Getting It Right—Paying for Performance Through Variable Pay Ken Abosch Marilu Malague Your Presenter(s) Ken Abosch, Lincolnshire Office 847.442.3580 ken.abosch@hewitt.com Marilu Malague, Woodlands Office 281.882.6268 marilu.malague@hewitt.com Bottom Line on Top Variable pay has become the primary mechanism to pay for performance today There are sub-optimal practices that are inhibiting the effectiveness of variable pay plans Now is the time to Get it Right! Road Map for Today’s Discussion Variable Pay’s Role in Pay for Performance Today Learning From Our Mistakes Getting it Right: Criteria and Tools Your Questions! Sources of Information Variable Compensation Measurement™ Hewitt Salary Increase Survey Broad-based plans Created in 1976 Created in 1996 Fortune 1000 companies 1,156 companies in 2009 Merit/overall salary increases Salary structure movement Variable compensation Special topics More than 380 cash variable pay plans 300 companies 1.9M employees Plan characteristic driven database Prevalence Effectiveness Variable Pay’s Role in Pay for Performance Today Use of Variable Pay Percent of Companies With a Variable Pay Plan 100% 88% 90% 70% 80% 70% 60% 47% 50% 40% 30% 20% 10% 0% 20 Years Ago Source: Hewitt Salary Increase Survey 1990–2009 10 Years Ago Today Participation in Variable Compensation Prevalence in Variable Pay Plans By Employee Group 100% 90% 80% 81% 74% 70% 60% 50% 52% 41% 40% 30% 20% 10% 0% 10 Years Ago Today Salaried Exempt Source: Hewitt Salary Increase Survey 1990–2009 Salaried Nonexempt Increasing Line of Sight Focus of Variable Pay Plans Based on Plan Type 100% 90% 80% 64% 70% 53% 60% 45% 50% 40% 35% 35% 28% 30% 20% 38% 20% 13% 18% 10% 10% 0% 20 Years Ago 10 Years Ago Individual Performance Plans Cash Profit Sharing Source: Hewitt Salary Increase Survey 1990–2009 Today Business Incentives Gainsharing Growing Role of Individual Performance Inclusion of Individual Performance in Variable Pay Metrics 100% 90% 80% 70% 60% 36% 50% 40% 30% 17% 20% 10% 0% 10 Years Ago Today Source: Hewitt Variable Compensation Measurement™ (VCM™) database 2000–2009 Budgeted Spending: Base Salary Increases in Decline Percent of Payroll 10% 9% 8% 7% 6% 5.5% 5.4% 4.2% 3.9% 5% 4% 2.5% 2.5% 3% 2% 1% 0% 20 Years Ago 10 Years Ago Salaried Exempt Source: Hewitt Salary Increase Survey 1990–2009 Today Salaried Nonexempt Budgeted Spending: Variable Compensation on the Rise Percent of Payroll 10% 12.0% 9.6% 9% 8% 6.5% 7% 5.0% 6% 5% 4% 4.0% 3.0% 3% 2% 1% 0% 20 Years Ago 10 Years Ago Salaried Exempt Source: Hewitt Salary Increase Survey 1990–2009 Today Salaried Nonexempt Projecting Future Budgeting Percent of Payroll 20% 16.0% 18% 16% 11.8% 14% 12% 10% 8% 6% 4% 2.5% 2.0% 2% 0% Today 10 Years From Now Base Salary Increase Budget Source: Hewitt Salary Increase Survey 2009–2010 Variable Pay Budget Focus on Total Cash to Attract/Retain Talent Compensation Total Cash Talent Risk Zone Base Salary $50,000 $100,000 Salary Level $250,000 Variable Pay Has Become a Global Phenomenon United States Canada Venezuela Puerto Rico Mexico Chile Brazil Argentina United Kingdom Switzerland Sweden Spain Netherlands Italy Hungary Germany Belgium Austria Thailand Taiwan Singapore Philippines Malaysia Korea Japan India Hong Kong China Australia 0 20 Source: Hewitt Salary Increase Survey 2007–2008 40 60 80 100 Why the Dramatic Shift to Variable Pay Fixed vs. variable costs Need to focus and drive behaviors Need to create alignment Perceived control Shareholders/analysts value it Learning From Our Mistakes Learning From Our Mistakes Plan Weights Corporate Employee With $50,000 Salary (5% Bonus Target) 50% ■ Net Income 25% $625 ■ Revenue 25% $625 10% $250 5% $125 Business Unit 20% ■ Cash Flow ■ Revenue ■ Quality 2.5% $62.50 ■ On-Time Delivery 2.5% $62.50 Department 20% ■ Safety 10% $125 ■ Attendance 10% $125 Individual 10% ■ Attendance 2% $50 ■ Project Completion 3% $75 ■ Idea Creation 5% $125 100% $2,500 Learning From Our Mistakes Executives Directors Managers High-Level Exempt Other Exempt Nonexempt Salary Increases Annual Bonus X X X X X Special Recognition X X X X X X X Learning From Our Mistakes Maximum Funding Gap Target Threshold $1.0M $1.5M $3.0M $6.5M Funding Funding Required by Plan Actual Available Funding Learning From Our Mistakes Corporate Results X X X X X Business Unit Results Department Results Individual Results X Nonexempts Entry Exempts Managers Directors Executives Learning From Our Mistakes >1 35 % -1 00 % 10 0% -1 05 % 10 5% -1 10 % 11 0% -1 15 % 11 5% -1 20 % 12 0% -1 25 % 12 5% -1 30 % 13 0% -1 35 % 95 % -9 5% 90 % -9 0% 85 % -8 5% 80 % -8 0% 75 % -7 5% 70 % -7 0% 70 60 50 40 30 20 10 0 0% # of Incumbents Distribution of Total Payout as % of Target Total Payout as % of Target Company Perf as % of Goal Learning From Our Mistakes Business Performance Bonus Payout 2001 2002 2003 2004 2005 2006 2007 2008 2009 Learning From Our Mistakes % of Target Incentive Percent of Goal vs Percent of Total Target Incentive R2 = 0.1331 190% 170% 150% 130% 110% 90% 70% 50% 70% 90% 110% 130% 150% % of Goal 170% 190% 210% 230% 250% Learning From Our Mistakes $10,000 $5,000 Grade Midpoint $5,000 – Employee Salary Salary to Midpoint Comparison Calculated Bonus Payment $5,000 = Less Salary Over Midpoint Actual Bonus Paid Bonus Payout Calculation Learning From Our Mistakes Participation Requirements No formal requirements to participate Communication Year-end pay statement left on desk Plan Administration Payout 5 months after close of year Create focus on required results Improve performance The Role of Variable Pay Share in successes and failures Motivate desirable behaviors Facilitate ideas and improvements Getting it Right: Criteria and Tools Getting It Right! It has never been more critical to get variable pay right Role in pay for performance Increasing investments Management expectations External scrutiny Getting It Right: Diagnosis and Ongoing Plan Validation Common Alignment Measures goals with clear linkages Controllable Relevant to the Business As few as possible As Line of Sight Funding Eligibility Targets much direct influence on outcomes as possible Accrued Reflective of Increasing Be actual results as inclusive as possible Competitive Appropriate pay Minimal Participation Requirements Plan Mechanics Communication Plan Administration at risk given line of sight and role performance standards Reflective of pay philosophy and culture Balanced between realistic and challenging Understandable and communicated Goals shared before plan starts Progress reports goals Not overly burdensome Should include assessment of continuous improvement Getting it Right: Performance Measures Problem The current STI was not effectively rewarding for business and individual performance Before Program Redesign Corporate Results Assigned Target + Individual 10% of Base = Annual STI Award Eligibility limited to Directors and above Program only paid for corporate results—no consideration for Business Unit performance Individual component (10% of base) was not aligned to an appropriate target, ill defined, subjective, and traditionally always paid Company’s recommendation was to have 4 to 5 measures weighted at 2.5% to 2% Getting it Right: Performance Measures Many Many alternative alternative design design approaches approaches and and performance performance measures measures considered considered Award Pools Additive Opportunities (Funding = % of Profit) (Funding = Sum of Required Payments) Participant A Participant C + Participant D Measure A Modifiers Earned Award + Measure A Measure B X (Funding = Sum of Required Payments) Earned Award Participant B (Funding = Sum of Required Payments) Multiplicative Models + Measure B Earned Award = Measure C Discretionary Plans (No Specific Funding Mechanism) X X Measure A Measure B Measure C Hybrids (Funding = Sum of Required Payments Modified by Pool Size) = Measure C = + Measure A Measure B + Measure C Earned Award = Getting it Right: Performance Measures Recommendations Expanded plan eligibility deeper in the organization (all exempt employees) Aligned the incentive plan and employees to the business goals Corporate Results + Business Unit Results X Individual Modifier = Annual STI Award Incentive Weighting Job Level Incentive Target Corporate Business Unit Individual Modifier Executives/ Sr. Vice Presidents 40% 100% N/A N/A Vice Presidents 30% 70% 30% +/- 15% Directors 20% 50% 50% +/- 25% Managers 10% 40% 60% +/- 25% Professionals/ Specialty Roles 5% 30% 70% +/- 35% Diagnosis and Ongoing Plan Validation: How One Plan Measured Up Measures Corporate, 50% Individual, 50% Performance measured at Corporate and individual levels Measures aligned with Plan Objectives Eligibility Funding Alignment Line of Sight Plan Mechanics Exempt Employees >$60,000 – 85% Exempt Employees <$60,000 – 78% Performance trigger High eligibility and high spend Consistency in the pay out of awards across all employee levels Common measure or measures across all eligible employee groups Primary focus on Corporate Measure Measures are balanced across all levels (i.e., not too much on Corporate) Relationship between amount of stretch in goal setting and formula parameters is reasonable Pay out is below target if objectives are not met Thresholds and maximums are reasonable Pay outs for key contributors relative to average is 175% Targets Participation Requirements Communications Plan Administration Pay out targets +/- 10% to 15% of market targets Degree of stretch built into performance target: moderately low stretch Gate for individual performance Part-time employees are eligible Must be employed on the last day of the measurement period Direct and indirect Only payout targets and maximum are communicated Frequency: Quarterly No process in place to evaluate the plan Takes 24 person weeks to administer Incentive Plan Scorecard: How One Plan Measured Up Variable Pay Index™ Scorecard Overall Score Effective Zone Score Maximum Score 696 1,000 Score Maximum Score 100 150 1. Measures Effective Zone 2. Eligibility Highly Effective Zone 75 100 3. Funding Highly Effective Zone 75 100 4. Alignment Highly Effective Zone 75 100 5. Line of Sight Effective Zone 50 100 6. Plan Mechanics Effective Zone 62.5 100 7. Targets Highly Effective Zone 75 100 8. Highly Effective Zone 100 100 9. Communication Highly Effective Zone 83.5 100 10. Plan Administration Ineffective Zone 0 50 Participation Requirements Diagnosis and Ongoing Plan Validation VPI™ Scorecard Participation Requirements 1 Highly Effective Zone Communication Eligibility 0.75 Funding Alignment Targets Effective Zone Plan Mechanics Measures Line of Sight 0.5 Partially Effective Zone 0.25 Plan Administration Ineffective Zone 0 -2 -1 0 1 2 3 4 5 6 7 Measures Eligibility Funding Alignment Line of Sight Plan Mechanics Targets Participation Requirements Communication Plan Administration 8 9 10 Incentive Plan Scorecard The analysis details each design characteristic through “speedometers” that compares to both best practice, our normative VCM Database, or a selected peer group Overall Score XYZ Company Ineffective Zone Partially Effective Effective Zone Highly Effective Company’s Score 0–249 250–499 500–749 750–1000 696 Partially Effective Zone Ineffective Zone 0 Effective Zone Highly Effective Zone 1000 Getting It Right: Answering Critical Questions… How does our annual incentive plan compare to best practices? How does our annual incentive plan compare to those in my industry? How can we change our annual incentive plan to make it more effective? How can we demonstrate to our leaders how our plan supports business objectives? What characteristics have the greatest impact on plan effectiveness? Your Questions Your Presenter(s) Ken Abosch, Lincolnshire Office 847.442.3580 ken.abosch@hewitt.com Marilu Malague, Woodlands Office 281.882.6268 marilu.malague@hewitt.com