Annual Cash Awards: Bonus or Incentive?

June 20, 2012

Virtually all companies provide their senior employees today with some form of variable cash compensation. Most do so because it is "competitive practice" but the genesis was an attempt to align the cost of pay with the fortunes of the business. Later that evolved into attempts to shape the fortunes of the business by providing incentives to complete certain repetitive tasks faster and, influencing management performance with incentives to achieve strategic goals.

While today most companies follow the practice because everyone else does and it is a necessary competitive practice, forward thinking organizations (and probably the more successful ones) think about how to get the most out of their variable pay plans.

In recent years for proxy disclosed executive positions there has also been pressure to adopt "best practice" causing Boards to too easily follow a formulaic method without perhaps giving full consideration to the best organizational approach. The approach selected then usually cascades down to the lower levels in the organization. 

Investor pressures aside looking the same as everyone else does not help differentiation or lead to superior performance so where should you start start in designing a meaningful plan. The organization's culture and point of evolution are probably at the heart. 

The smaller organization with a tightly knit team, highly dependent upon one another where everyone needs to contribute for success is likely to lean toward an egalitarian approach, with common or similar targets and for the top team, even similar amounts at risk expressed as a percentage of salary.

A more competitive environment where the organization is engaged in different commercial activities may require an approach that is more focused on rewarding key individuals for their specific contributions - rather like a sports team. This may be a key factor in retention too.

As the organization becomes larger and the CEO no longer knows everyone's work well enough and others become engaged in the work of determining payouts, internal equity will become paramount and organizational effectiveness will become dependent upon a sense of fairness. This is the point when organizations often adopt a formula based upon either future goals i.e. incentives, or they may look to reward past achievement e.g. profit sharing.

We have clients in both camps and the approach adopted reflects their culture and evolution. One particular client rewards its entire global team on a profit share basis - "we all work together and we are all rewarded in the same way". In their case the model reflects the way they conduct their business, the way in which they hire their teams and communicate to them. 

Others reward specific goals that may lie within different parts of the business without whose success the business may fail. 

All however follow a transparent and increasingly disciplined approach most often driven by a consistent and equitable framework and some with very detailed metrics measuring achievement. Few have retained discretionary approaches. Whatever approach is adopted Boards want to see more discipline (governance) behind the allocation of scarce cash.  

In all cases we would suggest reviewing variable cash plans every five years or so. Organizations change, best practice evolves and refreshing the plan at periodic intervals discourages "gaming" the formula!

The approach you adopt should reflect the values and culture of your business and be designed to meet your company's specific needs and not a formula copied from a competitor. 

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