Principles of a Successful Performance Based Pay Plan

Remuneration that is tied to performance is a double-edged sword. Whether you call it a bonus, variable pay, or pay for performance, the intention is the same: create a real and personal link between success and pay. This can be the single most effective weapon an organization can employ in helping employees get motivated and truly engaged in the strategy of the firm. On the other hand, performance pay can become an expected part of base pay, or worse: a major de-motivator of success.

To be truly effective, performance pay needs to be tightly linked with the business plan at the strategic, operational, and tactical levels. Organizations should consider some key principles:

The performance based compensation system should balance the good of the individuals, the teams, the divisions and the entire organization.
If too much of the compensation is aligned with high level measures such as ROE, most managers and employees will feel helpless to impact the measures in their work, and the compensation system will be either neutral or negative. If the measures are tied too heavily to team and individual components (impact on a single project, or a single sales target or budget for example) there will be an "every man for himself" mentality that gets downright dysfunctional.

The payout should be relatively material to every individual.
If the possible payout is just too small to matter, it won't. For staff at the lowest levels of the organization, they are going to need a possible payout of at least 5% of their total compensation to get their attention. For the senior team it will take at least 25% of their total compensation. Furthermore, the payout should come in a big chunk to have an impact. Paying out with every pay cheque has little effect and lacks the "good feeling" attached to a decent merit payment.

These targets should be absolute and untouchable.
With all my talk about recasting plans and targets every quarter, one thing needs to remain constant for a calendar year: the performance based pay targets.

The targets should create real stretch.
Performance based pay isn't meant to encourage people to do their jobs and achieve targets, but should inspire people to go above and beyond; stretch themselves and the organization beyond what they believe to be possible.

The payout really needs to be based on performance.
I have more than one client that pays between 90%-100% payout every year; year in and year out. This is no longer a bonus that drives behavior because everyone has come to expect a complete payout. When firms get in this situation, the performance pay starts to act more like a disincentive.

It should be a bonus, not a punishment.
Performance bonuses should be in addition to regular pay, not part of it. The regular pay scale should be fair and equitable, with the bonus as a motivator to reach aggressive targets.

The real reason we do business planning is simple: to drive results. Done right, a system of remuneration that is tied to performance can help employees stretch themselves beyond what they thought was possible and deliver results that are personally and organizationally remarkable.