Advice on bonus and incentive schemes – Take care!

I see that bonus schemes are re-entering the news as it seems some banks have forgotten the flak they took in the autumn and who owns most of their shares as they compete to maximise short term profit, irrespective of long term consequences again. Maybe it’s something to do with the ‘moral hazard’ (a technical economics term) that was created on our behalf last autumn. But that’s for another day. I’ll try to research the topic more thoroughly and if I think its useful do a blog on it another time.

Anyway, one of the topics that comes up in discussion regularly at our Managing Directors’ Group is the subject of motivating staff and management. One aspect of this is incentive schemes. Whilst many bonus schemes are not paying out at present, the recent fuss over bankers’ incentive schemes highlights how bonus schemes can go wrong so I thought it might be timely to provide some brief thought provocation on the topic of bonuses.

One

In the current economic environment, many bonus schemes are not paying out. Lots of businesses are content to leave it that way on the basis that they can’t afford to pay anything and in any case staff remaining are lucky to be keeping their jobs in the current environment. There is a lot of merit in that argument. One of the benefits of the recession is that cost of labour is actually reducing – thus helping businesses to survive. However, rather than dismiss the topic as ‘sorted’, do just ask yourself how you make sure you encourage the right behaviours in the absence of a ‘reward’ for them, and how do you ensure that the best, most able staff feel able to progress their careers with you rather than feeling they are carrying others who contribute less, getting disgruntled and becoming ready to leave as soon as things begin to pick up.

Two

Beware that almost any bonus scheme is capable of creating suboptimal behaviour. If you reward short term profits, don’t be surprised if long term profit and sustainability of the business are ignored. On the contrary, if you reward long term profit, don’t be surprised to hear arguments in favour of short term ‘investment’ and lower short term profit. It is probably best to build a scheme that includes a variety of competing goals, and to revise the shorter term goals annually so that individuals have to make the same sort of trade-offs that board/shareholders have to.

Three

Beware to that the degree to which a bonus scheme causes the wrong behaviour is heavily influenced by the weight placed on the bonus scheme. If a big proportion of someone’s reward is decided by a bonus it is difficult to argue against them focusing on the bonus. (Is it any wonder bankers focused on deals generating big short term profits with high long term risks when 80% or more of their income was based on the short term profit?) So keep bonus schemes in proportion, and then you are more likely to get sensible long term behaviours and if necessary, you can insist on more sensible behaviour as ‘that is what the basic pay if for’.

Four

On this topic, a useful idea I learnt earlier in my career that I have found useful to guide my thinking on team rewards is as follows: everyone should be rewarded on the performance of the team of which they are part; not the team that they control. ie the performance of their bosses team. The idea here is that everyone is encouraged to work with their immediate team to produce the best results for that team. Whilst this might encourage them to act competitively against the interests of the wider team, this tendency will be limited by their manager who is incentivised to produce the best result for the next wider team and so on.

Five

The key difficulty of the above comments is complexity. Despite all I say above, bonus schemes, if they are to work effectively must be simple enough to be understood. So don’t go overboard trying to reconcile all the competing pressures in one complex scheme. Focus on the key measures, keep the bonus amount reasonable and be prepared to adjust annually as needs change and as behaviour becomes sub-optimal.

Six

And finally remember that money is not everything. Most people admit to being driven by more than money, and in my experience, even those who profess to being solely driven by money are often, at root really driven by other matters such as image, status, self esteem, risk avoidance and an easy life. So make sure you’ve thought through what else matters to your staff too!

Written by Bob Bradley, founder of MD2MD.

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