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Designing an incentive compensation plan

Excerpted from West Virginia Employment Law Letter written by attorneys at the law firm Steptoe & Johnson PLLC
Cash is king.
One of the best ways to keep employees from walking out the door is to pay a higher salary. Paying employees more in salary, however, won't necessarily align them with the company's priorities.

To do that, you may want to adopt a compensation program that gives employees incentives to achieve the company's goals. The challenge is designing a plan that will accomplish the desired result.

What's your vision?
To design an appropriate incentive compensation plan, it is first necessary to understand the company's vision. What are the company's long-term and short-term goals? Does the company seek short-term cash flow or long-term capital appreciation?

Does it wish to cater to high-end customers who are willing to pay more for a superior product, or does it seek large volume profits in a low-margin market? The company's vision should be the cornerstone of any incentive compensation plan.

Once its vision is understood, the company should perform a self-evaluation to determine what must be accomplished to obtain its goals. In conducting the self-evaluation, the company should consider different factors as they impact the company's vision.

How can the company lower costs? What can it do to gain customers that otherwise go to competitors? What can the company do, or do better, to achieve its goals? In many cases, with a careful self-evaluation, the appropriate incentive plan would almost write itself.

Seeing eye to eye

There are as many ways to design an incentive compensation plan as there are to do business. There are, nonetheless, some universal design features to consider. The incentive can be paid in cash, property (e.g., stock), or benefits. Cash is king, but depending on the company's culture, incentives in the form of benefits or company stock may produce better results.

The arrangement can provide for long-term or short-term incentives. In general, long-term incentives are better suited for retaining employees on a long-term basis or for creating capital appreciation, but if the performance period is too long, employees may lose their motivation.

In contrast, if payouts are more periodic, such as monthly or weekly, employees should remain motivated. Short-term incentives, however, often do little to help with long-term goals.

The plan should carefully correlate the incentive award with the goal the company wishes the employee to achieve and at the same time ensure the incentive won't motivate bad behavior.

For example, rewarding assembly line workers for increased production may result in a sacrifice in quality. One key to preventing that sort of result is to provide incentives that adjust based on a framework of acceptable tradeoffs. The framework can be preestablished, or it can be built into the plan over time.

For example, an incentive plan may wish to encourage sales but not sales to customers who pay their bills late. The incentive arrangement could provide a bonus or commission level based on sales to 10 good customers but then reduce the bonus if more than one of those customers pays late.

The company can monitor how an incentive creates bad behavior and then adjust the incentive in a manner that will prevent the undesirable results.

It's critical that employees understand the link between their performance and their potential payout. Accordingly, the incentive arrangement should tie employees' incentives to performance objectives over which they have control.

For example, the CEO's incentive should be more closely tied to the company's performance as a whole, whereas a supervisor's incentive should be closely tied to the performance of his department.

The plan should be communicated to participants carefully. Education should be part of the communication process. One form of education that's often overlooked is instruction on how the employee's performance affects the company's financial statements.

For example, a manager's bonus may be tied to the company's gross profit. If the manager doesn't understand how gross profit is calculated, she may not understand or be able to explain why her department isn't getting any bonuses. That, in turn, may lead to lower morale and lower performance.

Other things to look at
There are many other factors to consider, though not all can be included here. If an incentive payment is mandatory, then the company should project its cash flows to ensure it will have the cash on hand needed to pay the incentive when it comes due.

Don't make a payout too high compared to the employee's base salary. Generally, when incentives constitute a higher percentage of an employee's salary, it is more difficult for supervisors to manage the employee through other methods such as performance reviews. Try to keep the incentive formula simple.

Finally, the incentive plan should be in writing. If an incentive is payable in a year after it is earned, then it could be subject to Internal Revenue Code § 409A, which requires the plan to be in writing.

It also is recommended that the plan be in writing to provide clear and unambiguous terms that aren't subject to dispute at a later date. It isn't necessary to provide a detailed plan. Most often, the best plans provide the company with broad flexibility.

Copyright 2006 M. Lee Smith Publishers LLC. WEST VIRGINIA EMPLOYMENT LAW LETTER WEST VIRGINIA EMPLOYMENT LAW LETTER should not be construed as legal advice or a legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only. Anyone needing specific legal advice should consult an attorney. The State Bar of West Virginia does not certify specialists in the law, and we do not claim certification in any listed area. For further information about the content of any article in this newsletter, please contact any of the editors.


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