Overview
To develop a pay strategy that rewards your people for their contributions to value creation, you will need to make some fundamental decisions. At a minimum, you must determine the right balance between guaranteed and variable compensation and between short and long-term incentives. Pivotal in that strategy development is how and to what extent pay will be tied to specific types of performance. This will differ from company to company. However, every business should be able to identify the particular outcomes it wants its people to achieve and how their fulfillment will impact the financial future of the company.
This kind of evaluation requires you to develop a financial model that helps you to envision future company value using various growth assumptions (base, target and superior for example). The purpose of the model is to determine what shareholder value will look like “down the road” if employees achieve the expectations you have set for them. With that picture in mind, the development of a performance-based compensation strategy starts by answering some key questions: How much of that increased value should be shared with employees? Which people should participate in that value-sharing? What form should that value-sharing take?
Your answers to those question will help you develop a philosophy that can guide you in the development of a compensation approach that effectively rewards performance. As you then translate that philosophy into an overall pay strategy and specific plans, there are five “essentials” that you will want to keep in mind. Those rudiments will only seem relevant, however, if you have defined clear objectives for your performance-centered approach and identified the alignment your pay strategy is intended to create.
Pay for Performance Objectives
If effectively constructed, pay for performance compensation plans should help a company fulfill the following objectives:
- Recruit and retain the highest quality employees
- Communicate and reinforce the values, goals and objectives of the company
- Engage employees in the organization's success
- Reward value creators
Line of Sight
Additionally, the rewards strategies that a company institutes should help employees understand the relationship between:
- Company Vision - where the business headed
- Company Strategy - how the business is going to get there
- Employee Roles and Expectations - the role employee has in that strategy and what is expected of him or her in that role
- Employee Rewards - how employees benefit (financially) from the achievement of the expectations associated with their roles
A pay for performance approach to rewards should help create this kind of "line of sight." Ultimately, compensation’s role is to reinforce the outcomes the company needs its people to achieve in a way that fulfills the financial vision of both shareholders and employees.
To accomplish this, you will want to pay attention to the 5 essentials that any pay for performance plan should include.
Essential #1 - It Must Align Performance Awards with Shareholder Objectives
All companies have a financial responsibility to their shareholders. As a result, compensation should be measured like any other investment by the company. Its effectiveness should be evaluated in the context of the financial outcomes (return) shareholders are expecting. As a result, the question that should be asked when any compensation program is being considered is: "Will the company’s investment in this plan contribute to an increase in company value?" There are really two potential parts to the answer. One is the hard dollar impact—increased revenues, profits, cash flow, etc. The other is the soft dollar impact—Increased productivity, turnover reduction, improved client service, etc. When we look a compensation through a “pay for performance” lens, then we treat it as an investment. This means we design plans that are “paid for” out of a superior value that employee performance creates. When approached that way, compensation doesn't really "cost" the company anything.
Essential #2 - It Must Employ the Proper Mix of Compensation Elements
Companies should look at their compensation offering like they would an investment portfolio. Each pay component is like an asset class. As with investment assets, to be effective an organization’s rewards “portfolio” must include the right mix of compensation plans and in the right volume. The range of pay elements that can be considered include: salary, bonus, long-term cash incentives, equity or phantom equity, retirement plans, core benefits and executive benefits. Each of these has a different role to play. What’s important is for the company to create an overall portfolio that drives maximum performance from employees while minimizing risk to shareholders. Because this evaluation is critical but not easy, many companies seek the advice of outside professionals to assist them in this effort, just as individuals do in seeking investment help.
When it comes to building a compensation “portfolio,” in our experience at VisionLink the biggest compensation mistake made by growth companies is not striking an effective balance between short-term and long-term incentives. Most businesses either ignore or dilute rewards for extended performance. This results in employees focusing on short-term results often to the detriment of the longer-term outcomes that are just as important to shareholders. An effective pay for performance strategy should make sure there is a balanced focus on both immediate and sustained value creation.
Essential #3 - It Must Result in Meaningful Dollars
In considering "pay for performance" strategies, business leaders should keep in mind that one of the intents of such an approach is to get employees to take ownership of the results their roles exist to produce. This gets back to the line of sight issue raised earlier. Employees are more likely to adopt a stewardship approach to their roles if they see a relationship between the value they create and the way (and how much) they are paid. And their earnings potential must be compatible with their personal wealth accumulation goals and ambitions. In other words, the payoff must be meaningful enough to get the employee’s attention.
The balance you are seeking is to offer rewards that are motivational to the recipient while still being in line with shareholder (financial, structural and organizational) goals and expectations. Although this balance is a little different in each company, these are some rules of thumb to consider:
- Short-term incentive plans
- 40-80% of salary for top managers
- 25-40% for 2nd tier managers
- Long-term incentives (for key contributors)
- 40-80% of salary for top managers
- 25-40% for 2nd tier managers
Essential #4 - It Must Reward Performance Employees Can Impact
This "essential" goes to the heart of what "line of sight" is all about. It is achieved, in part, when an employee can say: "I can see precisely how my compensation aligns with my contribution!" Employees become frustrated or indifferent if they don't feel they can impact the results required of them (and by extension, their pay). This is usually where employer frustration comes in as well. The business leader feels as though his employees don't "get it" - and feels like his people don’t show the same passion about his vision that he does. Ultimately, if employees don't feel they can actually impact the results they are asked to achieve, there will be no return on the compensation investment for the company either. For example, you can give an employee stock—but if that person doesn’t feel they can influence the stock price in the performance of their role, then the benefit is meaningless.
Essential #5 - It Must Effectively Communicate and Reinforce Rewards
Coaching and reinforcement are the keys to creating long-term focus and commitment in an organization. As a result, rewards should be viewed as a means of reminding employees what is expected of them—but more important, why it's worth it to perform. In other words, pay should create a kind of virtuous cycle between employee roles, expectations and pay. The clearer individuals are about their roles, the better the chance that they will fulfill what’s being asked of them. As they do, they are rewarded, which encourages continued, consistent performance in their roles.
Compensation, then, is the way the company defines the financial partnership it wants to have with its people and represents a kind of agreement between the employer and the employee. By agreement, I mean it defines an area of stewardship, establishes expectation levels for that area and provides a conditional incentive for its fulfillment. "If you can do this, here's what it will mean to you."
Can you see why it is important, then, to have a complete compensation “portfolio” where each pay “asset class” has a different role in communicating and reinforcing various aspects of performance that need to be achieved? And the degree to which those performance expectations and their associated rewards are communicated and reinforced will in large measure determine whether the desired performance is achieved.
In Conclusion
Like most things in business, compensation is something that requires a strategic approach. Achieving a pay for performance culture does not happen without paying attention to the behaviors, activities, rewards and motivations that must be linked and reinforced through a well-engineered and effectively executed process. And if that process does not tie rewards to shareholder financial objectives, employ the proper mix of compensation elements, result in meaningful dollars, embrace performance that employees can impact and are effectively communicated and reinforced, then the results it produces will likely fall short.
