Incentive systems

Incentive systems

1. Employees value, positive rewards, provide motivation which drives performance in results controls

2. Purpose of incentives

   • Informational benefits
     • Remind employees of importance of competing results areas
     • Signal to employees where their efforts should be directed
       • Remind employees in a meaningful way what their priorities are
     • More significant effect if paid a bonus for x as opposed to merely stating x's importance
   • Motivational benefits
     • Effort-inducing
     • Bridge the gap between self-interest and the org's best interests
     • Even the most hardworking employees have a natural aversion to difficult or tedious actions
   • Attraction and retention of personnel
     • Performance-dependent rewards offer a competitive package, linking rewards to their continued employment
     • Below average base salaries but above average total compensation will attract those confident in their abilities
   • Non-control purposes
     • May be a trade-off between control and non-control purposes
     • Performance-dependent incentives would make compensation more variable with firm performance, decreasing cash outlays when performance is poor; smooth earnings
     • Design of incentive systems may reduce firm's tax bill; tax deductibility of compensation packages
     • Design needs to comply with government regulations

3. Monetary incentives

   • Performance-based salary increases
     • Annual increment
       • Cost-of-living adjustments + merit-based increases linked to performance
     • Small proportion of employee's salary
     • Valuable because they provide an annuity that persists for many years
       • Salary increases come with an expectation of sustained performance, whereas bonuses represent one-off performance
   • Short-term incentives
     • Based on performance over periods of 1 year or less
     • Bonuses, commissions, piece-rate payments (usually timeliest)
     • Rational for pay-for-performance is so that rewards are provided in accordance with employee contribution (motivational)
     • Advantages
       • Encourages outstanding performance as size varies directly
       • Risk is shared with employees as size of compensation fluctuates with org performance
       • One-time payment, with no obligation to pay similar amounts in the future
       • Helps to attract and retain the right employee
     • Awards can be based on single or group performance, dependent of culture, nature of job, criteria for org success
     • Performance metric used in annual bonus plans
       • Financial used higher in org hierarchy; controllable earnings, pretax profits (under their control)
         • To avoid excessive payouts, bonuses can be capped at % of annual salary or firm's fully diluted EPS
       • Non-financial used lower in hierarchy (not entirely under their control, e.g customer satisfaction)
     • Common for bonus payments to be linked to multiple performance dimensions
       • Earn bonus despite poor performance in some areas
         • Can put in conditions where bonuses will be contingent on minimum performance thresholds in certain areas
   • Long-term incentives
     • Based on performance measures over periods over 1 year
     • To motivate employees to contribute to the org's LT success,; to attract and retain key talent by making total expected compensation more attractive
       • Useful for new startups with scarce cash in early periods
     • Often restricted to high levels of management bc executive DM at these levels most directly impact LT org success
     • Variations in LT incentive plans
       • Period they cover; typically 3-4 yr with a given target to be achieved by the end of the period
       • Performance metrics; financial and non-financial measures
       • Cumulative over period targets and end of period targets
         • Choice depends on whether EPS to be within a given range for each year is too restrictive or necessary
       • Timing of implementation
         • Cumulative, with a new cycle beginning only at completion of the previous
         • Overlapping, where new plans begin each year, multiple running simultaneously
           • Easier to tweak LT targets each year, facilitate enrolling newly eligible employees
     • Equity-based plans
       • Rewards based on changes in firm's stock value
       • 3 forms
       • Stock option plans
         • Give employees the right to purchase a set number of shares of company at exercise price after the options vest but before they expire
         • If stock options are in the money, stock price is higher compared to exercise price
           • Employee will exercise the option only if in the money because they can make a profit by selling in market
         • If stock options are underwater, stock price is lower
         • Advantages
           • Motivate employees to increase company's stock price
             • Improve incentive alignment as employees only benefit if SHs benefit
             • Because stock options will be of no value to employees unless in the money
           • Enticing to employees due to potential gains
             • Strong motivational effects because there is no limit oon the amount of profits employees can make from increases in stock price
           • Can provide incentive compensation without cash outlay
             • Positive cash inflow when they receive cash from employees when they exercise stock options
               • Attractive for start ups who are cash constained
         • Disadvantages
           • Will result in issue of shares, causing future dilution, putting downward pressure on stock prices
           • May motivate managers to undertake riskier business strategies because they are rewarded for gains but not penalised for losses
           • Stock options worth little when firm is performing poorly; erode motivation to perform
       • Restricted stock plans
         • Eligible employees given free shares in the company
           • Don't have to spend money
         • Sale restricted for a specified period of time
         • Contingent upon employment
         • Employee will have full ownership rights over shares, including voting and dividend rights
         • Employees bear lower risk if awarded these, so firm can issue fewer shared compared to stock option plans, causing less dilution
         • Stock still has value even if stock price declines, and restrictions on selling the stock disappear with the passage of time and continued employment
           • Serve retention purposes, motivator but not as much as for stock option plans
       • Performance stock / option plans
         • Stock
           • Restricted stock plans that vest upon the achievement of specific performance targets over a period
           • Right to sell shares contingent on achievement of specific performance
         • Option
           • Stock option plans that make vesting or exercise of the option contingent on improvement in stock or non-stock goals
           • Premium options
             • Exercise prices greater than stock price on the grant date
             • To ensure employees improve share price to a predefined level before reaping benefits
           • Indexed options
             • Exercise price contingent on performance targets relative to a peer group of firms
             • To motivate employees to perform better than the firm's competitors before they derive value from the options
           • Performance-vested options
             • Link the vesting of the options to the achievement of performance targets such as EPS
         • Provide stronger incentives to maximise SH value by raising the bar for stock price improvements before the options become exercisable
         • Require the setting of performance targets which is challenging to get right

4. Incentive system design - 3 design choices

   • The extent to which rewards are determined formulaically
     • Common for rewards to be communicated through an incentive formula described in an incentive contract
     • Rewards can be assigned subjectively; inevitable with promotions and job assignments
       • Annual bonus assignments can be subject when difficult to specify appropriate measures for performance area, predetermination of weights not possible, a performance override is used so management have the right to have the final say as to whether a bonus is paid
     • Reasons for use of subjectivity
       • Difficult to describe bases for rewards / weightings from a large set of evaluation criteria prior to performance period
       • Will mitigate motivating employees in directions that turn out no longer appropriate as conditions change
       • Without a specified target, employees will have no choice but to do their best - won't coast when target is achieved
       • Absence of pre-specified targets reduces employee's propensities to manipulate performance measures
     • Implications of subjectivity
       • Decrease employee risk; allows adjustments for effects or factors outside employee control
       • Increase employee risk; subject to hindsight bias, where evaluator may judge performance based on info not available to employees when decisions were made
         • May cause employee frustration, demotivation and friction if employees do not trust their evaluators to make informed and unbiased performance assessments
           • Employees may attempt to inappropriately influence evaluators for better evaluations
       • Need for the development of a working relationship with greater mutual trust between employee and evaluator
   • Shape of the incentive-performance function
     • When reward promises are formulaic, the link between rewards and basis on which they are awarded is often determined by a rewards-results function
     • Bonus promised only over a restricted performance range, with lower and upper reward cutoffs
     • Lower cut-off; do not want to pay for mediocre performance
       • Lower target set if predictability of target is lower to allow for uncertainty
     • Upper cut-off; set at % of budget target e.g., 150%; stops high payments because of windfall gains (unforeseen good luck)
       • So that employees aren't unduly motivated to increase current period performance at expense of LT
       • So hierarchically subordinate employees are not paid more than higher ones, to keep compensation consistent over time
   • Size of incentive pay
     • Employees invariably value money
     • A significant proportion of variable pay should motivate to achieve performance goals
     • Pay-for-performance serves an employee selection role; attract employees who are confident in their abilities to produce superior results is more likely accept risk
     • Appropriate risk premium needs to be provided should org hold employees responsible for performance not totally controllable by them

5. Criteria for evaluating incentive systems

   • Each incentive plan should be carefully evaluated, as a package and individually, regularly as circumstances change
   • Valued
     • To provide motivation
     • Taste varies; older workers want job security
     • Tailor reward packages to employee preferences
       • Costly
     • Everyone values money; widely accepted currency in transactions; symbolic value
       • Higher incentives do not necessarily lead to higher performance
         • May be unintended consequences; dysfunctional behaviours / gaming of performance metrics
   • Large enough to have an impact
     • If reward is visible to others, the motivational effect is enhanced by a sense of pride and recognition
     • Merit raises typically small; impact further reduced by inflation, lack visibility as kept confidential, communicated in vague terms, affecting understandability
     • Bonuses large enough to make impact but short-lived, taken for granted with people expecting similar payments in the future, then demotivated if they don't
     • May cause demotivation among top performers when firm doesn't do well; no pay rises or bonuses
     • Stock options have too much impact; granted in large numbers to top executives with short vesting periods
       • Execs may be encouraged to take action that effects stock price in ST but harm SHs in LT
   • Understandable
     • Understand reasons for and value of rewards to have a motivational effect
     • Equity-based plans usually complex and likely ill-understood by lower org levels
     • Subjective performance evaluations may be ambiguous
       • Problematic as the evaluators will be affected by the perceptions of evaluators. so needs to be greater mutual trust
     • Performance-related feedback incomplete or biased; affecting understand of size and rationale of rewards
   • Timely
     • Maximise motivational effects
     • Increase extent of learning from receiving reward and connecting it to the performance for which it was given
     • Piece-rates and sales commissions most timely
     • LT incentives least timely; control short-termism
     • Use risk-adjusted measures as basis for bonus determination to mitigate ST focus
   • Durable
     • Have greater value if good feelings generated are long lasting (employees remember them)
     • Small monetary rewards aren't durable
       • Salary increases lost in pay check, bonuses quickly spent and forgotten
     • Can be improved if reward is given but restricted for a period of time; trade-off between benefits of durability and cost of mental discounting
     • Promotions which go on CV are quite durable but not reversible
   • Reversible
     • Evaluators often make mistakes; some reward decisions more difficult to correct than others e.g. promotions
     • Bonuses reversible bc they are contingent on performance in a single period
       • Not always as employees will expect them once precedent is set
     • Salary increases provide almost guaranteed agreement bc pay cuts are rare
   • Cost efficient
     • Expensive - direct cost to firm
     • Non-monetary expenses less expensive
     • Cost-efficient if no cheaper alternatives that would deliver the same motivational effects
   • Monetary incentives do not satisfy all criteria, but not all are equally as important; satisfy the most important / valued by employees