Total Rewards Quarterly

Ten Enduring Truths of Pay Design

Brian Dunn is the Emeritus Chairman of McLagan. He specializes in incentive and executive compensation and advises the compensation committees and/or management of a number of the world’s largest financial institutions.

Prior to joining McLagan Partners in 1998, Brian spent 17 years with Towers Perrin in their New York and Hong Kong offices.

Brian has been actively involved in shaping the financial services industry's response to recent developments in the regulatory environment regarding executive compensation. He serves as an advisor to several principal regulatory bodies including the United States' Federal Reserve, Canada's Office of the Superintendent of Financial Institutions, and the United Kingdom's Financial Investments Limited. Brian is also a special advisor to the Financial Services Roundtable and the Institute of International Finance.

With more than 35 years of experience in the consulting space and working with clients across the entire talent solution spectrum, Brian is a veteran in the area of human resources. In this conversation, he shares with us the 10 most important lessons for any compensation manager.

'Always remember, fads may come and go, but there are certain enduring truths that have passed the test of time. Experience has taught me that certain truths are relevant across cultures, industries and generations. And you would be surprised that the ideas are very simple, but for many organizations the implementation becomes complex. We just have to remember that there are no quick fixes and all things require patience.'

1. More is not always better

All things being equal, more is better than less BUT all things are not equal. Perceived value is more important than cost. 

The perceived value of any compensation opportunity is tied directly to the degree that the recipient believes it is achievable, and realizable.

2. Consistency should not be a goal in itself

Emerson said “consistency is the hobgoblin of little minds…”

Integrity and the absence of arbitrary decision-making are what really count in pay design. It is imperative that there is a structured approach and integrity in the system and no decisions are left to subjectivity. It is also important to remember that this is different from being consistent. An organization needs variations and differences to thrive but they should be grounded in fact.

3. Trust in the decision makers is paramount

People want to believe they are being treated fairly.

Very often plans and structures are created because people don’t trust the decision makers. Why is that? Sometimes, it is because employees don’t know the decision makers at all. Sometimes, distance between the decision makers and the employees is too large. We need to make sure people believe they are treated fairly. They need to be assured that those making decisions have all the relevant facts and are applying them fairly. We can design the most elegant compensation plans but what really matters is that whether the people to whom these plans will be applied, believe that the plan is fair. There has to be transparency and some degree of fair application.

4. Incentives work

You get what you pay for.

Incentives which are properly structured and are measured against accurate metrics will change behavior.

5. Pay design communicates management priorities

For better or worse, the design of pay program communicates clearly and loudly what management thinks is important.

A compensation plan is a very powerful communicator of what the management believes is important. While the management might communicate a focus on quality of work, career progression, freedom at work and cultivating an entrepreneurial culture, what they often pay for is growth and profits. As long as there is a conflict between what organizations say they believe in and what they actually pay for, there will always be turmoil as people will be left wondering what they are really supposed to do.

6. Discretion should have limits

What management wants more than anything else is the discretion to make what they believe is the right decision once all the facts are known.

Discretion is a critical component of every effective pay plan. However, discretion needs to have limits so the employees aren't made to feel that what they receive has been left completely to somebody else's judgment. Employees want to have a line of sight into what they do and what they get paid. Breaking the line of sight between what people do and what they earn dramatically reduces the incentive impact of pay. On the other hand, managers want complete discretion. They need to cross subsidize. There are times when it is necessary to apply judgment because of external factors that may have affected the organization's financial outcome. The solution lies in finding a place in the middle where the range of compensation is based on specific defined criteria under control of the individual modified by the application of limited discretion to reflect broader corporate factors.

We can design the most elegant compensation plans but what really matters is that whether the people to whom these plans will be applied, believe that the plan is fair

7. Formulas are dumb

They are an easy crutch for those that do not want to think or have hard conversations.

They appeal to those who think linearly and on a single dimension. By definition, formulas are dumb creatures — they do not think or adapt. They can only operate at a mechanical level. It is very difficult to reduce work responsibilities to a simple formula which pays a % of profit or growth or sales. The formula will get the employee to focus on one thing only and jobs are obviously more nuanced than that. So a formula which provides structure and (limited) discretion is the most suitable combination for effective plans.

8. Extraordinary pay gets you extraordinary results

Great pay leads to the virtuous cycle of getting and motivating the best people which leads to the best results that leads to the ability to pay more.

Using pay as the plug to "make the numbers" will result in a vicious downward cycle. A very frequent concern I have heard from clients over the years is that the incentive plan pays too much. Although the plan pays on the basis of targets achieved, there are some people who make a disproportionately more money. My first question to these concerns is does high reward mean that as an institution you made more money? Organizations need to have variance. There has to be a balance between people who get paid more money for extraordinary outcomes at both individual and organizational levels and the people with lesser rewards due to their lack of performance. It is this variation that drives the success of an organization. Results that have positive long and short term financial implications for the institutions allows them to share that success with their employees. It is a simple cycle – people get paid well, it drives their performance up, the institution performs better and exceeds targets, the best people are rewarded and the cycle goes on. This is what we call the virtuous cycle of performance. The opposite of this is using pay to plug your financial number. Assume at the end of the year the organization is short versus budget, and decides to take it out of the employee's pocket. What this will result in is a disgruntled employee workforce who hasn't been sufficiently invested in. Either they will depart or redefine their contributions in the subsequent years. This will impact the organization's financial goals for the next year and there is a downward spiral.

A compensation plan is a very powerful communicator of what the management leadership believes is important

9. Everything takes time

Pay changes will not change behavior, culture engagement or productivity overnight.

A great incentive plan was never created in a day. They never work in the first year primarily because there are trust and legacy issues. There has to be a record of success that the programs organizations have in place are rewarding the right people. People feel the connection between what they have done and how they are being recognized. Properly designed, carefully communicated and implemented, in conjunction with clear strategic priorities is a clear accelerator of all of the above factors. A series of successes will help organizations realize that the plans work effectively. Mostly organizations are always trying to fix something that is broken. This approach doesn't work because they never invest in the gestation period to make a program successful.

10. Uncertainty carries a high discount rate

Lack of clarity around how much and why I get paid will make the ultimate payment worth much less than it costs.

The effects are amplified if the pay is held contingent into the future. Any compensation plan with an uncertainty on the actual payout makes that compensation plan less valuable than something that is certain. For example, while the salary of an employee is certain, the incentives are linked to multiple factors. One external factor for example could be the corporate performance over three years. All of a sudden, the incentive becomes less valuable as it will be paid out over 3 years pay with a clawback attached to it. We have done a lot of empirical studies and every time there is a trade off, employees will put a higher discount on the more uncertain compensation. The thing to note, is that this form of pay is highly inefficient. This is because the organization mostly like will ultimately pay out the money but to the individual it had limited incentive and retention impact because it is uncertain. Hence organizations need to make sure that the uncertainty of delivery doesn't discount the value of compensation.

Any compensation plan with an uncertainty on the actual payout makes that compensation plan less valuable than something that is certain
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