
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103 |
35 |
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For achievement between whole percentage points a straight line calculation formula will be applied |
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Personal 'SMART' objectives (what we need to do to achieve our business goals) |
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Personal objectives must be set by 31 January 2005 Examples might include:
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Sales commission schemes |
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Senior/Sales Executive Reports to Sales Manager |
100% of activity is sales oriented |
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Prime on sales for a territory or panel of accounts |
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Generates new business |
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Manages ongoing relationships |
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Conducts sales promotion and product briefings/launches |
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Senior/Sales Managers Reports to Head of Sales |
40% to 50% on sales with balance on management of team/ function/ and group sales |
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Manages a sales team responsible for part of total sales effort |
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Similar to head of sales but on smaller scale/narrower focus |
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Personally maintains key accounts |
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Sales Directors/Head of Sales Reports to Exec Director/country head. |
10% to 30% on sales, balance on leadership/ strategy/ budgets/ and group sales |
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Manages total sales and in marketing effort for a business, a channel or a country |
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Defines long-term strategy |
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Leads relationship management re key/largest clients |
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Has an external relations role |
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Section two: Job evaluation and grading Section three: Base pay and salary structures Section four: Variable pay Section eight: International assignments Section ten: Resources/ jargon buster
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