Eliminate Targets from Variable Compensation Plans Use linear

Eliminate Targets from Variable Compensation Plans Use linear schemes to avoid the hassle of target negotiations and the ill-effects of gaming. 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 -2013 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 A linear variable compensation scheme is an easy and effective way to compensate all employee groups. This Research Is Designed For: This Research Will Help You: üLeaders responsible for managing üMake the case for using linear plans to combat compensation who have already established base salary ranges. üOrganizations that have difficulty recruiting because their compensation lags behind market offerings. üOrganizations that have trouble engaging and retaining valuable employees because of compensation issues (e. g. pay inequities among peers). gaming, ease understanding, and lessen the administrative burden. üIdentify pain points and gaps to determine target employee segments. üDesign the linear variable compensation plan: • Determine the measure(s) • Select a slope • Decide on plan details • Measure business impact • Develop an implementation and communication plan Note: This set is focused on short-term incentives, not stock options, etc. , which typically have a longer term payout window. Mc. Lean & Company 2

Variable compensation is a core component of “Total Rewards” – the organization’s value proposition Competitive variable pay helps the organization attract, engage, and retain employees. It also helps align employee and organizational interests. Base Pay Total Rewards Total Compensation Performance & Recognition Learning & Development Benefits Variable Compensation Short-term Incentives Long-term Incentives This set will focus on the Variable Pay piece of Mc. Lean & Company’s Total Rewards Model – specifically, short-term incentives. Culture & Work Environment 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 way: a reward is not guaranteed if criteria are met; often it is a “best of the best” situation. Mc. Lean & Company 3

Executive Summary Limit plan gaming • The multitude of fixed targets baked into nonlinear plans incent people to “game the system” to achieve optimum payouts for themselves, regardless of the best course of action for the company. • To limit this manipulation, organizations should opt for linear variable compensation plans; the absence of rate jump points decreases the incentive to manipulate outcomes. Eliminate seemingly endless target debates • Oftentimes, organizations with nonlinear plans involve management/executive employees in target setting for their employee group; they are trusted to know when rate jump points are warranted. The problem with this practice is that these employees have a vested interest in the outcome and are therefore inclined to soften targets, causing lengthy debate. • To eliminate these seemingly endless debates, organizations should opt for a linear plan that eliminates discussions around reasonable rate jump points. Reduce the administrative and communication burden • Nonlinear plans often have multiple tiers, making the calculation of payouts more complex. This increases the administrative burden and increases the need for ongoing communication to both employees and managers with regard to payout calculation. • To reduce the burden, organizations should opt for a linear plan that reduces the complexity of payout calculation. Mc. Lean & Company 4

Understand the distinction between payout schemes before moving on Core payout designs Linear Stepped Curvilinear What about bonus plans? This set will focus on the use of linear plans. Throughout this storyboard, these designs will be referred to as “nonlinear. ” Bonus plans do not have a payout curve because they have an on/off design: either the employee is entitled to the full amount or nothing. Mc. Lean & Company 5

How to use this blueprint There are multiple ways you can use this Mc. Lean & Company Best Practice Blueprint in your organization. Choose the option that best fits your needs: Best Practice Blueprint Do-It-Yourself Implementation Use this Best Practice Blueprint to help you complete your project. The slides in this Blueprint will walk you step-by-step through every phase of your project with supporting tools and templates ready for you to use. Project Accelerator Workshop You can also use this Best Practice Blueprint to facilitate your own project accelerator workshop within your organization using the workshop slides and facilitation instructions provided in the Appendix. Free Guided Implementation We recommend that you supplement the Best Practices Blueprint with a Guided Implementation. For most Mc. Lean & Company members, these Guided Implementations are included in your membership plan. * Our expert analysts will provide telephone assistance to you and your team at key project milestones to review your materials, answer your questions, and explain our methodology. Onsite Workshops Mc. Lean & Company’s expert analysts will come onsite to help you work through our project methodology in a 2 -5 day project accelerator workshop. We take you through every phase of the project and ensure that you have a road map in place to complete your project successfully. In some cases, we can even complete the project while we are onsite. Book your workshop now by emailing: Workshop. Booking@Mc. Lean. Co. com *Gold and Silver level subscribers only Or calling: 1 -877 -281 -0480 Ext. 3001 Mc. Lean & Company 6

Book a free guided implementation today! Mc. Lean & Company is just a phone call away and can assist you with your project. Our expert Analysts can guide you to successful project completion. For most members, this service is available at no additional cost. * Here’s how it works: 1. Enroll in a Guided Implementation for your project Send an email to Guided. Implementations@Mc. Lean. Co. com Or call 1 -877 -281 -0480 and ask for the Guided Implementation Coordinator 2. Book your analyst meetings Once you are enrolled in a Guided Implementation, our analysts will reach out to book a series of milestone-related telephone meetings with you and your team. 3. Get advice from a subject matter expert At each Guided Implementation point, our Consulting Analyst will review your completed deliverables with you, answer any of your questions, and work with you to plan out your next phase. This symbol signifies when you’ve reached a Guided Implementation point in your project. *Gold and Silver level subscribers only Mc. Lean & Company 7

Make the case What’s in this Section: • Avoid gaming, negotiation, and administrative burden with linear compensation plans. Sections: Make the case Determine where a linear plan will have the most impact Draft the linear plan and measure the impact Develop an implementation and communication plan Appendix Workshop Mc. Lean & Company 8

Linear plans eliminate targets – and the gaming that often plagues them The targets embedded in nonlinear variable compensation plans – in particular, stepped plans – incent employees to “game the system. ” Common gaming techniques: • Withholding effort to delay an outcome to a future period when they may be able to reach a higher payout level (e. g. postponing purchases or other measurable outcomes – sometimes referred to as a “push”). • Advancing outcomes to reach a higher payout in the current period (e. g. advancing sales that may or may not be realized – sometimes referred to as a “pull”) or in order to potentially reach a higher payout in a future period (e. g. taking a “big bath”). • Engaging in illegal/fraudulent activity that manipulates the appearance of outcomes in order to reach a higher payout in the given period. These two forms of gaming are often referred to as “timing manipulation. ” Combat employee gaming with a flat-rate linear plan. • In flat rate linear plans, gaming is less incentivized because the return per unit stays constant over time; there are no “rate jump” points – the ones commonly associated with unethical or value-destroying gaming. … any time managers are within shooting distance of a kink (or in general any nonlinear segment) in the pay-for-performance function, the firm is rewarding them for taking actions that are harmful. Source: Jensen, 2003 Mc. Lean & Company 9

An incentive plan costs an organization twice as much as expected due to employee gaming A large software vendor incented its salespeople using a nonlinear plan, where payouts varied based on the quarter when a deal closed. Source: Ian Larkin, “The Cost of High-Powered Incentives: Employee Gaming in Enterprise Software Sales”, 2013 The Findings Sales cycles were a year or more long, and salespeople had some freedom to reduce prices to close a deal. A study found that salespeople were cutting prices unnecessarily to ensure deals closed in quarters where they could earn higher incentives which more than offset the money they lost on the reduced value of the deal. In other quarters, they kept prices high to maximize their payouts. The Cost Looking only at the cost of commission payouts, approximately 6% of revenue, fails to take into account another key cost of the linear compensation plan – the cost of the unnecessary price reductions which were estimated at 6 -8% of revenue. Therefore the actual cost of the plan was double that of the commission payout alone. The Takeaway Timing manipulation can come with a hefty price tag – lost revenue and sometimes even brand damage. A linear plan reduces the incentive to game, thereby saving the organization both money and reputation. Mc. Lean & Company 10

Plans that involve negotiation have two additional issues: time is wasted and goals are diluted How does target negotiation cause wasted time and diluted goals? Employees who will be personally affected by payout design have a vested interest in keeping targets easily achievable – and they will negotiate tirelessly to ensure that happens. As a result, management is typically forced to soften the goals in order to come to a resolution. Eliminate target negotiation; don’t pay people to lie or under-promise so they are seen to over-deliver. • Linear plans, by their nature, have no targets. As a result, there is no cause for target negotiation. • The only negotiation that could take place in a linear plan is related to slope setting because it affects payout. ◦ When it comes to slope setting, a simple rule will help you avoid the pitfalls of negotiation: Never involve employees in the slope setting process for their employee segment. After all, vested interest creates conflict of interest. Why do organizations engage in this “consultative” target setting? It’s hard to know why consultative target setting has become so popular; after all, involving employees in setting targets for their own variable compensation plans seems like an visibly bad idea. Perhaps the push for consultative goal setting in performance management has bled over to the compensation arena. A related issue to keep in mind is that better negotiators will invariably get a better deal than their less negotiation-savvy counterparts. In these cases, another flaw is revealed: lack of plan fairness. 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