How to build an incentive plan

Incentive plans can be a powerful tool to attract & retain top talent and drive performance. What are the key steps in designing & implementing such a plan?

Incentive programs are part of modern remuneration practice; executives, in particular, look for them and so every company regardless of their size or industry needs to think carefully about the design and implementation of reward plans and the behaviour they will drive.

What’s more over as little as three to five years, the investment made in incentive payments can run into hundreds of thousands or millions of dollars. It’s important to get the best return on that investment and avoid the enormously destructive power of a poorly designed program.

Although every company is different, in designing and implementing incentive plans we follow a ten part methodology built on more than two decades of experience.

1. Set the objectives

In designing the incentive plan, it’s important to have a clear set of objectives: why it the company putting in place an incentive plan? What does it hope to accomplish? Common objectives include: a. share the success that the company enjoys with those who make that success possible b. align the interests of staff and shareholders c. help attract & retain key staff d. offer a competitive package of remuneration e. motivate staff for the opportunities/challenges that lie ahead While it’s less common, some companies also recognise that the type of person attracted to an incentive plan is likely to be one that wants to back their skills and abilities. A well designed incentive plan will attract performance oriented staff (and deter those less interested in results). The objective of the plan should take into account the company’s broader strategy and the importance and role of people in that.

2. Set key characteristics

The next step in the design process is to understand any key characteristics that will be important in the plan. For example, key characteristics may call for rewards to: a. be determined as objectively and transparently as possible b. be meaningful for participants c. be determined fairly for both participants and shareholders d. encourage teamwork e. drive accountability for performance f. encourage a longer term view Most companies also look for the reward program to be capable of standing the test of time, ie not having to be amended constantly as the business or people in it change.

3. Prepare an initial plan design

Drawing on an understanding of the business, the objectives of the plan and the desired key characteristics, the next step is to develop an initial incentive plan design. This needs to address a range of factors including: a. How will performance be measured? b. Over what time period will performance be measured? c. What role will the ‘how’ of performance be taken into account – eg how did the employee go about their work in achieving the result? d. Will rewards be determined by a formula? e. Will there be a limit to how much can be earned under the plan? Why? f. How frequently will payments be made? g. Will rewards be paid out in a lump sum or will some be deferred? h. What form will payments take, eg cash or equity? The way that these questions are answered in the design of the incentive program can have a significant impact on the effectiveness of the plan and the behaviour of participants and hence vast and long term implications for the performance of the company.

4. Review and revise with broader input

It’s worthwhile canvassing the proposed design with a broader group of people, starting with those that know the business well but are not participants in the plan. Their role is to think through the behaviour that will be encouraged by the design of the plan. For example, if we pay for EBIT growth, they might identify that capital will be seen as free and capex will need to be tightly monitored (or the plan redesigned to use another measure). Importantly, they should not provide design/redesign suggestions as that limits their objectivity in reviewing the next draft. If possible, input should also be sought from one or two trusted participants in the plan. Although conflicted, this helps build buy in and can identify any aspects of the design that might be hard to swallow for staff.

5. Calibrate

Once the plan’s design is set it can be calibrated, ie the targets and sensitivity of the plan can be set for each measure of performance. While many companies will use the annual budget or longer-term plans of the company as the source for targets, staff quickly work out that the more ambitious the budget/goal set, the smaller their reward will be. The annual budget process becomes a drawn out negotiation as managers do their best to ensure ‘realistic’ budgets are set, while shareholders try to drag up the targets to match their ambitions for the company. An alternative approach is to think about year-on-year improvement targets that effectively decouple the budget process from the incentive process. Just as important, if not more so than the target is the sensitivity of the plan, ie how quickly rewards increase for beating target and how quickly they decline for missing target. Too often companies argue for months over the target then settle on a simple, ‘miss target by 10% get nothing, beat target by 10% cap out’. Yet the difficulty of beating/missing target by an arbitrary 10% can vary enormously from company to company, division to division, business unit to business unit, store to store, etc. The formula chosen should be tested under a wide range of scenarios to ensure the company is comfortable with payment outcomes come what may and can reduce discretionary override to a minimum.

6. Determine the opportunity for participants

The final step before implementation is to determine the amounts on offer to each participant at various levels of performance, for example, at target and max. Consideration should be given to what others in the market for talent are offering for similar roles and to the shareholder cost of the plan over all eg for every dollar of profit growth, how much is shared with participants? Sharing percentages tend to vary by industry and by the remuneration strategy of the company concerned but also by the number of participants and their seniority.

7. Document

To protect both the company and the participants in the plan, its workings should be documented. The plan rules would typically include: a. the objective of the plan b. the plan design and calibration c. how the plan will be reviewed d. who determines participation and under what circumstances an employee is invited to participate e. rights to payment on termination f. rights to payment in the event of the sale of the company g. what happens if a participant takes a protracted period of leave h. the treatment of new participants who join midway through the performance period i. what happens if the underlying metrics on which payments are determined are found to be in error and so on. While the temptation is to have a solicitor draft the plan documentation, that often leads to an overly legalistic document. It may be better to draft the plan rules in plain English and then have a solicitor review those for any concerns.

8. Communicate

Perhaps the most important part of the design & implementation of a reward plan is its communication to participants. Participants need to clearly understand why the plan has been put in place, how it works and what their entitlements are. But companies should also carefully craft their messaging to support the key objectives of the plan. For example, if one of the objectives of the plan is to attract & retain key staff, then the communication to participants should have the plan's most attractive elements – such as an uncapped opportunity – up in lights. For many people, their job and what it pays are strongly tied up with their sense of self-worth. Companies need therefore to handle this subject with care and be seen to be handling it with care. When communicating a new or revised plan, participants should come out of a briefing feeling excited by the opportunity but also that the company highly values them and their contribution.

9. Review & revise

Company strategies change, short and long term objectives change and markets for talent change. It makes sense therefore to review the workings of an incentive plan annually at least at a high level and in some depth every three years or so. Depending on the design this may involve little more than recalibrating targets, but if a review reveals wide-spread dissatisfaction or that the plan in its current form no longer supports the strategies or objectives of the business, then a more wholesale redesign may be appropriate.

10.Governance

Most people come to work each day wanting to do a good job. Incentive plans have to answer what ‘good’ is. They are therefore powerful mechanisms to shape behaviour, they are the ‘rules of the game’ that the company is asking its staff to play by. Those responsible for the overall performance of the company should therefore be involved in the design, implementation and on-going monitoring of an incentive program, particularly for the most senior executives within an organisation. If the Board or owner is not involved in the design of an incentive plan for the senior executive team, for example, it is a red flag for the success of that scheme. If they are not involved in writing the rules of the game that their people are expected to play by, sooner or later they will ask, ‘Why are my people behaving like this? Why am I paying so much for this result?’