Recently I spoke to 30 American CEOs and direct reports at small or mid-size companies. They are members of Vistage, a peer mentoring membership organization. Their companies do not have compensation experts on staff.
My topic–smart incentives for 2021–was in response to a question many of them had raised in their prior meetings: how should bonuses work?
I brought them through the business and psychological principles underpinning incentive design, and I then focused on critical considerations for 2021.
I don’t know it all, to be sure. I have designed many incentive plans, some lasting only 1 year and some in operation globally for more than 25 years. Incentive schemes I’ve been involved with have rewarded hundreds of thousands of people with a spend of perhaps half a billion USD over the years. I have seen what works and what doesn’t, I’ve made adjustments and seen how they work, etc. I am still learning as each situation is a unique challenge. As of this writing, I am actively involved with incentive design for a company with 2 employees (CEO and COO) and a company with over 50,000 employees.
For 2021, the key priority for many organizations will be ensuring bonus costs are strongly correlated with financial results. Simply put, if your company takes a loss in 2021, you should not pay bonuses. If you do well, you should. If 2021 is wildly successful, bonuses should be exciting.
Practices among smaller employers range from very simple to moderately complex bonuses. They tend to be highly discretionary, and focused on affordability as determined at year-end. The use of incentives which are pre-determined formulas communicated transparently, is rare.
The diagram below shows the general correlation between bonus costs and financial results found through some common approaches.
The black line represents payment of bonuses each year that have no linkage (correlation) to financial results. This could be considered an entitlement to employees, who receive bonuses regardless of the company’s financial performance. Some employers have a paternalistic philosophy, believing they have an obligation to pay bonuses each year, even bad years. Other employers get here by paying lower bonuses in a rare bad year but the employees complain (they have never not gotten their bonuses), and so management chooses to avoid drama and just pay bonuses going forward without any variability.
Entitlement bonuses are also paid where they are in fact a legal entitlement, i.e. in countries where the government dictates payment of a 13th month, for which there is no apparent rationale beyond perhaps political motives. This is an additional cost equal to 8.33% of annual salaries, in return for nothing of value to customers or owners/shareholders.
Employers wishing to avoid this zero-ROI cost can eliminate this payroll cost by scaling back salary increases, perhaps for a year or two (or three.) But this will be a big negative for employees. I would suggest such employers phase in variable pay to replace lost raises. For example, in lieu of 3% salary increases for staff, introduce an annual incentive plan that will pay 5% of annual salaries for on-target financial performance. This a good deal for employees and for the company. Don’t replace a 3% raise with a 3% bonus, which is a bad deal: a dollar of fixed pay is worth more than a dollar of variable pay, roughly by a 1:1.5 ratio. Two clients of mine have replaced every dollar of reduced salary increases with $1.50 of increased variable pay opportunity.
Performance Ratings and KPIs
Linking bonuses to individual performance ratings that include personal KPI achievement is a good step toward strengthening the correlation between bonus costs and financial performance, although the overall cost of bonuses will tend to be higher for many people and lower for only a few. This is because in most organisations, using a scale of 1 to 5 (5 being “far exceeds expectations” and 3 being meets expectations), about 75% of employees will get a 3 or 4 rating, and another 15% will get 5 ratings. This leaves only a small number getting a 2 rating. Those getting a 1 rating are already getting written warnings from HR.
Typically, companies that link bonuses to performance ratings will set the bonus “multiplier” to 1.0 for those getting a “3-meets expectations” rating. This means that if the “standard” or on-target bonus is 10% of salary, the employee will receive 10% of salary x 1.0, i.e. 10% of salary. The multiplier for getting a 4 rating might be 1.2 or 1.25, or possibly 1.5. The multiplier for a 5 rating would normally be 1.5 to 2.0. Multipliers are normally fixed, with no managerial discretion, although many employers allow managers some discretion to adjust bonuses up or down a bit, within a set range of multipliers (for example, for a 3 rating, a manager can set the multiplier anywhere from 0.8 to 1.2.)
Linking bonuses to performance rating only is a step in the right direction, and it sends an important message to people. But there will still be little to no correlation between overall bonus cost and financial results. If performance ratings include a KPI component, it helps, but just a little.
Until now, the examples given must still pay large bonuses, even if company takes a loss or breaks even, i.e. net income of zero. This makes no sense, especially in uncertain times. One way to address these downside or worst-case scenarios would be to use a funding gate (or hurdle or trigger.) It’s very simple: state that if earnings are zero or negative, there will be no bonuses, and that if earnings are below budget/target, they will be reduced by 20% or 50% (for example) as long as you at least achieved a threshold of x% of your earnings target. The threshold for bonus funding should be the level of earnings below which you feel bonuses were not earned.
In the diagram above shows a dotted green line. This represents bonuses for those in a poor performing business unit, even if the overall company performance is quite good.
EBIT and Ratings
The correlation can be strengthened significantly by using KPIs, i.e. key performance indicators as a separate performance measure apart from individual performance ratings. The most popular KPI used by multinational companies is EBIT, earnings before interest and taxes, or operating profit. Many organisations set KPIs as part of their annual business planning process:
- Increase net revenue by 8%
- Increase earnings before interest and taxes by 10%
- Achieve customer net promoter score of 85
- Increase customer retention rate to 90%
KPIs are usually measurable “SMART” goals, and are therefore easy to use for incentive purposes. KPIs can be a component of a person’s overall performance rating, or KPIs can be set on a company, country, business unit or functional/department level.
The bonus could work like this:
Half the bonus–50%–is linked to individual performance rating that has no KPI linkage. The other half is linked to the level of achievement one or more KPIs. Example:
Total on-target bonus is 10% of annual salary
50% of this (5% of salary) is linked to my rating, using multipliers;
25% of my bonus is linked to achievement of revenue goals
25% is linked to EBIT achievement
If my rating is a 3 and we achieve 100% of revenue and EBIT goals, I get my 10% bonus. (5% for individual performance and 5% for company KPI results.)
If my rating is a 4, then I get the 5% bonus for company KPI results, but my individual performance payout might be 6% (5% x 1.2 multiplier), for a total of 11%.
Profit sharing is an incentive that pays equal shares of a profit sharing pool to all eligible employees. The payments can be the same dollar amount or the same percent of annual salary for all employees. The pool is normally a pre-defined and transparently pre-communicated percentage of profits, or profits above a threshold.
Watch the video above to learn more about profit sharing.
The underlying principle of business is value for money. Why pay large sums of money for absolutely nothing, or for very little?
Far better to pay no bonuses, and save jobs and save the company’s future, than to pay entitlement bonuses, with no linkage to financial results, risking both jobs and business health.
Each situation is unique. I am not giving specific advice here. If you want my specific advice, contact me at firstname.lastname@example.org.
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