Improving Your Bonus Program

December 2009

Fourth quarter is when two of the more stressful, emotion-laden annual activities in white-collar America occur: bonus allocations for the year ending and goal-setting for the upcoming one. In most companies, the bonus program is so complex and opaque that employees do not know what they will have been working for in 2009 until they receive their bonus checks from deus ex machina.

Occurring usually at the same time, the process of setting bonus goals for 2010 is the annual kabuki show wherein shareholders and senior executives push an aspirational view of performance against the employee’s “poor me” world view.

If you recognize your company in the above scenario, it's probably too late to do much about 2009, but you might consider the following suggestions to help improve your bonus plan process for 2010.

1. Clarify what the bonus program is intended to do, communicate it to employees and shareholders, and stick to it. Sounds obvious and simple, but the problem with bonus programs is the frequent disparity between what they are designed to reward and what they need to reward. Compensation committees and management make up for the disconnect with special deals and black-box calculations. This is what causes shareholders to complain about bonuses for non-performance and employees to become overly stressed and cynical come bonus time. Not even the best bonus plans eliminate this problem altogether, but they do minimize it.

Take for example, the common bonus plan that pays on broad-based financial measures such as EBITDA, revenue or EPS. A nice simple approach that funds itself and keeps shareholders happy as bonuses are highly correlated with financial performance. In years with poor financial results, however, boards scramble to justify off-formula bonuses to the high-performing executives they need to keep motivated and on board. In fact, some of the strongest performances turned in by executive teams is during periods of great financial turmoil and distress.

Or consider a bonus plan that is based on the achievement of objectives more readily identifiable with individual effort such as implementing a new plant safety program, hiring a new CFO with SOX experience, or rolling out a new product. In good years or bad, it is hard to argue with this type of plan, which can pay out strongly in a bad year and poorly in a good year, all depending on individual performance. Such plans have the advantage of allowing boards to incent desired behaviors, focus the executive team on changing priorities, and reward outstanding performance (as opposed to results). Among the downsides are shareholder optics when strong bonuses are paid during financial downturns and the risk that the incented performance is not actually driving shareholder results. Boards often compensate for this by applying black-box adjustments to take into account the company’s financial results. But again cynicism and confusion can result.

Alternatively, companies that try to combine the results and performance approaches meet with equally disruptive results. It has been our observation that companies that use a bonus plan that pays out 50% based on individual objectives and 50% based on financial results, for example, wind up creating the problems inherent in both approaches.

A strategy that we have seen work is to create a bonus pool based purely on financial results – sometimes a rolling average of financial results - and to allocate that pool on the basis of individual performance and contributions towards creating that pool. This keeps shareholders happy and maintains the possibility that employees can earn a good bonus in a year with poor overall results. It also forces management discipline around allocating bonus dollars in the most effective way (often disproportionately towards the highest performers).

2. Assess your organization’s administrative capabilities before creating a new bonus plan. A theoretically correct bonus design is useless if your organization cannot effectively implement and administer it. For example, a bonus program based primarily on one or two financial results such as revenue growth or EBITDA can be managed by one person and a spreadsheet. A bonus program designed to drive certain employee behaviors or actions that is based on the assignment and measurement of individual employee objectives is going to require a lot more. People managers need to be trained and have the time to develop such measurements, assess them and communicate them to employees. Software needs to be developed or purchased that can keep track of everything.

3. Model payouts and review design to ensure that you are not creating any unintended consequences. Some of the questions to ask include:

• Are bonus payments reasonably correlated with any cash flow on which they are supposed to be based? An example of what might be a poor practice in this category would be bonus payments tied to deal completion or sales orders booked rather than to deal success or customer payments
• Is the bonus fixed in the employment agreement or otherwise not particularly variable in practice. If so, is it part of an overall compensation program that has too much fixed compensation in the form of base, bonus and retirement benefits?
• Are bonus payments based on the same measures year after year? (This can result in a lack of freshness in management approaches.)
• Could shareholders be unpleasantly surprised by a disparity between their gains compared to bonus payouts? Such might be the case, for example, if the financial results required to achieve an extraordinary bonus payout are not particularly extraordinary. As a good rule of thumb, results that double a target payout or create a zero payout should each be achieved every five years or so.

Incorporate these three actions into the development of your 2010 bonus plan and your organization will have a stronger, more supportable program - and maybe less stress - a year from now.