Turn Compensation into an Operations Partner

Design pay structures to drive profitability, but avoid unnecessary complexity

By Stephen Miller, CEBS May 27, 2015
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Align compensation with business goals to reward workers and drive profits, experts said at the 2015 WorldatWork Total Rewards Conference, held May 19-20 in Minneapolis.

HR and compensation managers should work closely with line managers when formulating pay strategy, advised Dave Van De Voort, a principal with Buck Consultants. The typical approach, he noted, is for HR and the finance team to "decide how to set the pay budget, and then operations people have to take that information and make money with it.”

To use compensation more effectively, “Have conversations about how we as compensation and HR analysts use people to drive profits,” Van De Voort advised. The compensation function, after all, is “about aligning total rewards with the way our businesses generate profits … And even if you're tax exempt, you know what positive margin is.”

Payroll as Profit Driver

Terry Macalady is director of compensation at Austin-based Corizon Inc., a firm that helps businesses to make their call center operations more efficient. “In business, payroll and productivity must be evaluated as profit drivers,” he noted, suggesting that pay programs be designed to:

Link compensation analysis to the business bottom line, for instance, by assessing how pay incentives drive profits and adapting compensation planning tools to business planning.

Integrate compensation with other HR processes and with broader financial and operational plans.

Use the compensation model as a way to communicate business priorities to the workforce.

When demand is high for key positions, it may be necessary to factor in pay above the targeted rate (whether the target is median, or 75th percentile, for instance). Consequently, “the pay structure may call for 80 percent of the workforce to be paid close to the median, with 20 percent of the workforce”—those considered key talent, not necessarily at the executive level—“paid above the median,” Macalady said.

“Highlight rate recommendations that fall outside” of the targeted market ranges, he advised. “Recommendations outside of the targeted range should be supported with local market, recruiting, financial and operational metrics.” Then “review the market analysis with operational leadership, and offer recommendations based on the feedback from the market review.”

Finally, “partner with the finance team to identify key cost drivers that will be impacted positively to help reduce the budget impact of a proposed market adjustment,” Macalady suggested. For example, explain how “above-market pay for key talent will reduce recruitment costs through reduced turnover and increase productivity due to higher staffing levels.”

Gauging Complexity

Jack Zwingli, head of pay consultancy ISS Incentive Lab, discussed once “exotic” compensation design features that are now being used to link performance measures to company strategy. Among these are modifier metrics, which adjust the payout structure of the underlying award based on performance, using a multiplier effect. “Think of it as a dimmer switch that moves up and down year to year based on performance changes,” he said.

Modifier metrics differ from conditional metrics, which are “more like an on-off switch,” adjusting payout levels upward when certain performance targets are met.

In addition, “Many awards now use more than the three standard levels of threshold, target and maximum,” Zwingli noted, giving the following hypothetical example (goals, probabilities and payouts would, of course, vary by organization and, more broadly, by industry):

How Many Pay Levels?

Payout Level

Goal

Probability

Payout

Threshold

2%

94%

25%

Below target

4%

87%

75%

Target

7.0%

65%

100%

Above Target

10.0%

23%

150%

Maximum

12.0%

20%

200%

Source: ISS Corporate Solutions



Zwingli pointed to a great deal of variation in setting threshold and maximum payouts. He cited “threshold payouts generally in the 25 percent to 50 percent range, but in a number of industries 0 percent is the norm.” Conversely, “there are companies with 75 percent payouts at threshold.”

Maximum payouts have “crept up over the years" and tend to be in the 150 percent to 200 percent range, but are now moving downward in some industries.

“Add complexity when it's a good business decision to do so,” Zwingli advised, but not when it isn't necessary. For instance, “avoid adding unachievable goals or unnecessary payout levels.” In short, “Don't add complexity for the sake of complexity.”

As for performance metrics themselves, “metric volatility should be considered in selecting the appropriate performance measures,” Zwingli said. For instance, the popular earnings per share (EPS) metric “can be very volatile, as share prices go up and down.”

As with payout-level complexity, he advised compensation managers to “avoid volatile or unstable metrics unless they reflect the nature of the business,” and to “run the numbers to get a sense of the impact.”

“Volatility for the sake of volatility isn't good” in terms of performance metrics selected, “unless there is a convincing business argument” for using a particularly volatile performance metric.

“Every design choice has an impact on the expected value of performance awards and the probability of achieving goals,” Zwingli noted. Adding complexity to incentive pay designs can be “like fine tuning” that better ties rewards to performance. But it also risks making goal-setting harder and requires clear and consistent communication about how the incentive program works—or you risk clouding up the employees’ line of sight between performance and reward.

Stephen Miller, CEBS, is an online editor/manager for SHRM. Follow him on Twitter @SHRMsmiller.

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