Incentive Compensation Plans Promise More Than They Deliver

A promise not met is worse than no promise at all

While it may seem like only yesterday, it was 60 years ago or so when companies began to introduce what was then considered a revolutionary new management concept: “incentive compensation.” That’s an eternity, especially in the fast-changing business world where change can happen faster than you can say, “disruptive innovation.”

The theory behind these plans was simple: Incent employees to work harder to add value to a company by paying them increased financial rewards when they do so. The idea seemed to embrace faultless psychological wisdom: If an employee is allowed to share in a piece of the value they create for the company, it would in their own self-interest to work harder to create that value.

But premise and practice are two different things. Once a handful of early-adopters instituted incentive compensation plans, the herd mentality of the Rewardscorporate mind took hold, spreading through the corporate universe like a virus through a first-grade classroom. And true to the mindset of corporate leaders who believe they — with their exalted rank — are the only ones who can add real value, participation in these “incentive compensation” plans became the corporate equivalent of a baseball “shutout” where one team – the top execs – prevents the other team, the lowly teams players known as rank employees, from scoring anything. It’s a major league blowout strictly favoring the corporate bigwigs.

Before long, these one-sided incentive plans became institutionalized in the ethos of corporate compensation. Today it is virtually impossible to find a corporation of any reasonable size that does not have some form of “incentive compensation.” And with the corporate rush for compensation plans grew an almost equally large coterie of independent “compensation consultants” who collect millions of dollars in fees for offering their “expertise” in designing incentive plans.

Are Incentive Compensation Plans Delivering on the Promise?

Since the idea for incentive compensation originally began to take root back in the 1950s, passing time seems to have fostered some welcome new thinking about the actual effectiveness of these plans. An increasing number of savvy business critics have come to the conclusion that these plans don’t work as intended and have become nothing more than an institutionalized boondoggle for senior executives, creating more waste than value. Count me among that group.

But don’t get me wrong; I have a deep conviction – gained from years of experience – that the concept of sharing value with those who create value is by far the most effective way to motivate fellow employees to do so. What has soured me on the effectiveness of current incentive compensation plans is that they have become so complicated and convoluted they no longer provide clear incentive. Indeed, the very concept of “incentive compensation” seems to have moved from the realm of compensation earned into “entitlements” that are mere “gimme” parts of the “pay-package” awarded for simply showing up and doing the job.  And that runs afoul of the basic reason for having an incentive plan in the first place.

Getting it Wrong Right from the Start

Specifically, there are four fundamental reasons why most of the current incentive compensation plans fail to deliver on the promise of increased effort to add value, causing the plans to be more cost than benefit:

  1. The vast majority of plans are developed by outside “compensation consultants.”
  2. The plans are complicated and convoluted to such an extent that very few can understand how they actually work.
  3. The plans are structured based on a top-down (or top-only) philosophy.
  4. The specific “value drivers” that create increase value are not identified.

Outside Consultants Offer no Inside Knowledge

Paying huge fees to outside consultants to develop an incentive compensation plan for a company has strong appeal for corporate leaders. The contention is that forking over exorbitant fees gives them more options. In reality it’s a blatant cop-out of their responsibilities, and a supreme example of laziness for shirking the hard work necessary to develop a company-specific plan.

For an incentive compensation plan to be effective, the triggers for benefit payments must be based on the unique value-drivers of each company. Bringing in an outsider who has little knowledge of the inner workings of the company and less concern for its success is a recipe for a complicated, copycat ineffective incentive plan. What company managers receive from an outside consultant is a cut-and-paste template like the plans adopted by “peer-group” companies. Management is led to believe that because other companies have implemented similar plans, they must be effective.

There is another, more insidious, reason why many companies use outside consultants to develop their incentive compensation plan. Because most of the incentive compensation is intended for the pockets of corporate bigwigs, using an outside consultant allows senior management and the board of directors to hide in the security of the herd. The notion is that if the plan adopted is similar to the plans of other companies, then it must be the right thing and protects management (the primary beneficiaries of the plan) from the criticism (and legal action) of being self-serving. None of these are good reasons to pay huge fees to outside compensation consultants, but it is an easy way out.

If It’s Complicated it Must be Better

A big problem with most incentive compensation plans is that they are so complicated that even those allowed to participate are unable to understand exactly how they work. In addition, many of the “trigger-targets” are based on results that the participants feel they have little power to directly impact. If participants are unable to decipher the details of the plan and don’t feel they have the power to effectively influence the outcome, the plan does not offer much incentive.

When I was CEO of Allianz Life of North America, I was among a limited number of executives who were graced with an incentive Complicationscompensation plan of the parent company, Allianz of Germany. I remember receiving a packet of information about the plan that ran to something like 15 to 20 pages of excruciatingly detailed explanation. It was wall-to-wall charts, graphs and nebulous “what ifs.” I kid you not, reading engineering plans for nuclear fission would have been easier to fathom than this plan.

Worse, the “triggers” of the plan were based on the international results of Allianz; 99 percent of which I had absolutely no power to influence or control. Like many who are “enrolled” in these types of complicated plans, I tossed the packet in a bottom drawer and forgot about it.  The Allianz plan (developed by outside consultants) was more like a crapshoot using someone else’s money. If I won, that was fine, but if not, then no big deal. Certainly there was not much incentive generated and if Allianz ever did pay anything out under its plan, it would be wasted money.

The Trickle-Down Theory of Incentives

Without a doubt, the principal complaint I have with current incentive compensation plans is that they are structured in a top-down format. These plans start with the CEO and then trickle down to upper levels of management, beyond that, most are cut off from participation. The justification for this methodology is that only the CEO and senior management are capable of adding value to the company. Evidence and experience has led me to believe that this is a flawed theory and even more, that it is dishonest.

My belief is that the CEO and senior management set the vision and direction of the company, but true value creation comes from the bottom up—not the other way around. To be truly effective, incentive compensation should start at the lowest levels of the organization and work its way to the top. The CEO and senior management should be the last ones – not the first – to receive incentive compensation; and the compensation paid to senior management should be a factor of what others have received. Under a well-constructed plan of this sort, the CEO and senior management of a company could ultimately receive more, not less in rewards.

The chief weakness of a top-down incentive plan is that most employees are not participants and have zero incentive to make the extra effort to add value. Even when those at lower levels of the organization are allowed to participate, more often than not, the incentive payments are based on objectives over which they feel there is little power for them to influence; this can result in even negative incentive.

Focus on Small Steps Rather than Big Leaps of Faith

Another glaring weakness of current incentive compensation plans is that payouts are based on broad, general results such as increased revenue, improved return on investment, increased shareholder equity and/or stock value. Certainly these results are important, but very few individuals in any organization understand how these objectives are achieved or believe that they have the direct power to favorably impact the results. Because of this, the plans offer very little, if any, incentive for individuals to make the extra effort to add value.

Instead, incentive plans should focus on the incremental “value drivers” that each individual, department or division can understand and have the power to influence. Taken together and coordinated, these individual value drivers will ultimately result in improved revenues, increased profit, enhanced return on investment and greater shareholder equity. When incentive payments are based on those individual efforts that drive value, incentive is achieved and value is added.

And the Moral of the Story …

Each one of the individual problems mentioned in the body of this piece can reduce the effectiveness of any incentive compensation plan, but when all four flaws creep into a plan – as is the case with most current plans – any hope for actual incentive is totally destroyed. At best these plans simply become a boondoggle for senior management (maybe the intended ultimate result) that increases costs, wastes corporate resources and fails to deliver on the promise of increased incentive for increased value.  This is good reason to junk current plans and develop a new type of incentive plan that allows all members of the organization to be in “incentive parallel” and deliver even more than it promises.

(This article has focused on the structural failure of existing incentive compensation plans, but it was not meant to suggest that the concept itself is flawed. It is the way the concept is implemented that is flawed. Next week, we will offer suggestions as to how incentive compensation plans can be structured to deliver on the promise of increased incentive to add value.)

One response to “Incentive Compensation Plans Promise More Than They Deliver

  1. I really like the trickle down theory for incentives. The whole idea means that everyone works together a whole lot better when the goals are the same. Lower employees may resent management if they see bonus and incentives not being distributed fairly. Thanks for this in depth look incentives!

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