Over funding the incentive compensation plan can be a problem for the bottom line

by on June 17, 2009 · 0 Comment POSTED IN: HR Info Center

Under funding the incentive compensation plan will destroy your recruiting advantage

The example I’m going to give shows the balancing act necessary with incentive compensation systems, we’re going to look at long-term incentives and stock options. But the same concept applies all the way down through the organization in terms of there’s this high wire act between as a business owner, “The less I pay my employees, the more money theoretically goes to profit. The more money I pay my employees all else equal, that comes out of my profit.”

From a staffing perspective, you need an attractive incentive compensation plan so that you can attract and retain quality employees. Potentially, you want to create incentives that encourage employees to achieve better results. But what’s that balancing act when we do achieve better results between what do employees get? What does ownership get?

You can also end up with a disconnect. Again, you see this oftentimes in executive goals between long-term incentives and short-term incentives. I think that this is true at just about every publicly traded organization with very, very few exceptions.

Here, you have these large companies, global Fortune 500 companies. But they aren’t focused on what are their results going to be three years from now. They’re focused on, “What are my results going to be this quarter because that’s going to have a direct impact on my stock price and I’ll worry about next quarter, next quarter. I’ll worry about next year, next year.”

Timing goals and rewards in an incentive compensation plan
It’s very important that there be a combination particularly for senior leadership of short-term incentives that have them focused on hitting those quarterly goals, hitting those annual goals. But you don’t want leadership doing that at the expense of the long-term success of the company.

For this reason, it’s critically important that senior leadership have some form of long-term incentive plan. Oftentimes in a publicly traded environment, that will be stock options, restricted stock. There’s a strong trend towards these days. You can do the same thing in a privately traded environment with stock appreciation rights, phantom stocks — things along those lines.

So, when we look at the balance between short-term and long-term goals for executives but also look at the balance between market competitive pay versus reward to the shareholders, we need to understand what is the market value for compensation in terms of – and really, I would identify that as three critical points — base salary, total cash compensation which would be base salary plus bonus, but then also, total compensation which would look at a component of long-term incentives as well.

Link your incentive compensation plan to market data
Our incentives for good performance should be linked to that market data meaning that if we perform at the 50th percentile of the market, we may design our bonuses to pay out at the 50th percentile of the market.

If we perform at the 75th percentile of the market, it should be structured such that our incentives pay out higher than the 50%. We don’t want to – it’s not fair to ask the employees to perform at an above market level but we’re going to pay you below market or at market. So, there needs to be a connection there between market performance and market compensation.

Oftentimes, this will be done and we can get into the whole complexity. That’s kind of another presentation. But this will be done by looking at different percentiles in the market. So oftentimes, compensation data will be reported at the 25th percentile, the 50th percentile, also known as the median, and the 75th percentiles of the market.

Edited remarks from the Rapid Learning Institute webinar: Incentive Pay Plan Blunders That Can Cost You a Fortune by Ed Rataj

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