Beware the Reward Plan Fiscal Cliff

No, not that fiscal cliff.  I'm talking about the kind of cliff that plays an unfortunate starring role in many total reward programs; the incentive plan with the all-or-none (or nearly so) singular award hurdle, very often set against prior year performance, that can throw the whole program out of whack.

Now I'll be the first to acknowledge that there are few hard and fast absolutes in incentive plan design.  There are very likely circumstances where a "cliff" of this nature is appropriate, even ideal.  But I bump into plan after plan where this feature, which always sounds like a good idea in theory, has become an unnecessary morale-buster and veritable fountain of unintended consequences.

Scenario 1: A salesperson's commission play pays out on sales growth; a certain percent of those sales dollars achieved above 90% of last year's total sales for her territory.  In other words, if she delivered $2 million in sales last year, this year's commission kicks in after $1.8 million is achieved.  The problem occurs when the sales rep realizes early on in the year that she is unlikely to clear this hurdle.  She now has little financial incentive to keep pushing through the remaining months since the only thing she will achieve is to raise her personal bar for commissions the following year.  As year-end approaches, the incentive to sandbag, to hold on to orders until after January 1, is overwhelming. 

Scenario 2: An employee cash profit-sharing plan has a history of generous awards.  To trigger any payout, the company must hit 95% of last year's profit level.  During the good years of market growth, no problem.  The company skates by the hurdle year after year.  When economic circumstances converge to deliver a blow to the industry, it becomes clear even by mid-year that the company will not hit the plan trigger.  This even though the company will be profitable and has made notable strides on a number of strategic efforts.  Morale tanks. Yes it's true, as leadership points out, that given the generous awards of the past few years, employees are paid quite competitively on a rolling 3 or 5 year average basis.  That doesn't change the fact, however, that the employee incentive plan is now an employee discouragement plan.

Scenario 3: A management incentive plan.  It's been a tough year and the top team has been busting tail to push through a number of unforeseen business hurdles, working hard to both maximize current year customer opportunities and earnings while also building momentum on some critical longer-term initiatives.  By the end of third quarter, however, it has become clear that the company will likely fall just short of the year's net income goal, the lone measure on which the incentive plan hinges and the hurdle that must be passed for awards to be earned.  As the CFO bluntly puts it: "We all know that the right thing to do is to keep up the balancing act, focusing both on short-term needs and long-term strategies. But now plan participants face the choice of doing the right thing and sacrificing the possibility of a short-term incentive payout OR refocusing all year-end efforts (and potentially exercising some accounting gymnastics) to deliver the net income results.  A bad corner for a management team to be backed into."

Bottom line: Incentive plan triggers and hurdles play an important role.  They protect the company from paying out award dollars when it cannot afford the expenditure or when it simply doesn't make sense.  The trick is incorporating them not only into a thoughtful plan design, but also into a well-balanced overall reward program.  I've written before about how helpful it can be to see a total rewards program as a portfolio of sorts.  Like the elements of a sound investment portfolio, there should be a sense of balance in the design and interaction of the different reward elements - a sense of balance missing in the scenarios outlined above.

Your take?

Ann Bares is the Founder and Editor of the Compensation Café,  Author of Compensation Force and Managing Partner of Altura Consulting Group LLC, where she provides compensation consulting services to a wide range of client organizations.  Ann was recently named President Elect of the Twin Cities Compensation Network (the most awesome local reward network on the planet) and has joined the Advisory Board of the Compensation & Benefits Review, the leading journal for those who design, implement, evaluate and communicate total rewards.  She earned her M.B.A. at Northwestern University’s Kellogg School and is a bookhound and aspiring cook in her spare time.  Follow her on Twitter at @annbares. 

Creative Commons image "Cliff" by Scarto

Comments

[E. James (Jim) Brennan]

So, Ann... are you advocating that the failure of accurate goal-setting should inspire a withdrawal from effective incentive plan design? Yes, that's a trick question. ;-)

I've seen such well-balanced portfolios of incentive plans at firms whose very name has become both a noun and a verb. They had so many overlapping, independent and confusing product incentive programs that salespeople just picked one they understood and sold the heck out of that product. No one single plan truly drove performance; failing to pass the gate in one plan could be offset by altering effort to a different product where that trigger-point hurdle could then be passed and the desired cash reward produced to the salesperson. Although the employee got the money they wanted, the company didn't get the output results they wanted even though they disbursed the same amounts of cash despite disappointing imbalances in productivity. It's a really complicated thing.

If the idea is to insulate participatants from downside risk, yes, such "balance" is needed. But you insulate people from risk of loss, then how can we balance consequences if there are no negative reinforcements for failure? Therein lies the dilemma of "moral hazard" that has wreaked such havoc on our economy.

Is is more important to make employees happy with their pay than to make the enterprise successful? They are different goals.

[Jacque Vilet]

This is a great remimder Ann. It's difficult to design a plan that is foolproof. I remember one VERY large well-known company that failed to design in a threshold of profits before payout. They quickly learned their mistake when they had to bite the bullet and pay out incentive awards to employees even though it ate into their profits much more than they had intended.

[Ann Bares]

Jim:

Nope, to your trick question. I don't see the notion of a well-balanced set of rewards necessarily meaning overlapping, redundant and confusions plans and elements. I would expect us to seek it in a (hopefully more sensible) place somewhere between a twisting, complex labyrinth of plans and features AND hanging everything on one stretch measure. Not to suggest that finding this sweet spot of careful, thoughtful, balanced plan design is an easy task - no sir. But that's what they pay comp pros the big bucks for, right? (Cue the hysterical laughter...)

Nor am I suggesting that we insulate people from downside risk. Rather, I think we're supposed to be aiming to maximize the likelihood of the circumstance where both enterprise AND employees win. As we define that. And to think through the downside and the circumstances likely (or possibly) surrounding it, so that we create a plan (to the best of our ability) designed to maximize balance and fairness considering both enterprise and employee interests, and minimize unintended blowback.

A tall order? You betcha! But shouldn't we try to get as close as we can?

[Ann Bares]

Jacque:

Right on. I'd even go so far as to say it's impossible to design a plan that's foolproof. Doesn't mean we don't try out best, though. And then, in the best traditions of tinker/tailor/experiential learners, we assess and learn from our mistakes and get better the next time!

[Jacque Vilet]

Well as you can guess I'm all for tinkering and tailoring! Whatever works in this "new world".

I do think that one very important component with any plan that is truly balanced --- meaning there is risk involved for both parties as well as reward --- is communication.

If your company truly believes in pay-for-performance then it should almost be made a mantra with employees doing the chanting.

Now don't laugh and be cynical. Employees need to understand that just as companies miss targets, miss winning a big client, miss deadlines and get kicked off a project, etc. ---- both company AND employees are affected by this and shouldn't expect to be insulated from it.

Now this works very well until some big time Veeps get huge bonuses while the masses get nothing. Then it all falls apart.