Bonus plans are back in fashion. Despite the outcry over bankers’ bonuses and public mood hardening against the perceived excesses associated with bonuses, there is a largely unmentioned recovery in the amounts being paid out in bonus.
Trends
In the run up to the credit crunch both the incidence and size of bonus payments had been growing year on year for five years. Immediately following the credit crunch, ONS data (see bar chart) revealed that bonus levels fell by a third in the economy as a whole and by half in the financial services sector, with headlines concealing vast differences in individual company practice. Post credit crunch, and largely unnoticed by media commentators, it is not merely financial services bonuses which have bounced back but most sectors seem to be going up on the same rising tide.
Given data lags reality, the resurgent trend line suggests UK employers have paid out c.£25bn in bonuses this past year. With this much spend attaching to bonus, it makes sense to ensure that bonus are designed to a high standard, with the key features of an effective bonus plan described below.
Eligibility
Successive CIPD annual reward management survey findings evidence the view many of us have formed, that there is a general migration towards all employee bonus plans. In past decades, all employee bonus plans were confined to the high ends of financial services, pharmaceuticals or other high margin sectors. True to say that certain low margin sectors like high street retail, support services and hospitality have so far remained largely untouched, but it seems an inexorable trend to extend bonus eligibility ever further down the organisational hierarchy. As a means of flexing pay bill costs and aligning reward to the business cycle, the extension of variable pay represents an effective alternative to headcount reductions. It also helps to explain the trend towards increased bonus expenditure.
Plan philosophy
Being clear about what you want to achieve for the organisation and its employees is critical. If the organisation wants to emphasise team work, whole company success and to thank employees for their contribution, a profit share may best fit. This is a practice famously promoted by John Lewis, as recently as last month awarding 15% of salary to all their 'partners'.
In contrast, if the business wishes to emphasise individual contribution and to promote a more competitive culture then individual incentives might be to the fore – in common language a bonus which is more of 'please' than a 'thank you'.
Performance measures
Selecting the most appropriate performance measures is key to aligning payments to results and to assuring the business of effective bonus spend. It may be a single performance measure is considered sufficient, but it is more likely that two or three of the following will achieve the optimum solution, possibly even blended into a balanced scorecard:
- Profit before tax;
- revenue;
- EBITDA;
- economic value added (EVA);
- net asset value (NAV);
- 'return on' measures such as ROCE;
- non-financial measures; and
- target-setting.
Too much importance can easily be attached to the design of a bonus plan and too little significance to the target-setting process. However well designed the bonus plan, its effectiveness will always be undermined by a business which proves unreliable or unrealistic in its target-setting. If the target numbers lack credibility and goes beyond the stretching but achievable, into the unimaginable, plan participants will likely disengage and the incentive value of the plan will be diminished.
To increase the likelihood of an effective bonus plan, attention needs to be given to the following three questions:
- Line of sight – are employees able to see the goals they are shooting at and are the goals within reach? If the distance to the target is too great or you are requiring them to shoot round blind corners they may feel the relationship between contribution and results is random.
- Calculation – can the business attribute performance accurately, in a manner which both incentivises focused activity and rewards results fairly in the eyes of recipients?
- Threshold – is a minimum level of achievement required to trigger any payment (e.g. financial results which are at least better than last year)?
Payment Calculation
The method for calculating bonus payments needs careful consideration, both to manage affordability and to ensure appropriate messages are sent to employees. The choices are:
- Percentage of salary – probably differing for employees at each grade/level;
- fixed amount – more commonplace in all employee plans; and
- to base bonus on a predetermined bonus pool formula – as a means of regulating expense.
If the calibration of results to payments results in a maximum bonus compared to an uncapped opportunity, it might unhelpfully suggest to employees that the organisation’s ambitions are limited. The same could be true for the speed at which bonus is earned relative to results, with many organisations preferring to accelerate the rate at which bonus is earned above target, thus recognising and rewarding the higher challenge of achieving superior results.
Timing
The last important consideration is the frequency and timing of payment. If the relationship between contribution and results is short-term it could be more effective to pay bonus (or at least a proportion of bonus), more frequently than annual. However, the prevailing convention is for a bonus plan to deliver annual reward, aligned to the financial year.
Most employers, particularly in financial services during the past two to three years have been extending rather than shortening the payment period, with the incidence of deferred bonus schemes featuring more highly among senior level employees. For the financial services sector, the FSA has specifically promoted deferral via its Remuneration Code requiring part bonus deferral in shares, as a means of aligning and adjusting reward to the longer-term/realised risk.
Do
- Think about the messages you want your bonus plan to send.
- Understand the company, its lines of business and sales cycles before tying to design a bonus.
- Involve line and finance colleagues in plan design.
Don’t
- Try to incentivise what you cannot measure.
- Believe current bonus plan design, however effective today, will remain effective in the future.
- Assume people will get it – you cannot over communicate a bonus plan design.
See also: 'Rewarding success' by Tom Gosling in The People Bulletin, 3 March 2010