Weighing Pay Incentives

Incentive plans should motivate employees to perform at a higher level, not encourage them to engage in questionable behavior.

There is an old story of a volunteer fire department that offered its firefighters incentives for responding to emergencies, only to see one of its members turn to arson in an effort to increase his incentive payout. Whether true or not, the story highlights an underlying concern among HR executives whenever they introduce a new incentive plan or modify an existing one: Will the plan yield better employee performance? Or, will it unintentionally encourage inappropriate behavior?

As more companies look for new ways to pay for performance and to extend incentive programs beyond the senior management ranks, these questions become ever more important.

Incentives that are administered effectively are useful tools for companies that want to encourage higher levels of performance from employees without increasing the fixed cost of base pay.

“When salary increases are running 3 percent to 4 percent, it can be difficult to differentiate between performers,” says Steven Gross, rewards practice leader for Mercer HR Consulting in Philadelphia. As a result, a growing number of employers are adopting incentive plans to help reward top performers. According to the 2006 WorldatWork Salary Budget Survey, 79 percent of the nearly 2,800 companies that responded are using some form of variable pay, up from 66 percent in 2001. These numbers do not include sales force incentives.

However, companies that don’t carefully devise and execute their incentive plans run the risk of including disincentives that can jeopardize high-quality performance and adversely affect the company, its employees and its customers.

Rewarding Quality Work

Avoiding subpar work was of paramount importance when MarineMax Inc., a recreational boat dealer based in Clearwater, Fla., rolled out its incentive plan for service technicians. The company’s incentive plan pays service technicians a flat rate for each service or repair they perform based on the manufacturers’ standard for the amount of time each type of job should take.

For example, if the manufacturer’s standard for a boat propeller replacement is three hours, the technician will be paid for three hours of work for that repair job no matter how long it actually takes him to do the job. This way, skilled and efficient technicians have an incentive to complete their work as quickly as possible. If an efficient technician is able to replace the propeller in two hours and 10 minutes, he saves 50 minutes that he can use for another repair. But if he takes three and a half hours to replace the propeller, his pay could be affected if he doesn’t catch up.

“Some technicians are so good that they can achieve 120 percent to 150 percent or even double the standard output” and, therefore, significantly increase their pay, says Jay Avelino, SPHR, vice president of team development.

Of course, without appropriate safeguards, this type of incentive plan can result in poor performance, with technicians rushing through repairs to maximize their incentive payout. To prevent that, MarineMax requires technicians to redo incomplete or improper repairs for no additional pay. “This makes sure they are penalized for shoddy work,” says Avelino. “If the work is done right the first time, it doesn’t come back.” Although it hasn’t been an issue for MarineMax, companies interested in implementing this sort of incentive must take care that any penalties for having to redo work do not bring employee pay below applicable minimum wage laws.

This checks and balances system is only one of several reasons why the MarineMax plan has achieved its desired results. In addition, the plan is closely tied to the company’s business goals, such as providing fast and reliable service to customers, and employees can see a clear link between better performance and higher incentive payouts.

Unfortunately, not every company’s incentive plan is as successful as MarineMax’s. The following suggestions can help employers craft an incentive plan that sets employees and the company up for success without incorporating disincentives that can reduce the plan’s effectiveness.

Laying the Groundwork

The first step in devising an effective incentive plan is to determine whether incentives are right for your company and your employees.

“It is important to dig deep and determine what the company really wants to accomplish before designing an incentive plan,” says D. Kevin Berchelmann, president of HR consultancy Triangle Performance LLC, in Spring, Texas. “It sounds simple, but it is important to articulate the ultimate goal of the incentive plan.” If the company is not able to articulate why it needs an incentive plan, it becomes more difficult to design a plan that will be successful.

The following actions can help ensure that employers don’t implement an incentive plan that is unnecessary or ineffective:

Involve employees. To get a sense of whether and what kind of incentives will help the company meet its goals, “It makes sense to get a few managers and employees together to discuss what the company wants to accomplish and how an incentive can support that,” says Berchelmann. “Line employees generally have a better view of how to do that than we give them credit for.”

In fact, this discussion could reveal problems that an incentive plan might not solve or might even make worse. For example, if employees are underperforming because of a skill or training deficiency or poor management, an incentive plan could simply exacerbate the situation as employees grow frustrated with their inability to earn a payout.

Moreover, not all individuals respond well to incentives and having a portion of their pay at risk. “Even when there is upside earning potential, the plan could end up demotivating employees who are afraid they will not earn enough money,” says Avelino. “If you are going to have pay at risk, make sure your employees will respond favorably to that.”

Find the right incentive payout. If employees do have an appetite for incentives and pay at risk, companies need to ensure that the size of the incentive is appropriate and motivating. “The incentive itself must be meaningful enough to have the desired motivational effect,” says Adrian Butler, vice president of human resources at Stamford, Conn.-based Thomson Learning, which provides education, training, reference and assessment solutions to organizations and higher education institutions.

The right amount for an incentive is likely to vary by situation. According to research conducted by Antonio Davila, a former professor at Stanford University’s Graduate School of Business, supervisors and product development managers in the United States and Europe responded best to bonuses of about 30 percent of their annual salary. However, in situations where a product is complex and involves technological and market uncertainty, the study found that optimal bonuses for this group were less than 30 percent of annual salary.

The rationale is that the lower bonus amount is enough to motivate creativity but not enough to tempt employees to ignore innovation or quality considerations in their desperation to secure more money. However, for relatively easy projects, the study found that bonuses of more than 30 percent can be effective for rewarding goals like getting a product to market or maximizing product functionality.

Establish a clear link between performance and payout. If incentives are to get individuals to change their behavior or improve their performance, employees must see a clear link between their efforts and their incentive payouts. “The power of an incentive is that it allows companies to say, ‘If you do this, you will get that,’ ” says Laura Sejen, practice director of strategic rewards with Watson Wyatt Worldwide in New York. “If companies don’t make that link strongly, they lose the power of the incentive.”

That is why incentive plan design should not fall solely on the shoulders of HR and compensation executives, says J. Mark Davis, managing principal of the Valitus Group Inc., an HR consulting firm based in Tustin, Calif. Davis suggests that companies involve senior executives and functional group leaders as a way to gain consensus on what the incentive plan is supposed to achieve.

“More often than not, companies implement incentives for competitive, rather than strategic, reasons,” he says. “It is important to discuss why the company needs to have incentives and what business objectives an incentive plan would support.” This cross-functional approach can also help ensure that the company adequately translates high-level strategic goals designed to guide the entire company or an operating unit into workable measures that departments, functional groups and individuals can understand and relate to.

“You could create a disconnect [between employee efforts and incentive payouts] if you are too driven by the spreadsheet side of things,” says Lane Transou, SPHR, manager of compensation, benefits and HRIS for Houston-based Global Industries, which provides construction and support services to the oil and gas industries. “Everything has to tie back to the goals so that people understand how their actions drive profit margins and other areas of financial performance.”

Keep it simple. “If a plan is over-engineered or over-complicated, it could end with a large number of measures and be too complicated overall,” says Butler. “If you keep the design simple, it will be easier for employees to see the link between what they have to do and what their payout will be and be able to do the math themselves. That is a great motivator.”

To avoid confusion, companies might consider limiting incentives to two or three measures at most, says Berchelmann. Too many measures can confuse employees and fragment their attention and efforts.

On the other hand, relying on a single measure can also be dangerous because there are no other measures to lend balance. For example, if a safety incentive rewards managers only for a reduction in the number of accidents, managers may simply stop reporting accidents. A better idea might be to measure the cost of each accident and the cost and duration of workers’ compensation claims.

Look Again

Even a successful incentive plan needs to be reviewed periodically to make sure it remains fresh and relevant. Incentive plans that remain unchanged for too long lose their power to motivate. Instead, they tend to be seen as entitlements by employees and, as such, are difficult to change. If a company allows its incentive plan to become static, “people could start to design their behaviors around the plan’s requirements rather than business needs,” says Transou.

Frequent evaluations of incentives also allow companies to make tweaks and other modifications if the plan is not delivering the intended results. “It’s a mistake to flip the switch on an incentive plan and let it run without evaluating its performance,” says Davis. “Too many companies end up with results that are not what they wanted.”

He points to a company that tended to focus very heavily on operational efficiency and designed an incentive plan to reflect that emphasis. However, once the incentive plan was up and running, the company realized that some of the operational decisions the incentive plan was rewarding were actually detrimental to its customer relationships.

“The company was not serving customers in the way that customers wanted because the incentive plan did not mesh with the quest for operational efficiency,” says Davis. “And it did not reward the cross-functional cooperation necessary to change the situation.”

From an employee relations standpoint, periodic reviews of the incentive plan can work in the company’s favor. “When employees know that the plan is constantly under review, they are likely to be more accepting of changes,” says Berchelmann. “It is when companies leave the plan unchanged for a year or two that they run into problems.”

While changes and adjustments are sometimes necessary, companies must strike a balance when it comes to tinkering with the plan. If companies change the plan too much and too frequently, individuals could become confused about priorities and what they need to do to meet their goals. Companies should be adjusting goals each year and reviewing overall plan design every three or four years, depending on how quickly business changes, says Sejen.

Show and Tell

“Companies can’t over-communicate about an incentive plan,” says Gross. “The more you share about the business, the more employees want to know. And the more they understand why the company is doing something, the more likely they are to accept it.”

Although communication should be broad-based, line managers should also be heavily involved in communicating with employees about the incentive plan on a daily basis. The goal, of course, is to make sure employees know and understand how the incentive works, including how goals are set, how decisions are made about payouts, and, most important, what employees need to do differently to achieve those goals and receive their payouts.

Line managers also are often involved in or responsible for setting goals and performance targets for individuals or groups of employees. Therefore, they may need support from HR as they determine how goals should compare to current performance levels.

Sejen says the good news is that “Companies are getting a lot better at leveraging the power of incentives. They are thinking about why they are offering the incentive, and they have gotten serious about putting meaning into pay for performance.”

In this way, companies can make sure that their incentive plans motivate employees to perform at a higher level without unintentionally encouraging them to engage in unacceptable behavior.

Joanne Sammer is a New Jersey-based business and financial writer.

Web Extras

SHRM white papers:
The Design of Employee Incentive Plans

Safety Incentive and Award Programs

SHRM articles:
Communication Is Just as Important as Design in Incentive Compensation Plans 
(SHRM Online HR Technology Focus Area)

Figuring Incentive Plans' ROI 
(HR Magazine)

Putting It In Writing

Companies with an incentive plan should develop a written document detailing how the plan will work and how payouts will be handled in various situations. The plan document should also clearly state that the company has the right to change the plan at any time as needed. Information in this document should cover:

• An explanation of how performance measures are set.
• Who is eligible for the incentive plan.
• How payouts are calculated.
• When payouts will be made.
• When incentives are earned (at the end of the quarter, at the end of the month, the day the work is performed or at some other point).
• How payouts are handled when someone leaves the company, takes a leave of absence, becomes disabled, dies, etc. Every contingency should be spelled out.