Fundamental Considerations for Designing your Variable Pay Plan
At a recent MEA Insights Webinar, Lou Lazo, Compensation Consultant for MEA’s sister-organization, Employers Council, presented on the design process for building a variable pay plan.
Basic Vocabulary for Variable Pay Terms:
- Fixed Pay: Compensation that has a low risk of non-delivery. Highly predictable and reliable.
- Variable Pay: Payment made only after the occurrence of an event or specific performance. May be predictable but not guaranteed.
- Leverage: The ratio of variable comp to fixed comp.
- Motivational Value: Subjective assessment of the degree to which a plan can motivate, change, or drive behavior. A large number and an unachievable goal will have little to no motivational value.
Variable Pay Illustrated
Bonus: Variable pay that is delivered based on time or event. The link to individual performance is weak or non-existent. Examples are holiday or year-end bonuses. Weak motivational value. Mid to high goodwill value.
Incentive: Variable pay delivered in response to specific performance against goals or metrics. Link to individual performance can be weak or strong. Examples are profit sharing plans or most traditional incentives tied to business metrics such as sales, profits, etc.
Commission: Variable pay delivered in response to very specific achievements or very measurable performance. The link to individual performance is very strong. Individual sales plans are the most common example.
Variable Pay Design Process:
1. Analyze and Understand your Ability to Pay, Business Metrics, and Business Relationships
Questions to Consider:
- What do we want to achieve?
- Who will participate?
- Is variable pay plan funded, paid for by performance, or funded with a pay mix shift?
- How much business performance detail do we have?
- Do we have high or low leverage?
- What is the impact on team behavior?
2. Set Goals for Variable Pay
According to Lazo, before designing the plan, your organization should set specific goals for the plan. Examples of these goals include:
- Improve profitability by 10%.
- Improve sales growth by 5% over market average rate of change.
- Improve employee productivity using a ratio such as Sales per Payroll dollar.
Remember, variable pay does not serve to replace the role of your managers, but it can be an effective management tool.
3. Review and Revise your Compensation Philosophy
- Describe the role of variable pay.
- Explain the leverage choices.
- Consider the type of employee and any new role or behavior expectations.
- Describe the results of nonperformance.
4. Design and Model a Plan
When designing a plan of action, make sure you layout the inputs, outputs, and parameters.
- Set the target bonus and target performance.
- Set the minimum performance and the minimum payment.
- Set the maximums.
- If using multiple parameters, decide on weighting.
Lazo emphasized the most critical point is to understand the financial impact. He stressed that if you can’t model it, you cannot manage it. While the model should include all inputs, outputs, and parameters, your model must also be dynamic. You should be able to follow an input change through to the outputs. He went through an example during the webinar.
Document the Plan and Develop a Strong Messaging Strategy
According to Lazo, this phase should be consistent with current organizational practices. In the documentation, include a goal statement as well as the reason for the plan being developed. You should also include these components:
- Variable pay levels and performance expectations.
- Plan entry and exit rules: mid-year hires, proration, termination, leaves of absence.
- Employment-at-will and contract language.
If you would like to learn more or speak with us about developing a variable pay plan, please reach out to Matt Roessler, email@example.com.