Over the last ten years there has been a significant increase in the number of organisations using variable reward systems as a way of recognising past performance and to providing an incentive for future performance improvements. The underlying assumption with these systems is that there is a linkage between the opportunity for improved earnings and improved performance.
From a psychological perspective this assumption has always been regarded as somewhat tenuous. Some authors, such as Alphie Kohn, argue that performance based rewards actually have the opposite effect from their intended purpose. However, most organisations and employees now accept that performance based reward is a risk sharing strategy. Salaried employment, like share acquisition or business ownership, involves risks. Like shareholders, performance based incentive plans ensure employees share in those risks. When performance and growth are strong rewards should be available to all.
However, also like shareholders, rewards may not be forthcoming in times of low performance.
Towards a New View of Performance Based RewardAn effective performance based incentive system requires focus on three levels of performance:
- Total Organisation Performance
All employees need to be aware of the organisation’s strategies and performance targets. These need to be clearly articulated at the commencement of each year and should include both financial and non-financial targets.
All employees (not just executives and managers) need to receive regular feedback on how the organisation is performing against its targets. They need to feel that their individual and collective efforts contribute to overall performance. An effective way to do this is to regularly report actual performance against targets and disseminate results to all business units.
Performance against overall organisation targets is synonymous with performance of the Chief Executive and Executive Group.
- Business Unit or Team Performance
Each business unit or team will have its own objectives and targets. These will also include both financial and non-financial measures.
These will be derived from, and contribute to, the overall organisations targets.
Performance against business unit targets must also be reported on a regular basis. It is at this level that the individual contributes most directly.
Performance against business unit targets are the key measures of performance for the business unit heads.
- Individual Performance
Individual performance management must form a key component of any incentive plan. Individual Key Result Areas (KRAs), Key Performance Indicators (KPIs) and Action Plans need to be linked back to organisation and business unit performance targets. Competency development processes are critical to ensure individuals possess and apply skills and aptitudes necessary to achieve performance outcomes.
Configuring Incentive PlansA number of options are available for configuring incentive plans including the pie chart (proportional) approach, the matrix and incentive pool.
The pie chart approach has proved extremely popular amongst our client base. It has a number of advantages including:
- Ease of understanding;
- Highly flexible in that the proportions can be varied to suit individuals at different levels in the hierarchy;
- Scales attaching to each segment can accommodate different trigger criteria;
- Each segment can stand alone or be dependent on a threshold level of individual, business unit and/or individual performance.
For operative employees the proportions will be weighted toward individual performance. For the Chief Executive and Business Unit Heads the proportions will reflect organisation and business unit performance.
The Role of Executive Option PlansThere has been a great deal of discussion in the media over the past few years about the role of executive option plans as a form of compensation. In a rising market option plans look attractive. However, if the bubble bursts, as it did recently with IT stocks, executives can find their options have no value.
There is also the underlying issue of performance evaluation. Executive option plans are intended to align the interests of executives with the interests of shareholders. However the assumption that movement in share price constitutes performance at the executive level is somewhat doubtful. As Dobbs and Koller point out in Financial Review ‘Boss’ (8th October, 2000 pp 60-61) the share price is subject to the vagaries of the market. Companies may perform well, achieve targets and have a top executive team. Yet the share price remains relatively stable.
On the other hand some companies with a relatively poor level of corporate performance have fared remarkable well in the share market. This has delivered windfall gains to executives when arguably performance does not justify such levels of compensation.
Share price movement is, at least in part, driven by total market and sector forces. These are usually beyond the control of individual managers or organisations.
Option plans are part of a risk sharing strategy for executives and need to be viewed as such.
Employee Share SchemesLike executive option plans employee share schemes have been rising in popularity over the past few years in Australia. According to one survey approximately 90% of Australia’s top 500 companies offer some form of employee share scheme . A Federal Government review is currently underway to consider the tax and regulatory framework surrounding employee share ownership schemes.
Advocates of employee share plans have long expounded the benefits such as:
- Positive impact upon employee performance, particularly motivation and productivity;
- More harmonious employee relations;
- Increased employee interest in company operations;
- Improved company profitability.
Some companies have introduced ‘Performance Rights’ plans where the right to acquire shares is issued in lieu of Short Term Incentives (subject to the achievement of certain performance targets).
The Effectiveness of Incentive PlansAs mentioned above there has been considerable discussion in the media and in academic circles regarding the effectiveness of performance based incentive plans.
In the real world it is difficult to separate out the various factors influencing performance.
We are not able to predict, with certainty, that the introduction of a performance based incentive plan will lead to performance improvements. As much depends upon the manner in which the plan is introduced as it does upon plan design.
We are, however, able to assert that where the plan brings into focus performance targets at the organisation, business unit and individual levels (and is supported by an open reporting system) then improvements are more likely to be achieved.
The fact that rewards are attached to performance at each of these levels may be less significant that the fact that targets have been identified, articulated and progress monitored.
A more appropriate terminology for performance based incentive plans is clearly ‘variable at risk’ remuneration’ This terminology implies that this component of remuneration is contingent on collective and individual performance outcomes. For senior executives this component may be significantly larger than it is for administrative or operative employees.
A Major Success StoryEarly in 1999 we commenced working with a company in the insurance sector. This company had been using a discretionary approach to bonuses and wished to introduce a more rigorous and transparent performance management system to support variable reward.
The ‘Balanced Scorecard’ approach was selected as the most appropriate. It required the company to establish a range of performance measures across all key aspects of its business. As the company was relatively small, business unit measures were subsumed within the overall company scorecard.
Individual performance targets were then linked back to company performance measures.
In order to develop the company Balanced Scorecard an intensive process was embarked upon involving:
- A review of planning documentation to extract and test critical financial measures.
- Interviews with all key managers and senior staff to determine measures relevant to each area of the business.
- A ‘Balanced Scorecard’ workshop for all key managers and senior staff to ensure agreement on the measures.
- Presentation of final draft ‘Balanced Scorecard’ to the Board of Directors for agreement and sign off.
- Development of performance monitoring mechanisms and reporting formats.
- Development of an incentive framework linking company and individual performance.
- The conduct of information sessions for all staff.
- Agreement of Key Performance Indicators for all staff.
At the end of twelve months the results were reviewed. A weighted index of performance against the Balanced Scorecard measures indicated the company was 30% ahead of its target level of performance (which was set at a stretch).
All staff received maximum incentive payment from the company component of the scheme.
It is not possible to say that performance improvements in this organisation we attributable to the introduction of this type of performance based incentive plan. We are able to say, however, that all staff are now completely aware of the organisations targets, and the contribution they can make through their own individual and collective efforts.
A New Approach to Director’s RemunerationThe ‘Fixed Annual Remuneration’ for non-executive directors approach is based upon the principles of job evaluation and takes into account the following factors:
- Company size as measured by gross revenue;
- Industry Sector;
- Market/Product diversity;
- Organisation ownership structure;
- Geographic scope;
- The scope of the directors role;
- The remuneration market for directors.
Essentially we have developed a set of regression equations from a number of published directors remuneration survey underpinned by standardised job sizing processes. This enables a far more accurate approach to setting fixed remuneration for non-executive directors.