Why Variable Pay Matters
A recent survey finds only 31 percent of companies report success in sustaining a positive impact for at least five years, but companies can use variable-pay programs to help sustain new business imperatives.
By Peter Gundy and Tim W. Weiler
When was the last time you bought a typewriter or an adding machine or printed encyclopedia? What happened to the companies that manufactured those products? You may be surprised to learn that some of them are still thriving today, including notable companies like IBM and ones that have reinvented themselves like Smith Corona. Much of our day-to-day experience has been transformed by disruptive technologies, industry consolidations, changing consumer preferences and buying behaviors, and these are major drivers of massive shifts in industries such as high technology, publishing, telecom, and consumer products.
What separates Apple from Wang or Shutterfly from Fotomat? How does a company transform itself successfully? To be sure, real success is derived from a significant change management effort that only a few companies can pull off and -- importantly -- sustain over time. Our recent survey of companies that have undergone significant change initiatives shows that only 31 percent report success in sustaining a positive impact for at least five years.
In the wake of an industry transformation, human resource managers and business leaders are faced with the challenge of moving their organization from an "old world" to a "new world". This article focuses on the companies that succeeded in transforming themselves and how they used variable pay programs to expedite the process.
Why Industries Change
There are many forces that trigger shifts to an industry and force companies to reinvent themselves. Among these forces are three significant ones:
This term refers to the tendency of different technologies to evolve toward performing the same task. The digital revolution has created so many new avenues for companies to reach their customers and to tap new demographics. For example, broadcasting and entertainment have been affected dramatically by this wave, with content being made available on TV, online, and handheld devices. Convergence has also threatened the revenue model in industries like broadcasting that have relied heavily on advertising revenues through the traditional print media and on selling printed copies as a way to protect intellectual property.
There are numerous examples of regulatory intervention (or deregulation) that have changed the landscape in many industries. A notable example is The Fair and Accurate Credit Transaction Act that became law in December of 2003, which provided that consumers have a legal right to a free credit report. While some credit score providers were already providing credit scores, this legislation cemented a permanent change for the industry. Credit reporting and credit-card companies everywhere in the U.S. began to diversify into personalized financial services (e.g., identity theft protection) and data mining services (e.g., predictive modeling to inform consumer marketing decisions).
Commoditization occurs when the market becomes saturated with competitive substitutes and with disintermediation. For example, office suppliers, distributors, and technology companies have adapted their business models dramatically over the years. These companies have differentiated themselves by providing value-added services on top of price-competitive products. Office supply superstores, for example, now compete in two additional categories: computer hardware and document services.
Why Variable Pay Matters
Many things have to go right for a company to be successful in adapting to change. A new strategy needs to be developed, the business model may need to change, and new types of skills and capabilities are often required. In nearly all cases, organizations will also use incentive compensation to support the change initiative.
The debate about whether or not variable pay truly drives behavior continues today. We don’t, in this article, seek to resolve this debate. In our experience, however, incentive compensation is one of the most effective tools a company has to achieve four basic objectives:
Convey to existing employees "the new path to success" -- what the company now values, what new behaviors are desired, what new results need to be achieved, and how these new results will be measured
Align and vary compensation costs with performance so that the company can modulate its investment in new markets
Attract employees with new skills or risk tolerances to help propel the company into new markets or geographies
Signal to low-performing employees or those unwilling to change behavior that it may be time to select out.
These four objectives are critical to a successful business transformation.
Seven Lessons from the Front Line
So what have companies that have successfully navigated from the "old world" to the "new world" done to motivate new business imperatives with their variable compensation programs? In our experience, these leaders apply seven basic principles:
1. Create a clear understanding of the imperative for change
The business case for change must be well understood to
ensure employees understand the context for changes in compensation and other
programs. The core purpose for such change should be reinforced in all
incentive pay, performance management, and measurement communications. Consider
the case of a technology company that was combatting the commoditization of its
hardware by reinforcing the importance of a cross-selling and solutions
orientation. Their objective was to reinforce with customers that they were not
just buying products but rather a unique bundle of products and services that
would solve their business problem (which could be priced based on value and
drive stronger profitability). As part of their incentive communications, this
company outlined examples of how single product/service customers had eroded
its profits margins over time as compared to multi-product/service customers.
2. Use performance measures to communicate both desired results and behaviors
The adage of "what gets measured gets managed and what gets managed gets done" is often used cynically to describe archaic management practices. Yet compensation professionals understand that there is an art to using performance metrics effectively. When line-of-sight measures are used in incentive plans and there is confidence in the goals and the underlying performance data, employee engagement and buy-in goes up. A national equipment rental company (an industry that has faced its own "convergence" of commercial and retail providers) was facing increased price competition from local "mom and pop" operators so it was imperative to meet minimum pricing standards to protect profitability. Incentive measures were added to both the sales and operations pay plans to reward those who protected and exceeded price expectations -- which pushed sellers to focus on the value proposition of renting from a full-service provider (faster delivery, and fewer costly delays due to breakdowns).
3. Set pay mix to promote the appetite for risk
A vital part of reinventing a business is innovation and risk-taking. In nearly all cases cited in this article, the companies increased the percentage of total compensation derived from incentive compensation. Successful companies have used pay mix as a way of signaling a new posture toward risk. One publishing company that was responding to the convergence described earlier was looking to change its pay practice to promote risk-taking and innovation and to reflect the practices of the smaller, start-up digital companies it was acquiring. Variable pay was increased over three years with a combination of reduced merit budgets and increased incentive targets. Selected leaders of the organization were also given the opportunity to forgo portions of their salary in exchange for a disproportionate increase in target incentive pay.
4. Balance risk-taking with risk management
Consider the impact recent regulation on the treatment of incentive pay in financial services brought on by the Dodd-Frank Act. The risks and consequences of a financial transaction can span many years after incentives are paid to those who involved in the deal (e.g., most mortgages span 15 to 30 years, which is a long time, but they can be as long as 100 years in countries like Japan). In addition to reorganizing their business model to address new capital requirements and other regulatory requirements, many banks now defer payment of a portion of the cash bonus over three- to four-year periods respond to risk-balancing concerns. Pharmaceutical organizations, faced with lawsuits alleging off-label sales / promotion practices have shifted to less pay at risk and balanced incentive plan production measures with physician satisfaction and key objectives tied to demonstrating skills.
Don’t underestimate the need for competency development and personalized touch to reinforce the new deal
Compensation is the most sensitive nerve in the body and any changes are bound to create organizational and personal anxiety. The U.S. Do Not Call Act of 2003 prohibits open telemarketing to the general public but does all allow companies to solicit existing customers.
Shortly after its enactment, many companies (e.g., insurers, credit card companies) revamped their incentive plans for customer service representatives -- to include not just efficiency metrics, but sales metrics as well. In this example, regulation fundamentally changed the role of the service rep, necessitating sales competency development, training, communication, and even one-on-one discussions about the new incentive program and ways to maximize personal earnings.
6. Use goal-setting and incentive leverage to address urgency and degree of influence
The goal-setting process can be used to lend credibility to the change effort. Leading companies set realistic goals, particularly in the early years of the change effort, because they know that success itself can be a powerful motivator. The use of performance thresholds in incentive plans convey the floor for results for the plan, but also establish the tolerance of downside performance. Conversely, the upside leverage communicates the payoff for taking risks. The interplay of thresholds and upsides can send a powerful message to employees about how an organization is willing to back employees who take appropriate risks and how it can shield others who have less influence on the overall results.
7. Avoid complex program changes; keep the messages simple
Avoid introducing too many new performance measures and overloading existing plans with more components. Introduce new plans that are clear, easy to understand, and reinforce the 3 or 4 main themes/business objectives of the change effort -- ensuring the incentive programs are easy to figure out. One organization undergoing a business transformation attempted to roll out a plan with seventeen different performance measures, which is what encompassed (or so they thought) exactly all of the things they wanted employees to focus on. The plan was scrapped after one year.
Incentive Pay Is Not the Whole Solution, but it is a Key Driver of Change
When companies take on strategic change based on forces affecting an entire industry, "turning the ship" can lead to market leadership or the organization can go the way of the Titanic. A broader view of the business strategy is required, one that translates into specific organizational, human capital, and financial imperatives that are actionable. Equally important are the financial incentives that help focus attention and speed change.
A new incentive plan needs to have the "chops" to deliver on management’s objectives. In other words, the downside and upside of incentive programs and degree of differentiation should be significant enough to instill the appropriate level of "fear of consequence and promise of rewards" among employees. New incentive plans that deliver on this promise avoid the "this too shall pass" attitude that can dampen a change effort and potentially condemn a company to obsolescence.
While not a "silver bullet", incentive plans that are properly designed and communicated can improve the odds that a firm ends up in the 31 percent of companies cited earlier that sustain the benefits of its transformation for at least five years. And maybe longer.
Peter. R. Gundy is managing director, Americas, reward, talent and communication for Towers Watson in Stamford, Conn. Tim W. Weiler is director, sales effectiveness and rewards for Towers Watson in Stamford, Conn.