By Simran Oberoi, Knowledge Advisor
21/2/2012

What is variable pay? What impact can variable pay have on an organisation?

Variable pay is defined as direct compensation that does not become a permanent part of base pay/salary and which may vary in amount from period to period. Other names for variable pay include: incentive compensation, incentives, bonuses, commissions, cash awards and lump sums.
Variable pay can be in the form of short-term (one year or less) or long-term (two years or more) incentives or bonuses and employee ownership programs.

Most organizations have a combination of variable pay plans that are used together or separately, in an effective manner, as compensation instrumentsfor communicating the linkage between individual performance and an organization’s business objectives, as well as for driving higher performance.
Variable pay supplements and enhances the organization’sTotal Rewardsvalue proposition. It leads to employee engagement, higher motivation to perform and better retention. Hence, it has been a key area of discussion and application, particularly during the downturn, since it helped organizations to manage their compensation costs by keeping the fixed components within limited budgets and using this aspect to drive business performance. What the variable pay also does is that it increases the commitment of the employee towards his or her performancebecause he/she has the onus of increase his/her own earning capability.

What is the difference between short and long term variable pay plans?

Short Term Variable Pay – This comprises of incentives payable on achievement of preset individual performance targets which are measured over a time period of one year. The amount is formula determined, paid in lump-sum annually and is taxable. Short Term Variable Pay might also contain cash bonuses where the performance criteria or amounts may or may not be specified from the beginning. Though the broad basis is organizational/departmental/business unitas well as individual performance, the amount could be also bediscretionary at times (example, a retention, sign-on, promotion bonus). Sales commissions and spot incentives would also be part of short term variable pay.

Long Term Variable Pay – Variable Pay that is paid out to an employee by measuring performance over a period of years and not one performance cycle, is defined as a Long Term Incentive. This consists of Stock Options, Stock Units, Phantom Stocks and Restricted Stocks.  Apart from being used for rewarding performance, long term variable pay is also often used as a retention tool or even as a retirement benefit when it consists of deferred shares.

What are the key elements to consider when designing a variable pay plan?

Prior to designing the variable pay plan, an organization would need to undertake some important steps that provide insights for the plan itself.

1.    Assessing the effectiveness of any current variable pay plan(s) to identify gap areas that need to be addressed in the new plan.
2.    Analysingany previous employee feedback on variable pay plans that has been captured. This also ensures that employee inputs have been considered while developing the new plan.
3.    Evaluating the best practices and provisions pertaining to the comparator basket that the organization competes with talent for.
4.    Earmarking the budget for the overall variable pay spending for the financial year and allocating it under the various programs (current and new).

When designing a variable pay plan, the key elements that need to be borne in mind are as follows:

•    Purpose and Eligibility:  It is important to define what is the intent of the of the variable pay plan. While performance is the primary reason for such programs, there could be a dual or secondary purpose of retention, recognition or enhancing the retirementbenefit element of the package.  The organization will also needto determine who is eligible for theprogram and whether this is a group/team based reward or an individual incentive.

•    Performance Metrics: The parameters and their definitions need to be developed. This is an important exercise since employees need to have clarity on what defines performance measures (qualitative and quantitative) and what types of demonstrable behaviour will be evaluated. The parameters should also signify the alignmentof individual goals with overall organizational goals.

•    Type and Frequency: The purpose will lead to the identification of which type of variable pay plan needs to be rolled out – short term or long term. At this stage planning the frequency of the plan (for example, annual, quarterly and so on) is also important.

•    Differential Payouts: It has been seen that during the downturn, a large number of organizations started focusing on differentiated rewards which worked towards providing the high performers and potentials with significantly high variable pay as compared to the average performers. Hence this payout matrix which will define the threshold values as well as differential amount needs to be calculated using a logical and fair approach.    

•    Measurement of ROI: Building in a mechanism to ensure how the business impact and return on investment can be measured on the new variable pay plan, is imperative. A review of the actual payoutsis also important to track the planned budget.

•    Communication strategy: While designing the plan itself, one of the key elements to be factored in should be a structured communication plan which should seek to provide clarity on all aspects such as eligibility, provisions ( how it is calculated, when payouts will be made) and other details to the employees. The communication plan should use internal platforms and methods which allow for dissemination of information such asthe intranet, company newsletter and mailers as well as those which allow for discussion such as open houses and help desks.There should also be adequate training provided to the immediate managers to answer queries from their teams, pertaining to the plan.If there are significant changes that are expected in the organizational culture, those can be addressed via the right communication strategy as well.

What are stock options? When are they most appropriate to use?

Stock options are a form of Long Term Incentive and a non-cash component of pay, that organizations provide to their employees, typically at the senior and middle management levels (there are certain organizations which are an exception and provide the same across the employee population). A stock option is actually defined as a right granted by the organization to its employee wherein, he/she is allotted a defined number of equity shares of the company that he/she can purchaseat a pre-determinedgrant price (this is determined by the compensation committee and is usually the fair market value of the share).

These shares typically are staggered or cliff in their vesting process, that is, they may become exercisable in parts over a period of years or in a lump-sum after a fixed number of years( e.g. if there are 100 shares, with uniform staggered vesting over a period of 3 years, then 33.33 shares become exercisable after each year. However if these shares have a cliff vesting after 3 years, then all 100 shares become exercisable only after a period of 3 years).

Stock options will have a defined exercise period within which they can be exercised, once vested. Exercising the option actually means exercising the right provided by the organization, to the employee to sell the vested shares at the exercise price (which is decided by the Compensation Committee and is typically not lower than the grant price). Organizations building stock option plans must ensure legal, accounting and tax pertinent compliance.

The purpose of suchplans is to promote retention, create a sense of ownership and provide the employees with incentives that stem directly from company performance (linked to share price).

What is Phantom Stock and when is it used?

Phantom stock is a long term incentive plan which works similar to a deferred cash bonus plan. As the name suggests it might not involve actually giving company shares to the employees and hence ‘phantom’, but only providing the employee with the benefits or financial gain that is made due to stock price appreciation. This amount that the organization commits to pay typically the value of the company shares calculated on a certain number of shares or the increase in the value over a period of time.

If an organization wants to provide a long term incentive, but would like to provide a straightforward way of calculating the same and without regulatory requirements, this kind of plan might work well. This kind of plan can also be rolled out if the company wants to prevent dilution of stock price, on account of ownership due to multiple stakeholders. It is usually given by family-owned, closely or privately held companies, though some publicly listed organizations might also use it to incentivize their employees. Even non-profit or government organizations might provide the same, since they would not be operating like companies.

What are some challenges associated in implementing variable pay? How best can they be addressed?

Some of the major challenges associated with implementing a variable pay plan are as follows:

1.    Setting the right performance measures: The organization needs to identify and apply the correct set of performance parameters which ensure that there is a line of sight that the employees have pertaining to the linkage between their individual goals and the business objectives. This can be best addressed by a detailed diagnostic prior to the design of the plan on what factors drive the success of the organization and how these can be percolated down to the various employee levels. What can also help to meet this challenge is a proper training for all managers on the goal-setting and communication process so that employees can understand their contribution to the organization.

2.    Plan Communication: Sharing the plan and its features with the employees in a concise yet lucid manner is a challenging exercise. Another associated challenge is important to ensure that the fairness and objectivity of the plan is communicated in the correct manner. Therefore, there are several tools and communication vehicles that organizations should build in – those which disseminate information andrespond to queries related to the plan, such as helpdesks, company intranet and newsletters.Alongside this there should be those channels that share the strategic intent and cultural impact of the plan, such as top management sharing sessions, open houses with the HR / Compensation team.

3.    Budget Distribution and Payout Calculations: While variable pay plans primarily reward performance, driving retention and engagement are also important objectives of some plans. Hence distribution of payouts based on the varied purposes that a plan might have, from a limited budget in order to suitably reward high potential talent is challenging. This can be addressed by firstly ensuring that the payout matrix is fixed in a manner to ensure clear differentiation between average and high performance. In order to meet this challenge it is also important to prioritize alongside maintaining a balance.

4.    Measuring plan effectiveness: While from a financial perspective it is typically easier to measure plan effectiveness since employee performance is linked to business returns, it is also important to work out the effectiveness of the plan in terms of its value to the employee. Hence regular tracking of the business relevance as well as value to the employee aspects of a variable pay program are critical to its sustained success.

While these challenges apply to long and short term plans, there are some unique challenges related to long term variable pay plans which are equity/stock-based.

1.    Choice of plan: Choosing the right LTI tool is important to drive what the organization stands for – whether it is stock options for performance and engagement or restricted stock for retention and so on.
2.    Valuation: There are standard valuation methodologies for stock-based incentive plans and typically organizations use consulting firms which apply a proprietary approach based on any of these methodologies, to value the LTI plan in financial terms. While these approaches are present, getting a comprehensive understanding and also ensuring that the employee understands the valuation are difficult actions. These can be simplified by sharing examples and sample calculations, when being explained. Another challenge could be identifying which approach is better or more relevant for your organization’s plan.
3.    Insufficient benchmark data: From an India market perspective, benchmark data on LTI plans, their typical values as applicable by job size and plan provisions, is insufficient and limited. In this situation, it might be challenging to use this data for decision making purposes.
4.    Tax and Legal implications: These plans are fairly complex from a tax calculation and legal perspective. Hence organizations must ensure that they validate these with their legal and accounting teams.

The author is a Knowledge Advisor with SHRM India. Prior to that, she has worked with Hay Group, PricewaterhouseCoopers and Hewitt Associates in the areas of Rewards Measurement and Strategy, Capability Building and Talent Management.