Is a Formula Better than Discretion in Paying Incentives?

Alignment between pay and performance has become increasingly important especially during economic uncertainties; there is constant debate on whether incentives should be determined by a formula or discretion to increase alignment. Some companies are swinging back and forth like a pendulum; struggling between a formula and discretion in determining how senior executives should be incentivized.

Which way is better?

Commission is Purely Formulaic

Commission, is the most formulaic payment used to calculate the incentive amount. It is a top-down incentive approach calculated by a predetermined incentive percentage based on revenue or profit generated. Some companies believe formulaic driven commission is more scientific and transparent as it provides a clear incentive mechanism for those talents who can make the deal. Commission works well for sales agent, account executive or broker whose primary accountability is to make sales; and individual effort and contribution will make a huge difference in driving the final outcome. Commission might be also good for startups or new businesses which revenue generation is the key for survival and rely significantly on individuals to generate revenue due to the lack of brand equity and company franchise to leverage on.

Since the level of revenue and profit as well as stage of development across different companies vary significantly, commission or incentive rate needs to be carefully determined. The percentage is usually set with reference to external benchmarks for similar roles in the market; but proper projection needs to be conducted to prevent employees from getting windfall or shortfall during economic fluctuations. Using a formula to determine commission seems to be a straightforward and fair incentive approach as it serves to reinforce pay-for-performance. However, commission is usually determined by a single key performance indicator (KPI) or outcome; it neglects the process that leading to such outcome. Revenue and profit tends to fluctuate with the larger economy, so business performance is sometimes largely the output of the macro environment rather than individual contribution. This undermines the performance orientation as employees are unduly enriched or penalized during the economic ups and downs.

The biggest drawback for commission based incentive is that it only measures and rewards short-term financial performance. Non-financial but critical aspects of performance such as platform building, employee development as well as internal and external strategic alliance that drive long-term and overall business results are often ignored. Besides, commission encourages silo mentality and internal competition; department or individual employee focuses only on its own success and forgets the larger goal of driving more business for the entire company. It is a short-term strategy that will not serve business goals over time.

Target Bonus is Less Formulaic and More Scalable

Target bonus is a defined, pre-established amount of incentive which is expressed as a percent of the incumbent's base salary. It is also formulaic driven, thus scientific and straightforward, as the final incentive payout is determined by achievement of specified KPIs based on the performance of the company, department and/or individual employee. This bottom-up incentive approach ensures pay competitiveness by ensuring target bonus amount or percentage of base salary is benchmarked against the market.

Typically, the minimum, target and maximum incentive payout range are pre-determined so that both the company and the employees understand the potential incentive opportunity under different scenarios. Target bonus is more holistic than commission program as multiple KPIs (e.g. in the form of a balanced scorecard) and their relative weighting can be defined. Typically, this includes a mix of financial and non-financial indicators which can be tailored for both the short-term and the long-term. Results from competency assessment, e.g. teamwork, communication, initiative, etc. can also be incorporated in the bonus formula to reflect the qualitative aspects of performance. Final bonus payout is determined by the extent of goal achievement against the corresponding KPI and competency assessment. The KPI and goal setting process enables the target bonus approach to be more versatile in covering senior executives, frontline departments and corporate functions.

With the above competitive edges of target bonus over commission, the former is more common at companies with robust KPI and goal setting process in place. These processes are pre-requisites to ensure a good balance is strike between financial versus non-financial KPIs and corresponding stretched goals are set. The defined KPIs can remain largely unchanged for 2 to 3 years but by changing the relative weighting of different KPIs and adjusting the corresponding annual targets enhances the scalability to reflect the prevailing business strategies and economic environment. Target bonus approach is more suitable for mature companies that are equipped with the skills in exercising their discretion in defining the right KPIs and conducting annual goal setting process. Though target bonus has a number of advantages over other formulaic incentive approaches, it is easier said than implemented since:

Target setting remains as the biggest challenge for both established and newly set up companies to ensure stretched targets are incorporated to drive company performance. This is partly due to the fact that past performance is not a good indicator of future performance and in part due to the unpredictability of macro-economic factors. Target setting is often the result of a tug of war between the Board / headquarters and the management; some companies rely on relative performance of the peer group as a benchmark so that no prior goal setting is required.
It is tricky to define the relationship and relative weighting of company, departmental and individual performance. A delicate balance needs to be strike to reflect overall company performance; encourage collaboration among teams and employees, and ensure performance differentiation at individual level in incentive payouts.
How the target, threshold and cap are placed along the payout curve and the actual payout equation directly affects the incentive opportunity and thus employee motivation. For many companies, the upward or downward performance adjustment is rather limited which affects the motivation in driving performance.

Discretionary Incentives Provides More Flexibility

As opposed to formulaic incentives that are more rigid by nature, discretionary incentive provides more flexibility since it is a performance based bonus paid at the discretion of the company. It relies on sound judgement in assessing the business environment as well as company, departmental and individual performance to determine the actual incentive amount. Discretionary incentive provides more leeway to the Board or the CEO in cross subsidizing new businesses that are still in investment mode at the company level. Department heads are empowered to widen performance and incentive differentiation to reflect individual effort and contribution. This is especially helpful under unpredictable macroeconomic environment such as changes in interest rate, commodity price and regulation which has a significant impact on profit or revenue which dooms prior target setting and/or revenue projection to failure.

Discretion is usually applied with reference to the considerations below:

The extent of market forces and regulatory impact that facilitate and hinder revenue / profit generation;
Progress in relationship management, strategic collaboration (both internal and external), platform, channel or product development that is non-measurable but serves the long-term interest ;
Level of individual contribution, effort and performance;
Competitiveness of total compensation and retention risk that drives the bonus required for talent retention;
Historical company or peer group performance and incentive payout.

Though target bonus, to some extent, can also incorporate some of the above considerations as part of the KPIs to calculate the final bonus payout, judgment rather than preassigned weighting is applied in discretionary incentive to determine the most informed and appropriate bonus for performance achieved corresponding to the relevant contexts in a particular year. Due to the judgmental elements of discretionary incentives, critics often argue that the bonus decision making process is like a “black box”. Incentive decisions could be perceived as “off the head” owing to lack of trust and creditability, and might fall into the trap of subjectivity and favoritism. Decision makers of discretionary incentives must be skillful in exercising judgement to determine and allocate incentives.

Make It Work - Structured Discretionary Incentives as an Alternative Approach

To mitigate among the pros and cons of formulaic versus discretionary incentives, some companies have applied discretionary incentives within a structured framework. The structured discretionary incentives involve:

Diversifying the KPIs. Decreasing reliance on one formulaic metric to determine the incentive pool or payout. Many companies have created a balanced scorecard with a combination of financial and strategic goals that align with long-range business plan to help mitigate the impact of uncertainty.
Putting structure around discretion. Companies could set up both a structure and process for determining incentives. The Board or the headquarters defines the scope of the discretion by identifying performance areas (e.g., strategic collaboration, talent development, etc.) which require discretionary judgment and adjustment. This judgment should be supported by statistic and relevant facts which include monitoring progress on strategic initiatives, or taking inventory of notable successes or disappointments in the midst of unforeseen events.
Establishing adjustment ranges. This approach adds structure by establishing a range in discretionary adjustment. The modification is largely based on non-financial or contextual considerations including strategic, market, customer, competitive, operational and environmental factors. The adjustment could be in the form of an incentive modifier that allows for an upward or downward adjustment (e.g., up to +/- 25%) to the formulaic outcomes or target awards with pre-determined distribution curve as guidance for bonus distribution. In some cases, the Board or the headquarters reserve the right to adjust final awards based on a variety of financial and non-financial factors. This is especially helpful when the formulaic incentives seem too high or too low, and do not necessarily reflect the true progress (or regress) in the business. These adjustment factors should be established upfront when goals are set at the beginning of the year so expectations can be appropriately managed.

No matter one is more in favor of a formula or discretion, the two approaches are not mutually exclusive and serve as a continuum to provide different incentive alternatives. Given the downside of a purely formulaic or discretionary incentive plan, a discretionary plan which incorporates some kind of a structure or a formulaic target bonus plan with discretionary adjustment can both serve as better alternatives. The degree of discretion or formula applied will vary depending on the development stage of the company, skills of decision makers, whether the team is sales or management focus, and the culture of the company. With the Board / headquarters or senior management being accountable for making holistic incentive decisions in the midst of uncertainties, they should not abdicate their judgment to just a formula. At the same time, their discretion should be bounded by the scope defined and/or its relevant weighting upfront. This allows the room to adjust for unforeseen events and resulting performance within boundaries.

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