Consider the pitfalls often inherent in the use of incentive compensation plans. While these pay plan designs are a common tool to focus employees on the goals of the employer/shareholder, there are generally inherent pitfalls to mitigate. The two broad categories of pitfalls are:
1. The smart people that you hire can potentially determine how to maximize their compensation in a manner that is not necessarily beneficial to the employer. Examples of possible incented behaviors are: overly aggressive selling, taking undue risks to meet a goal, timing transactions to maximize the incentive plan payout, loss of teamwork, etc.
Mitigation: Ways to mitigate these negatives are to combine the delivery of the long-term plan (if you have one) with the short-term plan or to defer a portion of the incentive amount that is above a certain level. The payout can be contingent on retention of business for a period, continued satisfactory employment, no fraud, etc.
“The key to success in providing a combined approach of short and longterm incentive plan elivery is communication.”
2. Another common pitfall is that the employee may expect the target value or more to be paid even though it is clearly stated as variable compensation. Payouts below target may spend money to make participants unhappy. Participants may feel that they should be protected from the unexpected hurricane, accounting change, loss of a major client, etc.
Mitigation: Synchronize a long-term incentive payment with the payment of the short-term incentive. The long-term payment can be a separate plan or the deferral of a prior incentive amount. This coordination can smooth the cash flow to participants while adhering to a pay-forperformance objective.
The use of long-term incentives to mitigate short-term plan risk requires a combined message on how the plans interact. Short-term incentives typically cover payouts for performance during or at the end of a 1-year period. Long-term incentives typically cover a period longer than one year. It is very important to understand that both short- and long-term goals must be met to maximize the payout.
The key to success in providing a combined approach of short and long-term incentive plan delivery is communication. The company and the employee must have the same understanding and perspective on the incentive plan design. This should include potential opportunity for calculation adjustments, accelerated payouts, and forfeitures due to unforeseen circumstances. A plan provision for positive or negative discretionary adjustments by the administrator is often considered a potential way for management to diminish a payout. So, while important to be in the document, negative discretionary adjustments are generally used by management with caution due to concern about damaging employee morale.
These comments should be considered as part of a comprehensive incentive plan design that also involves evaluation of information on market competitive practices, the company short- and long-term financial plans, and the culture of the organization. After the plan design is complete, model it under different scenarios for potential flaws. After the plan is implemented, monitor the results throughout the performance period to catch any flaws before they become a significant issue. An effective incentive plan requires attention from design through payout(s). Please contact us if we can be of assistance in maximizing the value delivery from your incentive compensation plans. stb