Variable Compensation

Variable Pay Plans

The last two articles in this series discussed how to develop a compensation philosophy as well as the elements of a base pay plan. In this article we will discuss variable pay plans.

First, what is a variable pay plan? It really is, as the name suggests, a pay plan in which the level of the award varies with some metric. This metric is normally tied to company or unit performance. It also may have an individual performance metric as well.

There are typically two main categories of variable pay plans. One is a bonus plan, the other is an incentive plan. A bonus plan is one where the bonus is awarded after the fact and typically has very little or no incentive value. The employees typically come to see it as an entitlement.

An incentive plan is a variable pay plan that is tied to some level of performance. The employee is rewarded with a payment that is predefined and non discretionary. The reward is paid when actual performance meets or exceeds predefined goals.

While many companies include long term incentive plans for executives, we typically see incentive plans that are short term in nature covering the majority of employees. By short term we mean no more than one year in duration. Another type of incentive plan is the sales incentive or sales commission plan. We will only address the short-term incentive plan in this article.

Philosophy

A typical philosophy statement might go something like the following:

A substantial portion of the annual compensation of each executive and some portion of all employees' compensation will relate to and be contingent upon the performance of the Company. This is intended to align the interest of employees with those of shareholders, customers, and the Company.

The short-term incentive payments when combined with base salary should raise the total cash compensation of most employees to a level above the market average. These two pieces of compensation make up the majority of the employee's total cash compensation.

According to the Corporate Leadership Council, performance measures serving as basis for performance pay should vary according to 'line of sight', i.e. the relationship between the measurement and employee's direct influence/control over them. Absolute financial measures such as return on average assets or net operating income typically are appropriate for senior executives.