When it comes time to establish target payouts for your incentive plan, you have four alternatives:
- Base them on the participant's current salary.
- Base them on the job's salary range midpoint.
- Use a flat dollar amount.
- Make them equal for all participants.
Selecting the right option is more than a merely mechanical decision; it can have considerable effect on the perceived fairness of the plan and its motivational impact on participants. The choice you make also sends a strong message about what your company hopes to achieve with the plan. Let's explore each of these options one at time.
PARTICIPANTS' BASE SALARY
This is the most common approach. It involves taking a percentage of each participant's current base salary and using that percentage to establish the target incentive payout (e.g., $100,000 base salary x 10% = $10,000 incentive target). This can be done one of two ways: 1) Different jobs (and levels of jobs) can have different percentages based on certain factors (e.g., sales jobs typically use larger percentages than finance jobs, and executives usually use larger percentages than lower-level managers) or, 2) every position can use the same percentage.
To understand the implications of either option, you must first consider that a person's base salary is a proxy for many factors. It represents their value in the marketplace; the knowledge, skills and abilities required to do the job; their prior experience; their past performance; the complexity and challenges inherent in the job; the importance of the job to the company; the incumbent's negotiating skill; the company's ability to afford increases; the sophistication (or lack thereof) of the current pay plan; the company's salary administration policies and practices; the ability of the HR department to stay abreast of changes in the market; management biases; and many other factors. When you are looking at a person's current salary, you are looking at a compilation of all these factors. And when you are comparing two person's salaries, you can safely assume that, in total, the company values the higher paid person more. (Determining exactly why is a much more complex issue).
Now, should you decide to use the current salary as the basis for establishing incentive targets, the higher paid person will have a higher incentive target (assuming both share the same percentage). Therein lies the problem. Ignoring differences in job content for the moment, let's compare an experienced, high performing, seasoned professional making $120,000 (Employee A) to a less experienced new-hire in the same job making $80,000 (Employee B). And let's use 10% as the incentive target for both employees. Employee A will have a $12,000 incentive target (10% of $120,000) and Employee B will have a $8,000 incentive target (10% of $80,000). This represents a 50% difference between the two targets.
Now, let's assume both employees have the same measures and goals on their incentive plans. Let's also assume that both employees generate the same performance at the end of the year. Even though the company received exactly the same results from both employees, Employee A makes considerably more money. Is this fair or appropriate? I would say no. Employee A is already being compensated and rewarded through his base salary for all the factors that make him more valuable to the company than Employee B. To also pay him a higher incentive is double-dipping unnecessarily. The same performance against the same incentive measures by two different people in the same job should produce the same incentive payout. Remember, the purpose of incentives is to motivate and reward employees to achieve certain results. Results have consistent value regardless of who produces them.
The situation described above is exacerbated when you also assign larger percentages to higher-level positions. Presumably, higher-level positions also have larger base salaries which are a reflection of the job's increased responsibilities and greater value to the business. Assigning higher percentages to these jobs increases incentive targets exponentially. This may be acceptable, even desirable in some cases, but it is important to understand the effect this has on incentive plan payouts.
JOBS' SALARY RANGE MIDPOINT
In many companies, jobs have been assigned to specific salary ranges. These ranges represent the minimum and maximum base salary levels for each position. Each range also has a midpoint and that midpoint is normally established using market data. Unlike a person's base salary, which is a proxy for the value of the person in the job, the midpoint is a proxy for the value of the job to the company. All employees in a particular job will have the same salary range midpoint.
Basing a person's target incentive on the midpoint of their salary range ensures that everyone in a particular position will have the same earning opportunity under the incentive plan. This is consistent with the philosophy that results have consistent value regardless of who produces these results. The net effect of this approach is that a new, inexperienced employee will earn the same incentive payout as a long-tenured, seasoned employee provided they both produce the same results. In my view, this is not only appropriate, it is desirable since an incentive plan is intended to encourage results and should be indifferent as to who produces these results.
In general, I vastly prefer this approach over using percent of base salary. There is one potential drawback to this approach that you should be aware of. Establishing incentive targets as percent of salary range midpoint might encourage employees to lobby for higher salary ranges. This is not usually a serious problem, however, since salary ranges rarely go up enough to result in substantially larger incentive payouts.
FLAT DOLLAR AMOUNT
This approach is similar to the one above, except that instead of using salary range midpoints to establish target payouts, you use a flat dollar amount. For example, you might decide that all executives should have a target incentive payout of $50,000; Directors might be eligible for $25,000; Managers $15,000; Supervisors and professional individual contributors $10,000; and everyone else $5,000.
Although not as elegant as using salary range midpoints, this approach is considerably more straightforward, does not require accurate salary ranges. and results in fair and equitable earning opportunities. You should use this approach if you don't trust the accuracy of your current base salary ranges.
EQUAL FOR ALL PARTICIPANTS
In certain cases, you may not wish to vary target payouts at all. Instead, you may want every employee (from executives to hourly staff) to have the same earning opportunity. This is more common in bonuses than it is in incentives (click here for a description of the difference between bonuses and incentives.) This normally occurs when the purpose of the incentive plan is not to encourage each employee to strive for higher levels of performance, but instead to reward everyone for being part of a successful team.
THE BOTTOM LINE
You really can't go terribly wrong with any of the above approaches. But when I design incentive plans, I prefer to establish target payouts based on salary range midpoints or flat dollar amounts. That said, I can be persuaded to use current base salaries, but only in those instances when clients convince me that their salaries are a true reflection of an incumbent's performance and value to the organization; not merely a reflection of their tenure, favoritism, or other inappropriate factors.