Create a Variable Compensation Plan Guide the design

Create a Variable Compensation Plan Guide the design and administration of variable compensation programs with a comprehensive variable compensation plan. Mc. Lean & Company is a research and advisory firm that provides practical solutions to human resources challenges with executable research, tools, and advice that will have a Mc. Lean & Company is a research and advisory firm providing practical solutions to human resources challenges©via executable research, tools and advice that clear and measurable impact on your business. 1997 -2012 Mc. Lean & Company. have a clear and measurable impact on your business. © 1997 - 2013 Mclean & Company. Mc. Lean & Company is a division of Info-Tech Group Mc. Lean & Company is a division of Info-Tech Research Group. Research Inc. Mc. Lean & Company 1

Introduction Variable compensation drives performance, but only if it’s well-designed. A poorly designed variable compensation plan can do more harm than good. This Research Is Designed For: This Research Will Help You: üExecutives or HR leaders in charge of variable üUnderstand the fundamentals of variable compensation program design. üExecutives or HR leaders looking to implement a variable compensation program. üAnyone interested in knowing more about variable compensation: what it is; how it fits into the organization’s total rewards offering; its advantages; and its possible disadvantages. üUnderstand organizational characteristics that drive variable compensation decisions: company lifecycle, strategy, and goals/objectives. üUnderstand employee group characteristics that drive variable compensation decisions: pay strategies, equity, and the link between behavior(s) and success. Note: Variable Compensation = Variable Pay The terms variable compensation and variable pay can be used interchangeably. Mc. Lean & Company has chosen to use variable compensation, but cited sources use both terms in this set. Mc. Lean & Company 2

Executive Summary Balancing the need to attract and retain talent against the desire for labor cost control is a problem faced by all organizations, large and small. Organizations need to reward performance that impacts their bottom line to avoid unaffordable outlays in turbulent times and incentivize behaviors that lead to increased profitability. Variable compensation helps organizations do just that: maintain their desired competitive position and drive company value by offering flexibility and plans that “self-fund. ” Variable compensation programs are complex and a variable compensation plan is needed to ensure that design at the employee group level takes into account the organization’s characteristics and goals; that plans fit both the organization and the employee segment, not one or the other. • Programs aren’t one-offs – even those created with care will need to be tweaked over time. ◦ Programs typically require tinkering and ‘plugging holes’ to keep them working at an optimal level. • Business strategy, business lifecycle, culture, industry, workforce composition and demographics, and laws and regulations should all be taken into consideration when creating a strategy and programs. • Having payout floors and ceilings is acceptable, so long as 95% of performance outcomes fall within the normal range – otherwise, they can act as strong incentives for employees to act in ways that strip business value. (i. e. “gaming”) • Budgets/targets should never be linked to compensation and/or non-monetary rewards (e. g. promotions, public accolades) because it creates a strong incentive for employees to set artificially low targets (i. e. “sandbagging”) and/or lie about their actions or performance. Either way, corporate value is eroded. • All payout designs – linear stepped, and curvilinear – are appropriate for all employee segments under different circumstances – with the notable exception of executives. ◦ Executives should always be on a linear payout scheme because the incentive for gaming is high on both stepped and curvilinear plans. Mc. Lean & Company 3

‘Total Compensation’ is a core component of ‘Total Rewards’, which represents the employee value proposition Variable compensation is a core element of ‘Compensation’ – it aligns employee and organizational interests and rewards employees for positive outcomes. Base Pay Total Rewards Total Compensation Performance & Recognition Learning & Development Culture & Work Environment Benefits Variable Compensation Short-term Incentives Long-term Incentives This set will focus on the Variable Compensation piece of Mc. Lean & Company’s Total Rewards Model. Note: Some Total Rewards and Compensation models include Recognition under “Variable Compensation”. Mc. Lean & Company has decided to address Recognition separately because it differs from other incentives in a fundamental ways: a reward is not guaranteed if criteria are met; often it is a “best of the best” situation. Mc. Lean & Company 4

A Compensation Philosophy is the basis of effective compensation planning Compensation Policy Compensation Plans by Employee Segment Compensation Philosophy The “Compensation Philosophy” sets the foundation for all elements of the total compensation offering, including variable compensation plans. As a result, you will need to have a written Compensation Philosophy in place to use this solution set. If you don’t have a written philosophy yet, don’t worry. Use Mc. Lean & Company’s Craft a Compensation Philosophy solution set to develop and get approval for an aligned compensation philosophy. Executive compensation is often considered to be a competitive-positioning document. As a result, details of the target market position is seldom included in the organization-wide Compensation Philosophy and specific plan details are seldom included in the Compensation Policy. If this is the case in your organization, be sure to document these details in the Executive Compensation Plan. Mc. Lean & Company 5

You will need a compensation philosophy and a compensation policy in place before using this storyboard Mc. Lean & Company recommends that you plan for variable compensation at the same time as you create a Compensation Plan. • Compensation planning includes designing a compensation philosophy and policy which set the foundation for all compensation offerings – including variable compensation. • Ideally, you would take the following 3 -step approach: 1. Begin the process of creating a Compensation Plan using Mc. Lean & Company’s solution set: Craft a Compensation Plan but stop after the philosophy and policy have been drafted and buy-in has been garnered. 2. Use this set to create a variable compensation plan and document your decisions in the Compensation Policy and Compensation Plan. 3. Revisit the solution set ‘Craft a Compensation Plan’ to finish the plan. Want to go ahead with variable compensation planning, but save the development of a Compensation Plan for later? • You still need a compensation philosophy and a compensation policy for this storyboard. o If you don’t have a written philosophy, use Mc. Lean & Company’s Compensation Philosophy Template. o If you don’t have a policy, use Mc. Lean & Company’s Compensation Policy template. Mc. Lean & Company 6

This solution set is the capstone for upcoming solution sets on variable compensation Taken together, the advice in these solution sets will help an organization design best-fit variable compensation plans for all employee groups. Create a Variable Compensation Plan Read this set first! The variable compensation plan will feed critical information into all your employee group programs. Build an Executive Compensation Program Build a Sales Compensation Program Build a Variable Compensation Program Coming Soon Note: The solution sets Build an Executive Compensation Program and Build a Sales Compensation Program will cover base pay and variable compensation for these two groups. For all other employee groups, base pay will be covered in the future solution set Craft a Base Pay Plan and variable compensation will be covered in Build a Variable Compensation Program. Mc. Lean & Company 7

Make the Case What’s in this Section: • Make the case for variable compensation and the development of a strategy to drive effective program design. Sections: Make The Case Set the Stage Select Plan Types Guide Program Design Appendix Mc. Lean & Company 8

Variable compensation is always focused on some type of achievement, but it is not always linked to performance What Is Variable Compensation? • Variable compensation is direct compensation that may • • vary in amount from period to period and does not become a permanent part of base pay/salary. Variable compensation is focused on achievement, such as sales acquisitions, project or task completion, the realization of a goal(s), or the acquisition of a new skill. Variable compensation programs can focus on the achievement(s) of an individual (I), a group/team (G/T), and/or the organization (O). For example: I Knowledge acquisition bonus Project completion bonus Sales commission Equity/stock options Gain sharing Profit sharing G/T O Variable Compensation is not always performance-based and Performance Pay is not always variable. 1. Variable compensation can be based on criteria unrelated to performance. For example, the acquisition of knowledge or the completion of a project. Variable Compensation Variable compensation isn’t directly related to performance Variable compensation tied to performance Base pay that tied to performance (i. e. merit pay) Performance Pay 2. Performance pay includes merit increases, which become a part of the employee’s base pay. The term “at-risk” pay is often used as a synonym for variable compensation because payment is not guaranteed. It’s best to avoid this term because it puts a negative spin on variable compensation, implying the organization is taking pay away that the employee is entitled to, rather than awarding extra pay for achievement. Mc. Lean & Company 9

Variable compensation programs are becoming more common in organizations of all sizes Respondents in a 2010 Worldat. Work survey reported increased use of shortterm and long-term incentive programs since 2007. Between 2007 and 2010 the number of organizations offering short-term incentives rose 20. 3% while the number offering long-term incentives rose 74. 3%*, indicating that companies are beginning to balance short-term and long-term rewards to ensure employee focus and motivation is sustained. Incentive Prevalence in Private Companies 95% Short-term incentives 79% Almost 2/3 of organizations have more than one short-term incentive plan. 100% 80% 61% Long-term incentives 35% 0% 60% 2010 40% 2007 20% 40% 60% 80% 100% % of companies offering employee incentives 60% 40% Two or more plans One plan 0% Companies with STIs Source: Worldat. Work, 2012, N=230 “Current trends are towards more use of variable pay. An organization without a variable pay component will be at a competitive disadvantage, at least for its best performers. Source: Human Resources Pro, 2012 Mc. Lean & Company 10

The trend isn’t limited to any single geographic region – variable compensation is prevalent across the globe Most nations have a healthy percentage of their compensation offering directed at variable compensation. Target variable compensation as % of base pay* High (>18%) Moderate (13 -18%) Argentina China Czech Republic Hungary India Latvia Russian Federation Slovakia Turkey Australia Austria Brazil Canada Chile Egypt Finland France Germany Greece Guatemala Hong Kong Indonesia Ireland Italy Japan Korea Lithuania Luxemburg Malaysia Netherlands New Zealand Norway Peru Poland Portugal Qatar Romania Low (<12%) Saudi Arabia Singapore South Africa Spain Sweden Switzerland Thailand Ukraine United Kingdom USA Venezuela Bahrain Belgium Denmark Kuwait Oman United Arab Emirates Source: Hay Group, 2010 Mc. Lean & Company 11

Mc. Lean & Company Helps HR Professionals To: ü Empower management to applyü HR best practices ü Develop effective talent acquisition & retention strategies ü Build a high performance culture Maintain a progressive set of HR policies & procedures ü Demonstrate the business impact of HR ü Stay abreast of HR trends & technologies Sign up for free trial membership to get practical solutions for your HR challenges "Mc. Lean & Company provides practical research, tools and advice covering the entire spectrum of HR & Leadership issues to ensure you experience measurable, positive results. " • - Rob Garmaise, VP of Customer Experience Toll Free: 1 -877 -281 -0480 hr. mcleanco. com Mc. Lean & Company 12