17 Feb 10 Mistakes Made When Designing Executive and Employee Compensation Incentive Plans
By Susan Malanowski at the Wilson Group
After developing executive compensation and employee compensation plans over the years for so many companies from iRobot to TripAdvisor, we’ve developed our “top ten mistakes” compensation consultants typically make when designing compensation plans:
Too many compensation performance metrics
“Less is more” when determining the criteria or metrics to use in the plan. Plans with three to five measures can provide balance and focus. Too many measures dilute a participant’s attention and motivation.
Performance metrics with a weight less than 10% of the total
One of the signs of too many performance measures is when a measure is weighted to be less than 10% in calculating the pay-for-performance incentive. For most participants, a measure that is less than 10% adds very little to individual earnings and so these are easily ignored.
Setting goals by metric that are difficult to tie to actual levels of performance
For each measure, goals are set. Goals are most effective when the manager and the employee clearly knows when performance has been achieved, has been under achieved and over achieved and how the payouts directly align with those levels of achievement. Binary or yes/no goals present a significant issue for the incentive plan participant. What happens if there is over achievement or the results were actually close to the achievement or “yes” level but not quite?
Not tracking performance results on an ongoing regular and frequent basis
When designing the plan, one important step is to develop a process for tracking and communicating progress on a regular basis. This is true of company or other types of group goals. Monitoring progress helps maintain focus on the metrics and goals and allows for mid-course corrections or acceleration of the goal. What would happen if no one tracked the score in a basketball game, would the teams know who won the game?
Trying to force the metric’s performance range and payout range to be the same
The most common range of payout opportunity as a percent of the target incentive is 50% at the threshold (or minimum) and 200% at the maximum. The next step is to determine what is the minimum performance required to earn that 50% of target payout or 80% of the goal at target. What is the exceptional level of performance required to earn 200%? Most commonly 120%. Often there is an assumption that these percentages should be the same, in other words, 80% achievement means 80% of incentive payout. This example may be paying out too much for 80% performance.
Not paying out an annual incentive within 45 days of the end of the performance period
If compensation earned from an annual incentive plan is not paid out within 2.5 months after year-end it is considered deferred compensation and must be structured to be compliant with IRS code section 409A rules. So, it is best to avoid 409A by paying out prior to 45 days following the end of the performance period.
Not being clear about the purpose and/or objectives of the compensation plan
Commonly we see either a purpose of many compensation plans being to reward participants for achieving results or to motivate participants to achieve results. Whatever the objectives or purpose of your pay-for-performance plans, first ensure it is stated clearly and then be as specific as possible tying it back to the results or behaviors you want to the plan to reinforce. Without a purpose or objective for your employee’s plan, it is hard to evaluate whether the plan is effective.
Focusing on individual metrics when it takes more than one person or function to achieve a goal
We had a client introduce bonus eligibility for all employees with a significant weight on individual measures or goals. This caused significant issues when, in fact, many individual employees chose metrics and goals that required significant IT support and IT could not meet this demand. In this example, there needed to be more coordination and communication at the start when finalizing individual and collective performance goals and measures.
Not modeling incentive payout scenarios can create multiple negative impacts, such as participants being paid very little for adding significant value or being paid too much for contributing too little
One problem with net payout scenarios is that often net payout amounts are not meaningful to employees after standard tax withholdings. This usually happens when there are many payout periods, such as quarterly payouts, but targets payouts can also be small at the lower levels of the organization.
Not aligning the performance measures with the right level of the organization
Utilizing a layer of performance measures (where appropriate) that include corporate, regional and/or functional areas and job specific measures then weighting these appropriately can create effective line of sight when designing compensation plans. At the higher levels of the organization, weighting for corporate metrics is higher than at the lower levels where increased weighting for job specific measures is appropriate. Better yet, is ensuring that performance metrics below the corporate area are cascaded to connect with each other. These multiple layers of goals help employees understand that when the company has a strong year, strong performance of individual goals maximizes payouts. When the company has a poor year, payouts are only driven by strong individual performance and significantly moderated.
What challenges have you experienced in designing your compensation plans for executives and employees? The Wilson Group is available to assist you.