Three Principles to Effective Incentive Compensation Plans

Bad Incentive Compensation Plans Get Companies In Trouble

The failure to design effective incentive compensation plans hinders a company’s employee compensation. There are three general principles for getting the absolute most that you can from incentive compensation plans or the highest return on investment for the compensation dollars you spend.

Even in the compensation world, it’s up to companies to figure out what to pay relative to the market. In many respects, they pay what they can afford. But try to set up a system so they can get the most for the dollars that they spend on incentive compensation plans.

1. Operate with as few people as possible. You know, I understand you need to have people in order to make money and no one has really come up with a good reason why everything in a business doesn’t eventually boil down to the people side of the equation. But people are expensive. It’s no secret why companies want to reduce expenses. A recession or bad economic times for the company or just the economy in general, they start reaching for the red button that essentially terminates people or lays people off because people are expensive. So, operate at least for the company with as few people as possible.
2. Number two though, provide better than average pay opportunity for the people that you do have. And by that I mean – and I choose the word opportunity carefully here. I don’t necessarily say that you need to pay them higher but at least provide them the opportunity to make better than average pay even if your – regardless of what the market might say in terms of what the 50th percentile or median or average pay rates are in the marketplace. If you’re going to operate with as few people possible, provide them with better opportunity. If you’re able to attract truly exceptional people to your organization, it’s been proven by research that exceptional people can do almost twice the work as an average employee would be able to do.

   And you may have to pay 30% higher than what the going – the average market rate is to attract and retain that individual. It seems like a good return on your investment in incentive compensation plans, even if you’re only able to attract good people. Good people can do about 1.5 times what an average employee can do. And you may have to pay 15% to 20% higher to attract and retain good people. So, operate with a few people but provide your people with the opportunity to earn additional compensation on the upside. It will give you also the opportunity to attract and retain more good and exceptional people.

3. The third principle is to put as much of your total incentive compensation plans in variable expense as you can. And there are some limits on how far you can go on this. So, what I mean by that is the total compensation package for an average employee, we want to put as much into variable expense which consists of bonuses and stock for example. The value of these kinds of compensation components actually vary based on the company’s and individual performance. And if the individual or company performance is not there, we’re not saddled with that expense.

Fixed expense are base salaries. And we hardly ever reduce anybody’s salary. Even in bad times, we don’t reduce salaries even though there are examples of whole companies taking 10% pay cuts but it actually doesn’t happen that often. So, try to put as much as you can in variable expense. And bear in mind the type of people that you attract to high variable incentive compensation plans. You actually are attracting more risk taking types of individuals. So, you may even want to vary this from job to job. But it’s to the company’s advantage to put as much as you possibly can into variable expense as opposed to fixed expense when developing incentive compensation plans.

Edited Remarks from “The Seven Deadly Sins of Employee Compensation Plans (and How to Fix Them)” by Rick Oliveri