The Problem With Incentive Plan Cliffs

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Oct 31, 2018
Triggers and hurdles and cliffs, oh my!

To be clear, I’m talking about pay plan mechanics and in particular about the kind of cliff that plays an unfortunate starring role in many pay programs. Specifically, the incentive plan with the all-or-none (or nearly so) singular award hurdle, often set against prior year performance, that can throw the whole program out of whack.

I would be the first to acknowledge that there are few hard and fast absolutes in incentive plan design. There are very likely circumstances where a “cliff” of this nature is appropriate, even ideal.  But I bump into plan after plan where this feature, which always sounds like a good idea in theory, has become an unnecessary morale-buster and veritable fountain of unintended consequences.

Let us count a few of the ways…

Scenario 1

A salesperson’s commission play pays out on sales growth; a certain percent of those sales dollars achieved above 90% of last year’s total sales for her territory. In other words, if she delivered $2 million in sales last year, this year’s commission kicks in after $1.8 million is achieved.

The problem occurs when the sales rep realizes early on in the year that she is unlikely to clear this hurdle. She now has little financial incentive to keep pushing through the remaining months since the only thing she will achieve is to raise her personal bar for commissions the following year. As year-end approaches, the incentive to sandbag, to hold on to orders until after January 1, is overwhelming.

Scenario 2

An employee cash profit-sharing plan has a history of generous awards. To trigger any payout, the company must hit 95% of last year’s profit level. During the good years of market growth, no problem — the company skates by the hurdle year after year.  When economic circumstances converge to deliver a blow to the industry, it becomes clear even by mid-year that the company will not hit the plan trigger. This, even though the company will be profitable and has made notable strides on a number of strategic efforts. Morale tanks.

Yes it’s true, as leadership points out, that given the generous awards of the past few years, employees are paid quite competitively on a rolling 3- or 5-year average basis. That doesn’t change the fact, however, that the employee incentive plan is now an employee discouragement plan.

Scenario 3

A management incentive plan. It’s been a tough year, and the top team has been busting tail to push through a number of unforeseen business hurdles, working hard to both maximize current year customer opportunities and earnings while also building momentum on some critical longer-term initiatives. By the end of third quarter, however, it has become clear the company will likely fall just short of the year’s net income goal. It’s the lone measure on which the incentive plan hinges and the hurdle that must be passed for awards to be earned. As the CFO bluntly puts it, “We all know that the right thing to do is to keep up the balancing act, focusing both on short-term needs and long-term strategies.”

But now plan participants face the choice of doing the right thing and sacrificing the possibility of a short-term incentive payout OR refocusing all year-end efforts (and potentially exercising some accounting gymnastics) to deliver the net income results.  A bad corner for a management team to be backed into.

Bottom line

Incentive plan triggers and hurdles can play an important role. They can protect the company from paying out award dollars when it cannot afford the expenditure or when it simply doesn’t make sense. The trick is incorporating them not only into a thoughtful plan design, but also into a well-balanced overall reward program.  I’ve written before about how helpful it can be to see a total rewards program as a portfolio of sorts.  Like the elements of a sound investment portfolio, there should be a sense of balance in the design and interaction of the different reward elements – a sense of balance missing in the scenarios outlined above.

Has experience taught you to be a fan – or an enemy – of triggers, hurdles and cliffs?

This article is from the archives of CompensationForce.