Variable Pay Plans: Selecting the Right Approach
James T. Stodd, MS, SPHR, SHRM-SCP
December 10, 2015
What we are seeing today may well be the advent of a new era in employee compensation. In this era, the continuity and security associated with compounding salary increases is being willingly (or not so willingly) exchanged for more aggressive contingency pay arrangements, where both employers and employees can realize a clear “win/win.”
Many sources(1) are again projecting 2015/2016 pay increases to remain modest (including those for most managers and executives) while variable pay programs continue to increase in both frequency and potency. These sources indicate that salary increases during the next year will average around 3.0{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7} for all levels of employees, and are likely to range between 0.7{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7} and 4.6{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7} based upon performance. Variable pay, however, is forecasted to average 12.7{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7} or more of base pay during 2015/2016, with almost 90{56cd7e6aa1a9e8b37b474966a37e40db52ca317c7a8b7c79ab3d6ff71decf1c7} of business organizations offering some form of variable pay program(2).
Employers, of course, tend to favor variable pay programs because they enable them to reward performance without growing their fixed costs. And as far as employee engagement is concerned, a recent study conducted by Aon-Hewitt1 indicates that employees not only want to be included in those variable pay programs, they feel they actually have more influence over the size of their bonus/incentive payments than they do the size of their salary increases. This is particularly the case given the multi-factor complexity, chronic subjectivity, and declining popularity of the typical performance review process. Variable pay programs, however, tend to be more concrete and specific about what gets rewarded, and how that is measured.
When it comes to “variable” or “contingency” pay programs, there is no shortage of options (or possible combination of options) for employers to select from. These include individual plans that focus on designated accomplishments (e.g., MBO programs) as well as metric-driven plans that reward sustained and incremental productivity (e.g., piece-rate, sales commission and individual productivity plans). Other options include providing rewards to all members of successful work groups for achieving either metric-driven goals or designated accomplishments that require the engagement of all members of the work group.
Finally, there is a whole class of variable pay options that reward individuals, work groups, or perhaps even larger sections of the whole organization for achieving outcomes that are aligned with the interests of the firm’s owners. These include group incentive plans based upon attainment of broad strategic objectives (often based upon revenue growth and profitability), gain-sharing plans that reward innovation and efficiency, and equity-based plans that reward efforts contributing to stockholder value (e.g., ESOP’s, stock options, stock appreciation rights, and phantom stock programs).
With so many options available, a difficult question often becomes “what type(s) of plan should I use?” In considering the options and making those decisions, here are some valuable points to consider:
1. Determine the behaviors (or outcomes) that you most want to encourage, reinforce and reward. It isn’t prudent to reward people simply on the basis of how the chips may fall, or with the expectation they will excel at everything. Rather, good variable pay programs are “instructive” concerning the behaviors and outcomes that an employer is advocating and willing to reward.
2. Select the program, or a combination of programs, that would best reward those behaviors. Remember, good variable pay programs embrace behavior that is consistent with the desired culture.
3. Conversely, be sure your approach does not undermine the desired behavior or culture! This may sound like a rather obvious “duh.” However, it is very common for organizations to say they value one thing, then turn around and reward something quite different. So, much so, that Professor Steven Kerr wrote a classic article some years ago illustrating how common it is for smart people, and smart organizations, to reward behaviors that they in fact want to discourage, while the desired behavior is not rewarded at all3.
4. Ensure the approach selected “supplements” your base pay and salary administration strategy, and does not “replicate” rewarding the same behavior. Again, that may sound rather obvious, but I’ve seen a number of organizations use essentially the same performance appraisal information for awarding bonuses and incentive payments as they use for determining merit increases. That’s simply doubling-down on the same thing, and does not make much sense.
5. Select a reward strategy that is “affordable”. When in doubt, modesty works best since its always better to completely fulfill a modest expectation than to fall short of meeting a grandiose expectation.
6. Consider using a “multi-level” approach to spread the inducements across a number of desired behaviors. For instance, in addition to using a merit review that covers the full breadth and scope of an employee’s duties and responsibilities, an employer may choose to supplement that merit increase with an incentive payment based principally on group outcomes. If it chooses, that employer can also weight that incentive payment based upon how the employee performs on individual assignments critical to the group’s collective performance.
7. Finally, guard against overlap! There is no sense in rewarding the same thing multiple times, and in multiple ways, while letting other desired behaviors go unaddressed.
1 Stephen Miller, Short-Term Incentives Are Playing Larger Retention Role; SHRM Online, August 11, 2015
2 Stephen Miller, Compensation Budgets Favor Variable Over Fixed Pay; SHRM Online, September 2, 2015
3 Steven Kerr, On the Folly of Rewarding A While Hoping for B, Academy of Management Journal; Dec 1975; 18, 000004; ABI/INFORM Global, p. 769.