AFFORDABLE AND EASY TO ADMINISTER
It is an obvious fact that there is an inherent conflict of interest in the relationship between employer and employee. The employee’s rewards represent a cost to the employer, which the employer wants to minimise. Clearly whatever reward scheme is in place, it must be affordable to the employer.
TARGET SETTING
Many reward schemes are based on employees achieving pre-determined targets, so some consideration of target setting is required.
In Fitzgerald and Moon’s building block’s model, three principles are given when setting standards or targets: equity, ownership and achievability. Equity in this context means fairness; when setting targets for the various managers, those targets should be equally challenging. Ownership means that the targets should be accepted and agreed by those managers for whom they are set. This can usually be achieved by participation. Finally targets must be achievable; otherwise the employees for whom they were set will become demotivated.
The building block’s model then goes on to specifically cover reward schemes. It states that there are three principles of a good reward scheme. First, there should be clarity – it should be clear how the reward scheme works. If your boss tells you that you will receive a bonus at the end of the year ‘if you do a good job,’ that is not very clear, since the boss has not specified what doing a good job means. Rewards should be motivational. Finally there is the important controllability principal. Employees should only be judged and rewarded based on things within their control. This is why profit-related pay might not be relevant to a junior administrative assistant, for example.
Hope and Fraser warn against the use of linking rewards to fixed performance targets, as this leads to gaming. In particular, managers whose rewards depend on fixed targets may be tempted to ‘always negotiate lowest targets and highest rewards,’ which suggests that management plans will understate the potential that the organisation can make. ‘Always make the bonus, whatever it takes,’ is another example of gaming suggested by Hope and Fraser, which suggests that managers may indulge in unethical behaviour such as fraudulent accounting in order to ensure that targets are met.
Hope and Fraser suggest divorcing the planning process and the target setting process, and basing rewards on relative targets and benchmarks. A relative target might be market share, for example, where rather than setting an absolute target for a sales manager, a market share (%) target is provided. If the market rises, then more is expected in absolute terms. This adds to controllability, since the sales manager could not be held responsible for a rise (or fall) in the overall market, which is outside of his control, but would be able to control whether or not he achieves the expected share of the market.
TYPES OF REWARD SCHEME
Base pay
Base pay, or basic pay, is the minimum amount that an employee receives for working for an organisation. For example, the employee may be paid $10 per hour for a minimum of 40 hours per week. The employee will therefore earn at least $400 per week. This will be paid regardless of how many of those 40 hours the employee is actually working. A fixed annual salary is another example of basic pay.
Basic pay may be supplemented by other types of remuneration. A blue collar worker may be paid overtime for example if he works more than 40 hours per week, and a manager may receive some form of performance pay in addition to the base pay. Basic pay is likely to address the lower levels of Maslow’s hierarchy of needs mentioned above.
Performance-related pay
Performance-related pay is a generic term for reward systems where payments are made based on the performance, either of the individual (individual performance-related pay) or a team of employees (group performance-related schemes).
In recent decades there has been a move toward performance-related pay schemes in many organisations. This has lead to a situation where a higher portion of the employees pay is dependent on performance. This rationale for performance-related pay is that it motivates employees to work harder, and rewards those who make a greater contribution to the organisation’s goals. This should lead to efficiency savings. There are many types of performance-related pay, and the most popular ones are described below:
1. Piecework schemes
Under Piecework schemes, a price is paid for each unit of output. Piecework schemes are the oldest form of performance pay, and were used for example in the textile industries in Great Britain during the industrial revolution. Piecework schemes are appropriate where output can be measured easily in units. They are typically used for paying freelance, creative people. Freelance writers for example are often paid based on the number of words.
The benefit of piecework schemes is their inherent fairness. The higher the output, the more the employee (or subcontractor) receives. From the employer’s perspective, the employer does not have to pay for idle time or inefficiencies.
From the employee’s perspective, such schemes mean that the employee bears commercial risk if demand for their product falls.
A further disadvantage of piecework schemes is that the payment is not based on the quality of output. However, some sort of quality control is likely, and if the quality is not of a required standard, the employee or subcontractor will not be paid.
2. Individual performance-related pay schemes
Individual performance-related pay schemes are where the employee receives either a bonus, or an increase in base pay on meeting previously agreed objectives or based on assessment by their manager, or both. They are typically used for middle managers in private sector organisations and for professional staff.
The advocates of individual performance-related pay schemes claim that their they are an obvious way to align to objectives of middle managers with the goals of the organisation. If performance targets set are based on the goals of the organisation, then it appears obvious that making part of the rewards of employees’ contingent on achieving those targets will mean that employees are motivated to achieve the goals of the organisation.
Individual performance-related schemes also have the advantage over group schemes that the employee has control over her rewards, as they do not depend on the effort (or lack of) of other members of the team.
Critics of such schemes point out that the link between rewards and motivation is far from clear, as discussed above. It is also argued that performance-related schemes lead a situation of tunnel vision whereby if something is not measured, and then rewarded, it won’t get done.
Individual reward schemes may lead to a lack of teamwork and may lead to variances in pay among individuals, which can lead to ill feeling.
An example of an individual performance-related pay scheme is one that is operated by a UK bank. Under the scheme, a bonus pool is allocated to each region based on the performance of that region. From this pool, individual awards are made based on assessment of performance, taking into account the rating on a five-point scale. Those with scores of 1 to 3 qualify for a discretionary bonus. The assessment depends on how much new business the individuals have brought in, or how much efficiency savings they have generated. The rewards are usually paid in cash, although for senior employees receive a portion as deferred stock.
3. Group-related performance-related pay schemes
Group-related performance-related schemes are similar to individual, in that rewards are paid based on the achievement of targets. However the targets are set for a group of employees, such as a particular department, or branch of a company, rather than for an individual. Since the rewards apply to a group, they are likely to be based on a pre-determined quantitative formula, rather than on assessment of staff.
A bonus pool is calculated based on the performance of the team, and this is shared among the members of the team. Bonuses may be paid up at the end of the year, or may be deferred, and paid at a later date, as this may encourage staff and managers to take a longer term view, rather than simply focusing on the current year’s bonus.
The advantage claimed for group schemes is that they encourage teamwork. The disadvantage is that the lazier members of the team benefit from the hard work of the more dedicated.
Hope and Fraser give the example of a scheme operated by Svenska Handelsbanken, where each year, a portion of the banks profits are paid to a profit sharing pool for employees, provided that certain conditions are made. The main conditions are that the Handelsbanken Group must have a higher return on shareholder’s equity than the average of its peer group. The upper limit of the amount paid into the scheme is 25% of the total dividends paid to shareholders. Employees do not actually receive anything from the pool until they reach the age of 60, at which point they receive a pay out based on the number of years that they have worked for the bank. The CEO of Handlesbanken claimed that employees are not motivated by financial targets, but by the challenge of beating the competition. The reward scheme is designed to be a dividend on their intellectual capital.
4. Knowledge contingent pay
Knowledge contingent pay is where an employee will receive a pay rise or a bonus, or both, for work-related learning. An ACCA candidate, for example, may receive a higher salary once he has passed all the knowledge level papers, and an even higher salary after passing all of his exams.
5. Commissions
Commissions are a form of remuneration normally used for sales staff. The staff may receive a low basic pay, but will then receive commission, based on a percentage of the amount of their sales.
The advantages of commission are that they should motivate sales staff to achieve higher sales, as their rewards depend on it, and they mean that the large part of the salesman’s salary becomes variable. If sales are low, the organisation will have to pay less.
The disadvantage of commission is that it may lead to dysfunctional behaviour. Sales staff may indulge in window dressing, for example to meet this years sales target, by selling on a ‘sale and return basis’ in the final month of the year, with the inherent understanding that the goods will be returned in the following month of next year. They may also lead to short termism, where sales staff ‘never put the customer above the sales target’ to quote Hope and Fraser.
6. Profit-related pay
Profit-related pay is a type of group performance-related pay scheme where a part of the employee’s remuneration is linked to the profits of the organisation. If the company’s profits hit a pre-determined threshold, a bonus will be paid to all members of the scheme. Typically the bonus will be a percentage of the basic pay. The bonus may be paid during the year in question; for example, quarterly, or it may be deferred until some later date, such as the retirement of the staff.
Advocates of profit-related pay argue that it motivates employees to become more interested in the overall profitability and therefore become more motivated to ‘do their bit’ to improve it. It may also encourage loyalty in cases where staff may lose their bonus if leaving the organisation means that they lose the right to it.
The obvious disadvantage with profit-related pay is that it does not match the primary objective of commercial organisations, which is to maximise the wealth of the shareholders. Managers may be motivated to increase profits by taking short-term actions that will harm the business in the long run, for example, or destroy wealth by investing in projects that increase the profits of the organisation, but produce a return that is below the cost of capital of the organisation.
Profit-related pay might not be a motivator for junior employees, who may fail to see the link between their effort and the overall profits of the organisation.
7. Stock option plans
Stock option plans have become very popular since the 1990s, when greater emphasis started to be given to shareholder value. Under stock option plans, staff receive the right to buy shares in their company at a certain date in the future, at a price agreed today.
For example, Alpha Co is listed on the stock exchange of Homeland. Today, shares in Alpha Co are trading at $100 each. The company has just awarded the CEO of Alpha Co the option to buy 1 million shares for $100 each in exactly ten years time. These options have no intrinsic value at the granting date.
If the share price rises to say $200 in 10 years time, the CEO could exercise his options, buying 1 million shares at a price of $100 each. Since the shares would be worth $200 each by then the CEO would make a gain of $100 per share, or $100m in total.
Stock option plans are most appropriate for the senior management of organisations as they are the people who have the most influence over its share price. The rational for using stock option plans is that they align the objectives of the directors with the objectives of shareholders. If the share price rises, the senior management benefit because their options increase in value. Thus senior managers will start to think like investors.
The big weakness of stock option plans is that share prices may depend on external factors as much as on the performance of the directors. During the bull markets of the 1990s and 2000s, many companies share prices rose simply because the market rose.
Another weakness is risk misalignment. Share options reward managers if the share price goes up. If the share price falls, however, there is no difference in reward between the share price remaining the same ($100) and falling to ($1) – so managers may be motivated to take extreme risks where the exercise price may not be met.
What shareholders really want is the performance of their company to be better than the market. One solution to this is to use an indexed exercise price, where the price at which the director can buy the shares is equal to the current market price, plus the increase in the stock market index between the date that the options are issued, and the exercise date. This means that the share option reflects the controllability principle
more closely, as directors would not be rewarded for rises in the stock market in general.
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