Broad-based variable pay concepts and practices have experienced significant transformation over the last two decades. While executives have historically participated in bonus arrangements, the remaining population of workers only became eligible for variable pay in the late 1980s when fewer than half of U.S. companies provided these opportunities more broadly.
Today more than 90% of U.S. companies have broad-based variable pay programs. In the short time broad-based variable pay has been in effect there have been striking changes in funding levels, plan design types and eligibility.
Several factors are responsible for the increased reliance on variable pay for rewarding the broader workforce. These plans are effective in getting employees to pay attention to key company goals and initiatives since part of their compensation is tied to results. Employees think differently and change their behaviors to accomplish activities they think will yield a higher bonus payout.
The key is to make sure that the focus and change in behaviors lead to positive outcomes and don’t undermine other important factors such as safety, margins, and customer service.
Variable pay creates the opportunity to link employees and leaders to aligned objectives which results in stronger teamwork that enhances organizational results. This tighter alignment of employee and leader efforts is also a benefit that shareholders appreciate. Variable pay provides greater flexibility to organizations in managing their compensation costs during volatile business cycles. Unlike base salaries, which are compounding fixed costs, bonuses hit the balance sheet for one year and should only do so when organizational performance results warrant it. Variable pay has also become a major component in organizations efforts to pay for performance.
One of the most striking changes in compensation over the last two to three decades has been a change in pay mix – primarily attributable to the emergence of broad-based variable pay. Variable pay spending became material enough to track beginning in 1988 when salary increases averaged around 5% and variable pay spending was just under 4%. (See Figure 1) In just four years, variable pay spending overtook salary increase spending and never looked back.
Three recessions later, salary increases are holding steady in the upper 2% range while variable pay spending is at record high levels at just under 13%. This is three times higher than the level of spending when broad-based variable pay was originally introduced in the 1980s.
It is rare to see such a fundamental shift such as this one in compensation. Equally striking is the fact that companies were investing five to 10% of their payroll in total compensation growth (base plus bonus) in the 1980s and are closer to 15% of payroll today. Factor in the rate of inflation, and today’s broad-based workforce has more purchasing power than what employees experienced in the past 20 years.
This change in pay mix allows organizations to re-think their approach to pay for performance as companies are now factoring in individual performance achievement as part of their variable pay programs. The perception is that reward differentiation is more easily attained when allocating a 13% of payroll bonus budget than a 2.8% salary increase budget. This has the advantage of creating greater line of sight for employees through these variable pay arrangements and encourages them to work toward both individual and organizational objectives.
Plan Design Types
The broad-based variable pay design approaches utilized by organizations have also changed dramatically since these plans first appeared in the late 1980s. Understandably, the early plan designs were more focused on organizational measures and rewards -- that made them easier to design and introduce. It was not uncommon for employees to be covered by a cash profit sharing plan, a gainsharing plan or a team award incentive.
Employees were happy to have additional earning opportunity, and they liked the fact that something that was previously only provided to executives was being made available to them. But they commonly expressed frustrations about the fact that they didn’t feel they could influence their bonus outcomes. Leaders were critical about an entitlement mentality and a lack of confidence about the return on their investment.
More recently (see Figure 2), plan designs have shifted in the direction of approaches that have much lower collective measures and instill greater granularity of metrics intended to create stronger line of sight. Business incentives are a popular choice in design due to their ability to measure multiple slices of performance.
These plans make it possible to focus a percentage of measurement on overall company achievement, business unit or function outcomes and individual performance results. They also allow the organization to apply variable weightings of these measures from the top to the bottom of the organization to align with accountabilities and influence on results.
Special recognition awards have been a stable and popular design approach, often supplementing an organization’s broad-based incentive plan (such as a business incentive plan). These plans offer advantages in that they don’t cost the organization much (most companies budget 0.5 to 1.0% of payroll for funding) and are highly valued by employees.
The key success factor for these plans is the immediacy of the award. Employees attach high psychological value to knowing that something they contributed was noticed and appreciated in real time. They are very willing to trade off a higher monetary value for this form of recognition. This is one reason why, with the increasing number of millennials entering the workforce, it is logical to assume this design type will only gain in prominence.
Individual performance plans are also seeing resurgence in popularity primarily due to the likely continued uninspiring salary increase budgets. Companies who do not have or do not desire to have plans that measure aspects of organizational performance favor this design type. It is relatively simple to create (based on individual goals) and execute since this ties into the annual performance review process. The primary hurdle to overcome with this design type is the degree of discretion that exists in determining performance results and how that translates to a bonus payout.
Broad-based variable pay plans have undergone a tremendous change, but more progress is needed. While the number of U.S. companies who have added broad-based variable pay arrangements has grown at an astronomical rate to more than 90%, the depth of participation in these organizations has not progressed as rapidly. Twenty years ago, the median base salary level of the lowest eligible employee in these plans was $49,000; today, that salary level has dropped to $33,000.
This would suggest that variable pay eligibility has been pushed down deeper into organizations. Looking more carefully at different employee segments reveals a huge disparity in the participation levels for salaried nonexempt and nonunion hourly employees.
This trend is disappointing for a number of reasons. It is critical that this segment of the workforce be as aligned as possible with the understanding and pursuit of the organization’s goals and desired results. Having such a large segment of the population disconnected from a collective interest in achievement and rewards could result in sub-optimal performance.
It should also be recognized that the accomplishment of company goals is not possible without the efforts of the entire employee population. Otherwise, there exists a potential for a “have and have not” scenario where only some employees benefit from the efforts of others. In some industries the entry-level workforce is the long-term talent pool for creating future managerial talent. Disenfranchisement of this group could be detrimental.
Broad-based variable pay has burst onto the scene and has dramatically changed the landscape for how organizations approach pay for performance. With companies continuing to face intense competitive pressures, the current trend of minimizing fixed costs will not be reversed and the challenges of providing differentiated rewards through salary increases will be perpetuated. Organizations have been willing, and all indications are they will continue to grow the funding of variable costs since they are contingent on performance.
The ability of these arrangements to capture employee focus and shape behaviors as well as provide the means to assess and reward performance at multiple levels makes them a valued management tool. Balancing the need to be in sync with organizational results and ability to pay with employees’ abilities to influence outcomes will be a key ingredient to the success of these plans. And taking steps to ensure that a meaningful opportunity is available to contributors at all levels of the organization will ensure that productivity, quality and overall achievement are optimized.
Editor's note: This is a guest contribution from Ken Abosch, Broad Based Compensation Marketing, Strategy & Development Leader for Aon Hewitt.