September 25, 2015
The Right Way to Structure a Bonus Plan
Payroll is one of the largest, if not the largest, expenses for many closely held businesses. But many owners don’t view compensation through a strategic lens. This is especially true when it comes to paying employee bonuses. Often, businesses decide that they are going to create an employee bonus plan because they want to provide an additional incentive for employees to work hard, or an additional financial reward for deserving employees. But it’s important to go beyond these and other valid reasons and strategize exactly what you want to accomplish with your plan. Otherwise, you will have wasted an opportunity to motivate and reward deserving employees and work toward the accomplishment of key business goals and objectives.
Why Create the Plan?
The first step in creating an effective employee bonus plan is answering the simple question: Why do we want to create this plan? There are many valid reasons, including:
To share company profits with employees.
To reward hard-working employees for a job well done.
To boost employee morale and retain key employees.
To respond to competitors who offer employee bonus plans.
Next, decide what you want the plan to accomplish for your business. The plan should be structured so that employees are motivated to focus their energy and efforts on activities that will help achieve specific and measurable business goals — increase sales (company-wide or within departments or divisions), improve new customer acquisition or existing customer retention, increase profitability, or achieve key performance indicators (KPIs), for example.
Let’s assume that customer retention is a primary goal during the up-coming year for ABC Company, which has set a client attrition goal of 10 percent or lower. Its bonus plan could be structured as follows:
Attrition below 5 percent: Employees receive bonus of 10 percent of salary.
Attrition between 5-10 percent: Employees receive bonus of 5 percent of salary.
Attrition higher than 10 percent: No bonus is paid.
A plan like this would meet several important criteria for a bonus plan. First, it’s measurable and easily understandable, which makes it easy for employees to monitor progress toward the goal. Second, it is focused on a key company objective (client retention). And third, it enables the company to reward employees financially if the key objective is met.
A Department or Individual Focus
A potential drawback of a plan like this one is that, since it’s based on a broad company goal instead of more focused departmental or individual goals, some employees might not feel like they have much direct input into whether it’s achieved or not. In theory, each employee probably has some degree of impact on client retention, but employees who aren’t on the front line might feel like there’s little they actually do that can help or hinder achievement of this goal.
An alternate bonus plan structure would be to make bonus payments contingent on the achievement of departmental or individual goals over which employees have more direct control. The bonuses of employees who work on a manufacturing floor, for example, could be tied to increasing production output or decreasing defects. Or, individual bonuses could be tied to any number of different performance criteria, such as a measurable improvement in personal productivity, an increase in personal billings or the attainment of some other important personal KPI.
Another option is to tie bonuses directly to company profitability via a profit-sharing plan. Such a plan provides your company with maximum flexibility since payment is contingent on the company achieving a certain level of profitability — if this level isn’t met, the bonus pay-out can be lowered or eliminated entirely. However, this can severely damage employee morale, especially if employees feel like they have very little if any direct impact on the company’s profitability.
Structuring the Plan
A well-structured bonus plan can help employees learn to think and act like business owners and shareholders, not just employees. Consider the following tips as you think about how you will structure your plan:
Formalize the plan in writing. Clearly communicate all the plan’s details to your employees so everyone understands exactly what the “rules” are. Don’t try to play “gotcha” with employees by including fine print or loopholes that would make it easy to get out of paying the bonuses.
Make sure goals upon which payouts are based are finite. In other words, goals shouldn’t be open-ended. Usually, measurement against goals happens at the end of a fiscal or calendar year or quarter.
Tie the rewards to measurable performance standards. An old management axiom states that “what gets measured, gets done” — this is especially true when it comes to paying bonuses. As noted earlier, employees should feel like they have some level of influence over the performance standard(s) being measured.
Use the plan to boost long-term employee loyalty. The plan should give employees (especially key managers and executives) an additional incentive to remain with your company for the long haul. See below for more information on “golden handcuffs.”
Don’t make the rewards too small. The financial rewards should be substantial enough to motivate your employees to work hard toward achieving the goals. One common benchmark is to give employees the opportunity to earn between 5 and 10 percent of their salaries in bonuses.
An employee bonus plan can present a win-win scenario for both your company and your employees when it is well-planned and properly structured. So take the time to think through your goals and objectives for a plan and structure it in a way that provides maximum benefits for everyone.
“Golden Handcuffs” for Executives
Companies often desire to offer their executives and other key employees opportunities to earn additional compensation and bonuses beyond what rank-and-file employees have the opportunity to earn.
Sometimes referred to as “golden handcuffs,” the idea is to give executives the chance to earn additional deferred compensation that will be paid out at some time in the future, thus incenting them to remain with your company over the long term in order to collect. Examples of deferred compensation plans include:
Phantom Stock Plans — As the name suggests, phantom stock is not actual company stock; rather, these stock plans mirror the value of the company’s actual stock. As the actual stock’s value increases over time, the value of the executive’s phantom stock units also increases similarly.
Stock Appreciation Rights (SARs) — Similar to phantom stock, SARs give the executive the right to the monetary equivalent of the increase in the value of a certain number of company shares of stock over a period of time.
Section 162 Executive Bonus Plan — Your company would pay the premiums (via a bonus) for a whole life insurance policy with cash value for your executives. The executive can then take loans and/or distributions from the plan’s cash value to supplement income during retirement.