71: Bonus and Incentive Compensation Plan Anatomy

The bones of a great bonus plan
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Make sure the Plan is measurable and not left to arbitrary interpretation or shady math.

I recently had a listener write in asking how to bonus their employees without discriminating and I thought this would be a good topic for an episode (or two), especially with the holidays coming around.

The right bonus plan will help you achieve your business objectives but an ill-conceived one is a waste of money and has the potential to backfire, creating the opposite results.

The trick is developing the right one, and that means identifying your objectives.

There are many different types of bonuses, attendance, holiday, mission, production, retention, and sign-on, to name a few – but there are three compliance issues you need to be aware of when creating a plan, no matter what type…

  • Federal income tax withholding rates
  • Compliance with the Fair Labor Standards Act overtime rate of pay calculation, and;
  • Pay discrimination.

We’ll learn about these three issues in the next episode. For today, we’re going to focus on the anatomy of bonus and incentive compensation plans.

But before we go any further let’s talk about the difference between a bonus and incentive compensation. Who cares…that’s what I say. Once you decide what you want to do, then you can give it a label. But just for fun, let me give you the industry definition of the two.

A bonus is traditionally defined as an “after-the-fact” reward based on performance, whereas incentive compensation is a pre-determined variable earnings plan based on achieving designated results.

Another important distinction is that a bonus is discretionary and incentive compensation is not. But again, we’ll get into that in the next episode.

Who are trying to incentivize?

Ok. The first thing you need to do when developing a bonus plan is to decide who you want to bonus.

Maybe your Managers or the line produces. Maybe its your the full-time servers, or everyone in the sales department?

The plan should be customized for each department or class because everyone’s role in the success of your business is different.

What are you trying to accomplish?

Next, decide what you’re trying to accomplish? Do you have a revenue or production goal. Are you trying to solve an attendance problem or do need to improve quality or reduce expenses?

I believe that most people are motivated by incentive. I believe you can drive results by influencing behavior but if you don’t understand your objective, you’ll end up wasting your money.

Not everyone believes that bonuses and incentive compensation are effective and some actually believe it’s detrimental. These people are mostly scholars quoting studies and I wonder how many of them have ever actually been a private sector employer.

I wonder what these scholars think about the Zappos quitting bonus that offers newly hired and trained customer service employees $3,000 to quit. In an article by David Burkus on inc.com, about 5 years after Amazon acquired Zappos in 2009, Amazon implemented a similar policy – they offer fulfillment center employees up to $5,000 to quit – and they make that offer every year.

Mr. Burkus quotes Jeff Bezos, CEO of Amazon as saying “The goal is to encourage folks to take a moment and think about what they really want,” and “In the long-run, an employee staying somewhere they don’t want to be isn’t healthy for the employee or the company.”

When should you pay a bonus?

Think about how often you’ll pay the bonus. For example, an attendance bonus might be best paid quarterly. If you are going to pay a holiday bonus, make it in early December. It will help reduce their holiday stress.

What should the basis and amount be?

Now you’ll have to figure out what the terms and conditions are. This is the working guts of the plan. What is the basis for the bonus and how much will it be.

A holiday bonus is a simple example. I’ve always based the amount on annual compensation and designated a fixed rate, like 3%. Everyone gets the holiday bonus because it isn’t based on any performance measures. A holiday bonus isn’t designed to drive behavior or achieve a specific result. It’s a general gesture of good will and an expression of your gratitude for your entire staff. Your not recognizing any specific individual’s performance.

Whatever you decide to do, keep it simple and easy to understand. You want to make sure your employees understand the plan. Put it in writing and remind them of it regularly.

Finding the right basis and amount can be challenging. It can’t be too small or too large. You don’t want a bonus or incentive compensation plan to evolve into a replacement of base wages. In my opinion that defeats the entire purpose. Base wages should be enough to eliminate a reliance on bonuses as a contributor to basic income. By basic income I mean the earnings that the position warrants in the free market.

If the base salary for an office manager for your industry, in your location, for a company of your size is $45,000 then don’t pay a salary of $35,000 with a bonus plan that might get their earnings up to $45,000.

And remember that after December 1, 2016 you can’t pay an office manager or anyone else a salary of anything less than $47,476 unless you track actual hours worked an pay the applicable overtime.

To learn more about this change go back and listen to episodes 18, 19 and 33.

Be fair:

Your plan should be fair – I mean everyone who qualifies should have the same opportunity to earn the bonus. Don’t rig it so only certain employees have a chance at it.

Make sure it is measurable and not left to arbitrary interpretation or shady math.

And whatever you do, don’t base the qualification on race, religion, sex, nationality or sexual preference. I shouldn’t even have to say that because you already know, right?

Being fair doesn’t mean that random individual bonuses given to employees who performs exceptionally don’t have a place. I’m a big believer in rewarding an individual when they do something extraordinary.

For example, anytime a customer takes the time to recognize one of your employees for great service, give them a gift card. You don’t need a formal written plan for this type of bonus. This is a discretionary bonus and we’ll address the compliance and tax implications of both discretionary and non-discretionary bonuses in the next episode.

About the author, Thomas

I have 20 of years insurance industry experience in C-level management, focusing on all aspects of workers compensation, risk management, loss control, employee benefits, HR, payroll and professional employer organization (“PEO”) operations. Currently, I am the owner and CEO of Humanly HR, and founder and host of SmallBiz Brainiac; a podcast providing employer intelligence to small business owners.

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