4 Rules for Balancing Salaries and Incentives

By Ken Gibson

balancing-salaries-and-incentives
If you run a business, you want to pay people the least amount possible while still achieving maximum performance, right? You also want your employees to have an ownership mindset and be effective stewards of the outcomes their role should help the business achieve, correct?  In addition, you want your people to focus on driving the revenue engine of the company so this year’s targets can be met while simultaneously moving towards the growth goals you’re trying to achieve, agreed? Finally, you’d like to minimize guaranteed pay and tie as much of your employees’ compensation to actual results as possible, am I right?

Simple enough.  You just need to find the right balance between salaries and incentives and then plug it into your pay structure. Voila!

Okay, so assuming you’re struggling a bit finding that balance, here are some rules that might help.

Rule #1: Identify and Communicate Clear Business Performance Targets

Presumably, your company has a vision of the future business that is in some way bigger and better than the present one. What are the markers that have to be met for that growth to be achieved?  What are the leverage points in your business model that will allow that to happen?  What kind of quarterly and annual targets need to be met (such as sales, revenue, profit) versus long-term results (margin improvement, return on equity, market share).  How is value created and accelerated in your business?

Rule #2: Define a Clear Pay Philosophy

Given the performance framework you have addressed in Tip #1, what do you believe about pay? Exactly what should your employees be paid for? To what degree should employees share in the value they help create?  How does that differ based on the tiers or roles you have for employees?  What balance do you want in paying for short versus long-term results? Which is more critical right now—or are they equally important?  Where do you need to be vis-à-vis market pay to compete for premier talent in your industry?

Rule #3: Create Pay Plan Alignment

Ultimately, there are about eight different compensation and benefit components that could make up your value proposition.  They would include:

  • Salary
  • Annual Performance Incentives (short-term value-sharing such as bonus plans)
  • Long-Term Incentives (equity sharing, phantom stock, profit pools, performance units, etc.)
  • Sales Incentives (commission-based programs)
  • Welfare Plans (health benefits)
  • Executive Benefits (car allowance, supplemental life or disability coverages, etc.)
  • Retirement Plan (usually 401(k))
  • Executive Retirement Plan (usually deferred compensation or 401(k) mirror plans)

For a pay plan to be aligned, you need to determine which of those eight components will be included in your compensation strategy and how much weight will be given to each. This can only be decided as you identify the purpose of each component as it relates to your performance framework (see Tip #1).  Alignment occurs when there are specific pay plans that reinforce each of the outcomes you’ve identified with your company performance targets. For example, if a company has a three-year target to grow from $100 to $150 million in revenue while improving return on equity by 2%, but the only components of compensation currently in place are salary, annual bonus, a group medical and 401(k), then there is a lack of pay alignment. There is no component of pay that communicates the importance of the organization’s long-term growth goals.  Or, if this company is paying its people at the 80th percentile of market pay while allocating 80% of value-sharing dollars for short-term (annual) results and 20% for long-term, there is also misalignment.  There is still too much of a short-term focus and probably too much being allocated to guaranteed pay in the form of salaries.

Pay alignment is at the heart of the balance issue when it comes to guaranteed versus variable pay.  This is why a pay philosophy is so important.  That philosophy forces you to think carefully about what you care enough about to reward. Those priorities are like the sketch you make before completing an oil painting.  They tell you what needs to be emphasized and to what degree to create a whole picture that reinforces the outcomes you seek.

Rule #4: Build and Maintain a Total Compensation Structure (TCS)

A TCS is a framework you build for managing and analyzing all the components of pay and benefits you are offering.  Ideally, it gives you an “all in one place” view of every employee tier, what plans they’re eligible for and at what level.  It allows you to evaluate the whole value proposition as opposed to each individual component in isolation.  Within this framework, it is easier to make decisions and adjustments in specific pay plans because you can measure each against its impact on the whole picture.

When a TCS is built properly, it allows you to have integrity in how you operate your overall compensation strategy.  By integrity I mean there is continuity and consistency between the company vision, the business model and strategy, the pay philosophy, employee roles and expectations and specific rewards for achieving results. That structure creates the assessment symmetry needed to achieve the right balance between salaries and incentives—and every other part of your pay offering.

In the end, perfect design is rarely achieved in an organization’s approach to compensation. However, if you apply the four tips just discussed, balancing salaries and incentives will become much less an esoteric ideal and more an implementable strategy.

To dive deeper into this subject, watch VisionLink’s webinar recording entitled “Salaries and Incentives: What’s the Right Balance?”