Overview
Incentive compensation programs are primarily used to promote efficiency and productivity of the workforce, but organizations can also use them to enhance employee recruitment, engagement, retention and employer branding.
Overview
Designing Incentive Compensation Programs
Managing Incentive Compensation Programs
Additional Resources
Incentive compensation programs stem from the theory that rewards drive behavior. Applied to the corporate setting, incentive compensation programs enable organizations to produce targeted results by rewarding employees who are responsible for those results.
Although sales-based commissions are perhaps the most well-known example of an incentive compensation program, the arrangement is common at every organizational level—from the shop floor to the C-suite. See Designing Compensation Systems for Sales Professionals.
Many organizations view incentives as an important tool for improving performance. In a 2021 WorldatWork survey of privately held companies, 93 percent of respondents said their organizations offered employees some form of short-term incentives, and 51 percent offered long-term incentives beyond regular pay.1
Rewarding high performers, and ignoring or punishing low performers, correlates strongly to greater overall corporate performance. However, achieving this goal requires advance research, planning, performance tracking and evaluation to determine whether the incentive is ultimately working as intended. Some experts believe the business case for incentive compensation may grow stronger as organizations compete on a global scale.
As unemployment rates shrink and employee resignations grow, many employers are turning to incentive compensation such as retention and sign-on bonuses.
See:
Employers Rely on Incidental Bonuses Amid Tight Labor Market
Companies Attempt to Lure Seasonal Workers
Job Seekers Are Gaining Control over Hiring.
Designing Incentive Compensation Programs
Organizations considering incentive plans must define who will be eligible. Common criteria for eligibility includes the following:
- Job category (such as production or sales).
- Length of service.
- Job classification (such as executive or administrative).
- The goal of the incentive.
- What the payout will consist of (such as bonuses, stock or cash).
Examples of common short-term incentive pay plans include:
- Annual incentive plan. A pay plan that rewards the accomplishment of specific results. Rewards usually are tied to expected results identified at the beginning of the performance cycle. Unlike bonuses, they are not primarily discretionary but may have a discretionary component.
- Discretionary bonus plan. A plan in which management determines the size of the bonus pool and the amounts to be allocated to individuals after a performance period. This plan has no predetermined formula or promises and is not guaranteed.
- Spot awards. Recognize special contributions as they occur for a project or task, generally accomplished in a short period.
- Profit-sharing plan. A plan through which employees share in the organization's profits. The plan normally includes a predetermined, defined formula for allocating profit shares among participants and for distributing funds accumulated under the plan. Some plans, however, are discretionary.
- Gain-sharing plans. Any one of a number of incentive programs that share the results of productivity gains with employees as a group.
- Team/small-group incentives. Any incentive program that focuses on the performance of a small group, usually a work team. These programs often are used when measurable output is the result of group effort and it is difficult to separate individual contributions.
- Retention bonus. A payment or reward outside of regular salary that is offered as an incentive to keep a key person on the job during a particularly crucial business cycle.
- Project bonus. A form of additional compensation paid to an employee or a department for successfully completing a project within a certain time frame.
See Use Variable Pay to Retain Top Performers and Viewpoint: How to Reward Your Employees Without Breaking the Bank.
Long-term incentives such as stock options or restricted stock are common in companies that issue public or private stock. Long-term incentives are most often reserved for executive level employees. Historically, executive incentive metrics were primarily focused on measuring financial performance, such as revenue and profit growth, and the quality of performance, as reflected in cash flow and return objectives. Increasingly, incentive objectives reflect the interests of various stakeholders and the priorities of investors beyond financial performance. Environmental and social objectives—such as greenhouse gas emissions, water conservation, employee engagement and diversity—are increasing in prevalence in executive incentive plans. See Executive Compensation Is a Powerful Communication to Stakeholders.
Managing Incentive Compensation Programs
The management of incentive compensation programs consists of five main tasks:
- Determining the technology needed to implement the program, especially the metrics technology.
- Applying the metrics methods on a continuous basis.
- Adapting as appropriate to unforeseen circumstances.
- Communicating with employees and management concerning the program.
- Applying the data received to determine whether changes to the incentive compensation program are warranted midstream or at the established endpoint.
Dealing with Booms, Busts and Disasters
Economic uncertainty can wreak havoc on incentive compensation programs. A recession can make incentive compensation goals so unrealistic that the incentive to outperform is lost. Alternatively, a boom can make incentive compensation goals so easily attainable that the incentive to outperform is lost. On the other hand, using variable pay effectively can be a useful countermeasure to pay freezes. See The Pandemic Alters Pay.
Legal Issues
Employers must consider several legal issues when designing and managing incentive compensation programs and must be ever-mindful of eligibility rules that violate employment laws, including civil rights and occupational safety rules. For the most part, the legal issues depend on the following:
- The type of incentive (money based, stock based or prize based).
- The status of the employee as exempt or nonexempt under the Fair Labor Standards Act.
- Whether the incentive plan falls under the Employee Retirement Income Security Act (ERISA) as a defined contribution or defined benefit pension or welfare benefit plan.
- Whether changes to a plan will be made before the anticipated expiration.
Depending on the foregoing legal breakdown, several practical questions may arise:
-
Is the reward taxable to the employee? If so, at what tax rate? See Are bonuses taxable?
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Is the reward deductible to the employer?
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Is the employer required to withhold for employee-owed taxes?
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Is the reward to be included as part of the employee's regular pay for purposes of calculating overtime? See How to Calculate Bonuses into a Regular Rate of Pay for Overtime Purposes.
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What kind of reporting and disclosures are mandated to the employee regarding the plan?
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What kind of communications are mandated to the Internal Revenue Service (IRS) regarding the plan?
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What kind of communications are mandated to public shareholders regarding the plan?
See:
Must an employer pay out a bonus to a terminating or already terminated employee?
Program Monitoring
Periodic performance reviews (individual, team or organizational) coupled with incentive payouts are the strategic core of incentive compensation programs.
Many incentive compensation programs fail for the following reasons:
- Employee input was not sought, so no one understood what actually motivates workers.
- The performance goals were unclear or unrealistic.
- The incentive plan was too aggressive and encouraged the wrong behavior from employees to meet targets.
- The plan failed to state performance goals that are within the target employees' scope of influence.
- The performance standards were changed midstream.
- The performance standards were not objective.
See Keeping Bonus Programs Fair and Equitable and Be Careful Where You Give Bonuses.
Metrics
Of course, organizations that offer incentives must be able to measure employee performance to determine who is deserving of an award. But they must also be able to assess whether the incentives are having the desired effect on corporate performance. If the incentives are not working, there is no point in continuing them. Put another way, an employer may be working with the assumption that if it puts more widgets on the market, it will make more money, so it might provide an incentive to employees to produce more widgets. But if no one wants to buy the widgets, there is no point in paying workers to step up production. See Employers Adjust Pay and Incentives Amid Economic Turmoil and Does Incentive Pay Work?
Technology
So-called enterprise incentive management technology helps organizations analyze, track and pay bonuses, commissions and other types of variable compensation. The software collects data from various systems to provide management with a comprehensive picture of payout versus performance. Many compensation management software programs now incorporate incentive compensation into their analysis and reporting capabilities. According to a WorldatWork and Deloitte Consulting LLP report, 50 percent of employers use an enterprise system to administer short-term incentive plans, and the most prevalent tool used is a spreadsheet application.2
Global Issues
In some instances, incentive compensation programs have produced a significant pay gap between persons in the program and persons outside the program, particularly in global organizations where competition for the most qualified, internationally capable employees is fierce. According to WorldatWork's 2016 Compensation Programs and Practices Survey, 82 percent of organizations with multinational operations have a compensation philosophy that is the same across the company with 53 percent designing pay programs at the corporate level and 47 percent allowing for limited adaptation at the local level.3 See Viewpoint: Cross-Border Considerations for International Executives.
Additional Resources
Tools and Samples
401(k) Election/Change Request
Bonus Policy: Officer and Management Level Plan
Bonus Policy - Basic Profit-Based Plan
Bonus Policy: Employee Retention Plan
Bonus Policy: Customer Service Incentive Plan
Endnotes
1WorldatWork and Vivient Consulting. (2021, July). Incentive pay practices: Privately held companies. Retrieved from https://worldatwork.org/media/CDN/resources/surveys/2021_Incentive%20Pay%20Practices-Privately%20Held.pdf
2WorldatWork and Deloitte Consulting LLP. (2014, February). Incentive pay practices survey: Publicly traded companies. Retrieved from https://www.worldatwork.org/waw/adimLink?id=74763
3WorldatWork. (2016, August). Compensation programs and practices survey. Retrieved from https://www.worldatwork.org/adimLink?id=80656
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