- Blog post
Incentive compensation plans and the merit matrix
Design in incentive compensation plans is crucial to effective optimum performance
The matrix approach in incentive compensation plans is an old reward scheme with grids. In this situation, they’re paying on two measures, profit and growth.
In that situation, the grid payout is anywhere from 5% in the lower left hand corner(lowest performing) up to 80% in the upper top corner(top performing), is that typical step function grip.
If you go back and start plotting actual performance, what you see is, in many times, the actual payout, the actual performance as opposed to being a smooth line, as a normal distribution would suggest, what you often have, is people that produce in the lower left hand corners.
And basically, they do enough just to get to the next level in the incentive compensation plans. Either the next profit level on the right or the next step function up in terms of growth, but if you cluster the actual results, you get a huge amount of clustering in the lower left hand corner.
Now, if they’re below the payout line grid, they’re no help. They stop trying. If they get all the way to the upper right hand corner, the last payout, it’s just like the cap. They also stop trying. They reach a point of no return.
Problems with the merit matrix in incentive compensation plans
What these kind of grids result in is spikes and volatility and inability to manage the portfolio, to renegotiate the targets and again, I challenge you to analyze your existing performance systems and your incentive comp to begin to detect the kind of behavior you’re achieving, because the behavior is a direct result of your process.
If people learned a long time ago that incentive compensation plans are a game and the game is about understanding payouts. And they are highly inventive in terms of understanding what they get paid on and then responding to that, because once you’ve declared it as a gain, they’re not intrinsically motivated anymore, they’re extrinsically motivated and everybody likes to win the game.
So, don’t be surprised when you put these systems here if you get the behavior that the gain suggests that you want.
Three key points about incentive compensation plans
Almost three things is really — incentive plans, the design can often destroy, because either it discourages innovation, because I don’t want to have to be pushed beyond that. It limits the adaptability of the response time. And in many cases, it undermines teamwork.
Now, your company can move on to the talking about what we can do about this. We’ve got those problems, what can we do to correct them. We submit that Beyond Budget and there’s seven principles of incentive compensation that we can focus on that will help us overcome this.
Edited remarks from the Rapid Learning Institute webinar: “How to Avoid Incentive Pay Plan Disasters” by Steve Player