Build a better bonus

How pay-for-performance bonuses could be hurting your business

For employees at Wall Street powerhouse Goldman Sachs, opening their latest paycheque was a real treat. Workers at the investment bank recently split a whopping US$16.5 billion in bonus pay. That reward for the firm's soaring revenue, profits and stock price works out to an average of about US$622,000 per employee. And while most can only dream of such a rich payday, some form of bonus-for-performance plan is now a common part of pay packages. According to compensation consultants, however, a lot of those plans are not helping improve corporate financial performance–and some may actually be hurting business.

Nearly 88% of companies pay their professional employees some sort of performance bonus, according to a recent survey by Mercer Human Resource Consulting. The average professional worker will earn about $7,200 in bonus in 2006–representing about 10% of base pay. Senior managers will do even better, taking in just over $65,000 in bonus money–or about 34% of base salary. According to Mercer, the average Canadian CEO will rake in about $179,500 in bonus pay in 2006, or about 52% of base. “For CEOs as well as other workers, a good performance-based bonus plan is necessary for any company that wants to offer a competitive pay package these days,” says Michael A. Thompson, principal at Mercer in Toronto.

For most companies, the pay-for-performance bonus plan has replaced the annual free turkey or Christmas bonus shared equally by all. Today, most variable performance bonus plans are determined by a formula based on a mixture of both corporate and individual results, says Todd Mathers, a senior consultant at human resources consulting firm Hewitt Associates in Toronto. Data collected by Hewitt shows that about 90% of companies have some sort of bonus plan in place, up from 43% in 1994.

However, a recent Hewitt survey revealed that most companies don't know if their bonus plans are effectively helping to grow business. While 77% of organizations surveyed cited “financial” reasons as the primary driver for implementing a bonus plan, only 28% reported that theirs actually helped improve their bottom line. A whopping 62% said they did not know (or did not track) whether their bonus plans were actually improving financial performance, while 10% reported that theirs were not helping at all. “In some organizations, using a bonus program to provide more attractive or competitive compensation takes priorities over using the program to improve business results,” says Mathers.

Bonus plans can range from a pure incentive plan (such as sales commissions) that reward nothing but individual performance to pure bonus plans (such as profit-sharing) where the reward has nothing to do with individual performance. Most plans fall somewhere in the middle.

The most important first step in creating an effective bonus plan is for a company to effectively communicate to its employees how much of their bonus is based on individual performance and how much is dependent on the company achieving its goals, says Mathers. “It can be very de-motivating for an employee to think they have achieved all the goals that entitle them to a bonus only to discover that there were benchmarks in the plan that reduce or eliminate how much they were expecting to receive.”

Once employees understand what kind of plan is in place, it's important to measure goals that they can realistically achieve. Those must be properly thought out to ensure they are rewarding behaviour the company actually wants to promote, says Liz Wright, a compensation consultant with Watson Wyatt in Toronto. A poorly designed bonus plan can produce unintended and sometimes disastrous results. For instance, Wright is currently helping one Canadian company in the service industry revamp a plan that emphasized the individual achievements of its employees without taking into account the overall performance of the business units they worked within. “The plan was rewarding employees that took business from other employees within the firm rather than working collaboratively with other team members to help meet the needs of the client,” Wright says.

The most effective bonus plans are also flexible enough to take into consideration changing business conditions–and will reward employees for exceptional performance in dealing with unforeseen circumstances, according to Wright. “Without a plan that has some flexibility, you can wind up with employees who are afraid to take risks for fear they will lose out at bonus time,” she says.

Ultimately, when it comes to getting the best efforts out of employees, even the most generous performance bonus plan cannot take the place of active and effective management, says Mercer's Michael Thompson. Employees shouldn't have to wait until bonus time to find out what their managers think about their performance. “Employees always know where they stand in a well-designed and well-communicated bonus plan,” Thompson says. “There should be no surprises when they open up their bonus cheque.”