Do incentive compensation plans distort performance?

by on June 25, 2009 · 0 Comment POSTED IN: HR Info Center

Perverse incentives in incentive compensation plans

In many cases with incentive compensation plans, you’ll have a target representing the bull’s eye in the middle and say, that’s 100% of the compensation. Then you’ll have a threshold target where if you get 80% compensation of the target, it will cap out at some level, typically 120% of the target. So, this is what we’ll call an 80/120 plan.

Now, the problem with those kinds of incentive compensation plans is it leads to distorted behavior.

Below target in incentive compensation plans
If you look down to the low zone, below 80% level of the target, there are people at 70, 75%. They can’t see how there going to make 80%. These people are not motivated to push on and try to reach the goal, because once they understand that, I might not make it there, then they begin to hold back profits. They don’t optimize, but they begin to slow down and moonwalk a little bit.

In that situation, what they’re doing is they’re giving up on this year in hopes of negotiating a lower target for the incentive compensation plans next year.

Now, there is some motivation that they will try to do enough to make sure that they don’t get fired. Beyond that, you, basically, have incentive compensation plans that are working against themselves.

Activity doesn’t equal prosperity all the time

If a person hits in the 80-100 range they are in the bonus pay-out zone, you see a behavior pulling forward profits. People try to collect as many carrots(bonus dollars) as they can.

The problem with this behavior in incentive compensation plans is it distorts the normal flow of business.

In a factory we can minimize cost and maximize efficiency if we have a level load. But in this situation, we’re pulling everything forward, so we’re dramatically trying to make sure we can book performance results this year. In many cases, it drains the future pipeline, creates a business spike and unnecessary cost, but yet, that’s what often happens.

Incentive compensation plans and performance at the bonus cap.
In the cap area, where a person’s individual performance has exceeded the upper performance limits of the incentive compensation plans, the problem happens again, we start moon walking again.

Once we — if you believe carrot/stick theory, extrinsic motivation, once I get out of the pay-out zone, I go above the cap, then everybody starts holding back. They start trying to flatten everything up, because I don’t want to not get paid for what I’m doing. And hey, if I get up higher the next year’s target will be higher. So, in that case, they begin to moonwalk again.

And this is a typical example of some of the problems that you can run into.

Edited remarks from the Rapid Learning Institute webinar: “How to Avoid Incentive Pay Plan Disasters” by Steve Player

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