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Boost Productivity with an Effective Incentive Compensation Plan

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When your business and the local economy are booming, incentive compensation can help you hang on to valuable employees who could easily be lured away to work elsewhere. When the economy is slow, employees may not have many alternatives to their current jobs. In that circumstance, you need motivated employees evenmore -- particularly if you have stretched your staff thin to offset stagnant or declining revenue, or are on the ropes.

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Short-term incentives (STIs) are incentives which measure performance over a one-year or less period. A recent study* showed nearly every employer who participated in the research offers STIs. Three-quarters of those employers offer more than one STI plan, and the use of multiple plans is rising. In 2011, roughly 23 percent of private employers offered at least four plans, and by 2013, this figure had grown to 30 percent. Most often, these plans are made available only to exempt salaried workers.

Long-term incentive plans, offered by 56 percent of the survey base, include stock options, restricted stock and phantom stock and similar mechanisms. In general, the smaller the company, the less suitable or practical stock-based incentive plans tend to be.

Focus on Short-Term Incentives

The most common form of STI is the annual incentive plan, which bases pay-outs on pre-established, objective formulas. The survey showed that annual incentive plan eligibility is almost universal among senior executives and managers. However, only about 42 percent of nonexempt salaried employees and 45 percent of hourly workers were also eligible.The median anticipated cost of STI plans is six percent of annual operating income.

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Of those employers surveyed, 68 percent said the primary reason for having annual incentive plans was to "align employees' incentives with short-term goals" of the company. No surprise there.

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When asked to rate the effectiveness of their annual incentive plans, the results were mixed. On a one-to-five scale, with one being the most effective and five being "not effective," the largest group (42 percent) rated their plans smack in the middle, with a three. Thirteen percent rated their plans as four, and another 13 percent ranked their plans at five.

The accompanying tables provide more detail. Table 1 shows how employers with annual incentive plans understand the strengths and weaknesses of those plans. Table 2 shows the prevalence of various components of the formula which determines the size of the incentive payout for any given year

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Table 1Most Commonly Identified Strengths for Annual Incentive Plans

Performance linkage (corporate, unit, individual) 78%

Type of performance measures 71%

Level of reward opportunity 72%

Most Commonly Identified Weaknesses for Annual Incentive Plans

Risk-reward tradeoff 78%

Level of discretion 59%

Goal setting 52%

Source: Worldat Work / Vivient Consulting Incentive Pay Practices Survey

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Table 2Annual Incentive Plan Performance Indicators

Financial Profit/income 79% Revenue/revenue growth 56% Cash flow/cash flow growth 15% Total shareholder return 1% Other 19%

Operational Customer satisfaction 26% Service/quality 21% Operational efficiency 19% Safety/occupational injury 10% Employee satisfaction / engagement scores 3% Other 9%

Individual Performance ratings 50% (approx.) Individual goal attainment 33% (approx.)

Source: WorldatWork/Vivient Consulting Incentive Pay Practices Survey

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What other kinds of STI plans are out there? Table 3 gives a rundown.

Table 3Types of Short-Term Incentive Plans Offered

Annual incentive plan 86%

Discretionary bonus plan 47%

Spot awards 39%

Retention bonus 27%

Team/small group incentives 17%

Profit-sharing plan 16%

Project bonus 13%

Gain-sharing plans 4% Source: WorldatWork/Vivient Consulting Incentive Pay Practices Survey

Plan Characteristics

Following are key characteristics of these STIs as defined by WorldatWork:

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• Annual incentive plan. Tied to the accomplishment of specific results, generally not discretionary.

• Discretionary bonus plan. Amounts determined by management, with no preset formulas, promises or guarantees.

• Spot awards. Reward special contributions as they occur for a specific project or task.

• Retention bonus. A reward offered to employees who stay put during a defined period critical to the company's success or survival.

• Team/small group incentives. Often offered when it is difficult to separate the contributions of particular employees from the measurable results of a team.

• Project bonus. Can be paid to an individual or team upon successful completion of a project by an assigned deadline.

• Profit-sharing plan. Ties employees' total compensation to company profits, usually based on a pre-determined formula. Some profit sharing plans have a discretionary component.

• Gain-sharing plan. Rewards calculated on productivity gains, by either an individual or a team.

Sources and Solutions for Ineffective STIs

When employers aren't fully satisfied with the impact of their STIs, the common culprits and solutions include the following:

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11 Employees have begun to take these bonuses for granted.Possible remedy: Mix it up. You don't have to offer the same STIs forever. Also, be careful not to assume that all employees will respond in the same way to particular incentives. Sound them out to gain insights on what's motivational.

22 The size of the awards is too small.Possible remedy: Try to be as generous as you can, based on the value of the rewarded performance to your company's success, instead of an arbitrary number that just sounds right to you.

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33 Employees don't understand the purpose or calculation method for the incentive.

Possible remedy: With the exception of spot awards, be sure you have taken enough time to explain the purpose of these incentive schemes and how they connect individual employees and employee teams to the broader success of the organization.

44 You didn't give enough thought to your specific expectations for the incentive plans, or how results could be measured.

Possible remedy: Take a strategic and holistic approach to establishing bonus programs, and ensure you are clear about the measurable results you are looking for. Analyze the results carefully before drawing conclusions about the incentives' success or ineffectiveness, then modify your offerings accordingly for the next performance cycle. Keep in mind, your business needs might have changed, and your STIs need to be adjusted accordingly -- or even dropped.

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