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Your variable pay plan probably does not work...

New research indicates that variable pay plans need to be highly contextualised and need to factor in dimensions that were not being considered in their design

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Organisations today are increasingly concerned about the effectiveness of their programmes. In a simple test to evaluate its relevance in your organisation, ask yourself the number of objectives your variable pay programme aims to meet. If you have more than two, you probably have an ineffective programme. Even companies that get the objective right, more often than not, do a poor job on the execution and communication.

The problems with variable pay plan programmes start with design, which in most companies is based on obsolete thinking. Conventional approaches need to be revisited so as to take advantage of the recent research. The continues to remain the most predominant thinking that guides companies on how they organise their reward programmes. The focus on the Agency Theory came about because of research by economists in the area of risk sharing (Boyd, 1994; Larcker & Weigelt, 1993 etc) which was followed up by organisational researchers probing the link between performance and rewards.

The Agency Theory postulates that most transactions involve a principal and an agent. As the word implies, an organisation is a cluster of principals and agents looking to deliver bigger or better results because of the association. In such arrangements, a principal can influence an agent to act in a certain way if the principal can control the incentives. The assumptions are that the agent is motivated by self interest, acts rationally and has an aversion to risk.

The research around this model has helped with it, now branched out into two parts of the problem. Aspects concerning the basic assumptions of the Agency Theory are being tested and make up one branch of research. The other approach is around the process aspects of the programme — that is, administration, distribution and communication.

An example of the research into assumptions would be a probe into risk aversion. Recent studies seem to show that people become more risk friendly if the rewards were tied to a perceived loss. Imagine an employee who is given a sum of money and told that money will be recovered from him if he didn’t meet a certain milestone. Results show that the employee will work harder and take more risks to avoid a loss. Similarly, there are studies that prove self-interest is relative. Take for example the experience of day care centres that started fining parents if they came late to pick up children. Instead of reducing late pickups, it led to increases. By setting a financial value or commoditising the time of teachers at the day care centre, a social obligation got converted into an option for parents who could choose between different priorities. In the organisational context, we have seen plans backfire when used to stem late coming, absenteeism and boosting collaboration etc.

Research into workings of the incentive programmes is more intense and has attracted a larger number of researchers and some of the findings are startling.

The most concerning aspect is related to the objective of the programme. Usually, companies have objectives that are guided either by (a) a need for a financial cushion; a need to manage fixed costs in a year and hold paying incentives until one is certain that the company will reach its targets. The other objective (b) is to drive behaviours and attitudes that result in better performance, and lastly (c) as a form of profit share/wealth creation (extremely rare) vehicle.

In most organisations, the objectives are poorly understood, and generally derived by combining aspects of external ‘best practices’ with myriad internal considerations.

The problem with this approach is that first, external benchmarks always lag market issues. Second, determining objectives on internal considerations doesn’t often follow a rational process. It becomes a victim of choices facing the organisation at that point in time and decision makers move between choices offered by the mix of known challenges, available resources and capabilities. The consequence is that variable pay programmes end up trying to solve too many problems and are poorly aligned with the business strategy of the organisation.

Once we get past the strategic objectives of a variable pay programme, we are left with the tactical approaches where we most need to start applying our learning’s from recent advances in organisational research. In our work with clients, we often find that even those organisations that consider themselves mature in matters relating to variable pay programmes, are actually aligned in very few functions in an organisation. These are generally functions where outcomes are easily measured and are prominent in their ability to impact profitability or results. Even here, the key performance indicators used are often not contextualised to the companies needs and may be determined based on what ‘others’ are doing. These are measures that are not ‘fit to perform’ their function. Most other organisations are trapped in annual cycles of calibration and payouts which are only partly effective and make employees question the credibility of the firm and its human resource programmes.

Towers Watson estimates that outside of the top executives and some managerial roles, most of the organisation is not clear on how their efforts translate into business success. At most there is a vague sense of how it all fits into the big picture.

But we all know that the ‘line of sight’ between effort and reward is essential if people are to contribute. The issue is less of communication as much as it is of alignment in a very dynamic business environment. Compensation programmes that are firm wide and monolithic (for reasons of administration or governance) do not conveniently translate to a level or language that makes sense to most employees.

The scope of error in having a large, firm wide (and globally consistent) variable pay programme is getting so large that some studies are questioning how far variable pay programmes go in delivering competitive advantage. The organisational focus, unanticipated costs of management time, administration efforts and the time to manage fallout is contributing to an increasing body of literature arguing against variable pay programmes.

All considered, it is too soon to declare variable pay programmes as a great but impractical idea. Its instances of failure are mostly on account of its poor relevance to context and it has far too numerous instances of success for us to dismiss it. Interestingly, the occasions where the approach is successful is almost always in situations where things were measurable, were specific and focused and clearly understood by the eligible employees.

Depending on certain industries, the latest thinking in variable pay design are moving towards customised approaches. The customisation happens by segmenting the workforce on lines of impact on profitability and control over results (See illustration) and then having contextualised metrics, payout schedules and vehicles.

This would mean that the number of programmes under management will increase (see figure below) substantially and there will be consequent investment in administration costs and efforts, but on the other hand, programmes will become more specific and relevant to people in each function. In our experience, we have also seen that the quality of communication relating to variable pay plans improves and employees are better able to align efforts to business direction.

However, certain functions will remain far from value creation and expending efforts to customise for such groups may not provide returns that match the effort. For such roles, it is important to ask if the quantum of variable pay and the ability of role holders to influence results justify the need for incentives. Short of acting as a financial cushion for the organisation, variable pay programmes at this level/for these employee segments will probably only serve to disengage employees and their managers. For variable pay plans, such situations should be considered for elimination.

Like most other strategic interventions, designing and deploying variable pay plans is easier said than done. Despite all other things being thought through, communication and managements ability to reassure employees on fairness probably is as important as addressing design issues. Considering that current variable pay programmes are often seen as unfair, opaque, ineffective in driving business strategy, a targeted approach is required and is the next step in the evolution of workplace incentives.


The author is director, talent & rewards, Towers Watson India

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