3 Rules for Balancing Short and Long-Term Employee Incentive Programs

In an article for Strategy+Business, Ken Favaro offered the following perspective about organizational growth:

"Peter Drucker once wrote that the manager’s job is to keep his nose to the grindstone while lifting his eyes to the hills. He meant that every business has to operate in two modes at the same time: producing results today and preparing for tomorrow.

"But 'preparing for tomorrow' really means investing in the future, an expensive and uncertain proposition. It demands taking an incremental hit to today’s performance in exchange for an unguaranteed payoff. Meanwhile, you have to meet your previous promises of big gains to have the wherewithal to continue investing. But that wherewithal will soon be lost if meeting those promises means forgoing new investments that are essential to future results. Drucker’s dictum is not only an acrobatic feat, but a managerial one as well."

Forward thinking business leaders recognize that the "acrobatic feat' Drucker references has implications for pay. Hence their dilemma.  How do you use pay to reinforce the need for your people to maintain the revenue engine of the company while simultaneously focusing on growth?  If your compensation strategy rewards only one or the other, employees will likely have only half the focus you want them to have.  The pay approach you take needs to emphasize both priorities and help the company sustain a kind of performance equilibrium.  

There is no silver bullet answer for striking the exact right balance between short and long-term employee incentive programs in every organization.  However, there are some principles that can help you arrive at a ratio that fits your organization.   So, let's talk about three rules that will help you build incentive plans that reinforce a balanced focus on both short and long-term organizational results.

Rule #1: Shift to value sharing.

 he first reason organizations struggle with balancing short and long-term incentives is the word itself—incentives.  It’s an old term that doesn’t really work in the new business environment.  Paying an incentive implies that you are rewarding someone for behaving in a certain way or perhaps achieving a team or individual objective.  It is a carrot and stick approach to compensation that essentially tries to “force” people into performing their role in a certain way.  “If you do this, I will pay you that.  If you don’t do it, you won’t earn it.”

Instead, you want to take a value sharing approach to rewards.  This is rooted in a basic philosophy that suggests you want your employees to be growth partners in driving company growth.  As a result, you are willing to share value with those who create it.  This encourages people to adopt a stewardship approach to their roles.  “Here are the outcomes for which we want you to assume responsibility.  Here is our philosophy for how we reward those outcomes and the specific programs in which you participate that fulfill that philosophy for your role.  If we produce value at this level, here is how you will participate in the value you help create.”  It is a “reinforce” instead of “force” approach.  You reinforce the person’s role and how they will be rewarded for the value they help create.

The shift to value sharing requires companies to become very clear about how value creation is defined in their businesses.  It encourages a focus on productivity profit, which is the amount of profit attributable to human capital as opposed to other assets already at work in the business.  When companies begin speaking about and measuring value creation—both short and long-term—it becomes easier for employees to understand what amount of focus they should give to driving the performance engine this year versus more sustained results over the next two, five or 10 years. 

Rule #2: Build a total compensation structure (TCS).

A TCS is a framework you build for managing and analyzing the range of pay and benefit plans you are offering.  Ideally, it gives you an “all in one place” view of every employee tier, what plans each is eligible for and at what level.  It allows you to evaluate your entire value proposition as a whole instead of each individual component in isolation.  Within this framework, it is easier to make decisions and adjustments in specific pay plans because you can measure each against its impact on the whole picture.

When properly designed, a pay structure becomes the practical, “real life” manifestation of a company’s rewards philosophy.  Ideally, a company’s TCS is consulted before adding any new program.  That way, as plans are developed, they are always measured against their impact on the composite pay strategy. A total compensation structure gives company leadership a comprehensive lateral view of all rewards programs and the degree of their alignment with the organization’s rewards philosophy.   A pay structure is much more than a salary structure (although a salary structure is part of it).  If a pay philosophy is the company’s “North Star,” the TCS is its sextant guiding the organization to the desired rewards and results destination.

Once a TCS is established, it is easier to see how short and long-term value-sharing are balanced not only against each other but against the entire pay landscape.  It becomes easier to look at each tier of employee and evaluate whether or not the “weighting” you have applied to each category of compensation seems right and where gaps exist in rewards offerings that should be considered. 

Rule #3: Use short-term value-sharing to reinforce your business model’s revenue engine and long-term to protect against bad profits.

Your company’s business model defines how you make money—and how consistent revenue flow is generated.  Employees should know what role they play in that model and be rewarded for ensuring it produces what it is supposed to produce.  This means their short-term rewards should have a heavy focus on revenue and profits—should reinforce the importance of both.

Long-term value-sharing acts as an insurance policy against bad profits that can emerge when employees go overboard in their focus on short-term results and rewards.  In his book, The Ultimate Question, Fred Reichheld, a Bain Fellow and founder of Bain & Company's Loyalty Practice, offered the following on the subject of profits:

Too many companies these days can’t tell the difference between good profits and bad. As a result, they are getting hooked on bad profits.

The consequences are disastrous. Bad profits choke off a company’s best opportunities for true growth, the kind of growth that is both profitable and sustainable. They blacken its reputation. The pursuit of bad profits alienates customers and demoralizes employees.

While bad profits don’t show up on the books [at least they aren’t identified there as such], they are easy to recognize. They’re profits earned at the expense of customer relationships.

Whenever a customer feels misled, mistreated, ignored, or coerced, then profits from that customer are bad. Bad profits come from unfair or misleading pricing. Bad profits arise when companies save money by delivering a lousy customer experience. Bad profits are about extracting value from customers, not creating value. ( The Ultimate Question, Fred Reichheld, Harvard Business School Publishing Corporation, 2006, 3-4.)

Long-term value sharing arrangements, if designed properly, become a self-enforcing means of perpetuating good profits. Everyone has an interest in good profits if everyone’s wealth multiplier rises or falls on the ability of the company to sustain the right kind of profitability.

Conversely, companies that focus solely on short-term results (in terms of “at risk” pay) set themselves up for bad profits. Leaders of such companies can (and do) talk all they want about building value for the customer and improving return on equity for shareholders; but if they pay people in a way that communicates the opposite, how can they expect employees not to pull them into the bad profit trap? For evidence, look no further than Wells Fargo. In this sense, long-term value sharing protects the company’s interest in developing good profits.

If you follow these three rules consistently, you will find that your approach to value-sharing falls into place pretty naturally.  As you refine your pay philosophy and use your TCS as a tool of evaluation, the appropriate allocation of value-sharing between short and long-term results will become apparent.  Give it time.  Adjust as you glean new insights and understanding.  Soon your value-sharing approach will become a key means of defining the growth partnership you want with your employees.