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Overcome the Challenges in Creating a Compensation Plan

Friend to Groucho Marx: “Life is difficult!” Marx to Friend: “Compared to what?”

In chapter 6, “Why You Need to Reward Different People Differently,” we introduced the trend in professional services firms toward pay for performance. We also discussed a wide variety of variables when considering criteria. In this chapter, we look at specific best practices in pay-for-performance plans, how to go about creating one, and the obstacles you are likely to encounter along the way.

Of all the decisions that must be made in multiowner professional services firms, determining how to change the reward system for owners is perhaps the most difficult for several reasons:

1. No matter what the current system and how well it’s working, a special sensitivity to pay programs always exists. Few want to upset the current apple cart.

2. There may be a long history of compensating owners in a certain fashion, and the new system may also upset the apple cart.

3. No one likes to admit they are overpaid, and the new system may more openly point out discrepancies in pay, either overpayment or underpayment.

4. Owners usually do not want to confront each other about their absolute and relative value in the firm. Finally, we now know there is a right and wrong way to design a compensation system, and not everyone is up to the task, nor all firms.

Some compensation consultants to professional services firms used to say that as long as the majority of owners believed the compensation plan was fair, it was a good plan. That may or may not be true today. We have found that many programs today have far too many objectives. When each bonus objective is worth only 5 percent of the total bonus amount, how meaningful is that performance objective?

As said before, no single compensation plan is best for every firm. The compensation system should be derived by the firm’s goals and strategies. Hence, the design of the compensation system should follow, not precede, goals and strategies.

Every compensation plan should be constructed to

1. help the firm achieve its strategic goals.

2. attract, reward, and retain the right people.

3. focus on profitable and sustainable growth.

If the plan does not accomplish these three objectives, it needs to be restructured, unless your goal, of course, is to attract and retain average or less-than-average performers. Jim Collins in Good to Great: Why Some Companies Make the Leap…and Others Don’t writes, “The purpose of a compensation system should not be to get the right behavior from the wrong people, but to get the right people on the bus in the first place and then keep them there.” Collins is clearly saying that a compensation system by itself will not change behavior, and we would agree with him. Rather, if you hire people who are excited about your vision and want to be part of your organization, then the compensation system is one element that will keep those people at the firm.

In Practice What You Preach: What Managers Must Do to Create a High Achievement Culture, David Maister observed, “The method of compensation is largely irrelevant as a causal factor for high and sustained performance.” He continues, “Those who contributed the most to the overall success of the office are the most highly rewarded. Notice that this does not suggest what the pay scheme should be. The determining factor is just whether the people think it rewards the right people.” We also agree with Maister that high performers will always do a better job. We have seen this at all levels of jobs. Whether one is the CEO or the utility person cleaning the floors at night, the high performer takes more personal pride and accountability in his or her work.

Best Practices in Designing a Compensation System

The incentive plan must have a purpose that everyone in the firm can clearly see. The ultimate purpose of an incentive plan is to reward people for doing the right things—activities that make the firm better and more profitable. It must also have a way to standardize the benefit or reward that will be provided. Finally, it must determine how much of increased value (that is, profits) it is going to allocate to owners and employees and how its value will be measured.

This alignment is held together by forming the right measures in your reward systems, especially the firm’s incentive plans. Those indicators should be measurable, although they may or may not be directly reflected in the financial statements.

Here are the best practices in designing a compensation system that we have seen over our years of consulting:

• Embrace a total compensation philosophy that reminds employees that their compensation includes a lot more than just base pay.

• Define and communicate your compensation philosophy. A focused compensation philosophy answers these fundamental questions:

  — What do you want to pay for?

  — How do you want to pay for it?

  — How will your compensation plan differentiate you from other firms?

  — How will you split up the pie?

• Tailor the plan to your firm’s culture and values. Too many professional services firms generally have little or no connection between their stated values and what the compensation plan rewards. Matching organizational values to performance requires a new approach to compensation. This requires firms to identify, define, and describe representative behaviors for each core value.

• Link compensation to achieving the firm’s vision, mission, and strategy. This involves identifying the firm’s top strategic objectives, defining what they mean in terms of organizational behavior, and designing your compensation plan in a way that rewards and recognizes those behaviors.

• Know what creates value in your firm. In accounting firms, for example, value is created by identifying and satisfying client needs in a profitable manner, serving premier clients, attaining high loyalty marks from clients, being known in the community as a contributor, and developing processes and systems that improve work flow efficiencies.

• Create and hold people accountable to competency maps that outline needed skills and behaviors.

• Focus on criteria that improve both top line and bottom line.

• Reward skills and behaviors that drive results (for example, developing more efficient processes, training others, billing in a timely fashion, and so on). You can only create permanent behavior change by first changing the culture and environment then using compensation to reinforce those changes.

• Measure and reward individual, team, departmental, and firmwide objectives.

Entitlement Performance Continuum

All firms, except those that are just starting, have some existing type of compensation plan. These can range from a very formal written plan to an unwritten informal one. Some plans reward for longevity, equity interest, or lifetime origination, and these plans are referred to as entitlement-oriented plans because the individual does not currently have to produce anything to get paid. Other plans are more performance oriented, and individuals are rewarded for their current contributions to the firm, as well as developing future capacity, such as new service lines, niches, new systems, and so on.

Evaluate Current Plan

Whatever your current plan, we encourage you to evaluate the plan’s current effectiveness. Here are some key questions to ask:

• Do your people see a cause-and-effect relationship between their results and performance bonus?

• Is the firm recruiting and keeping the right people?

• Is the firm providing financial and nonfinancial incentives for its people to stay with the firm?

• Is the firm getting the desired behavior from its owners and employees? If the answer is “Yes,” you have an effective plan. If the answer is “Somewhat” or “No,” you need to do some work.

• Does the plan align rewards with the strategic initiatives of the firm?

• Are performers rewarded more than nonperformers?

• Is the plan fair?

• It is fairly administered?¹

Getting Started

After you address the preceding issues, you can begin to build the actual compensation plan. Remember, today’s workers may be more loyal to themselves first and the firm second. Your father’s compensation plan won’t work today because today’s workforce requires a very different kind of compensation plan. Although firms will design different plans, every plan should align with fundamental and foundational principles.

Although no book can provide all the answers to your compensation-design questions, we believe the following checklist will help you get started in the right direction:

1. Ask foundational questions. Before getting too far into the design plan, ask the following questions:

   1. What is the life of the plan?

   2. Who will be responsible for administering it?

   3. Who will participate in the plan? Owners or owners and employees?

   4. How often and when will payments be made?

   5. How will you determine the payout?

   6. How will you measure the goal?

   7. How will you track results?

   8. Will there be minimum thresholds, or will it be an all-or-nothing payout?

2. What is the goal of the compensation system? In addition to attracting and retaining qualified employees, do you intend to reward owners and employees for good performance, motivate good performance, or create or reinforce a particular type of organizational behavior?

3. How does the compensation philosophy and plan fit with the rest of the organization? How will the firm grow and compete in its markets? What competencies does the firm need to be competitive? How can the compensation practices reinforce other overall management philosophies and objectives?

4. What is the firm’s desired market position relative to pay? Will the organization choose to pay market rates, above market, or below market? How does the desired market position fit with other strategic goals? Are any competitive factors involved that will determine the pay strategy (for example, is one of your major competitors paying significantly more that you)? Although this may be true for entry-level personnel, your wage levels and movement are higher and quicker than your competitors.

5. Owner and employee inputs. Although not up to the employees to design the compensation plan, garnering their input when creating a plan is important. You want to know their perceptions of internal and external pay equity; how they see the performance bonus pay working (individual, teams, combination of the two, and so on); and their overall trust that the firm will do the right thing. We like to borrow an oft-said phrase at FranklinCovey, “No involvement, no commitment.” Be sure you provide all owners with an opportunity to participate in the design of the plan. By inviting participation, valuing all viewpoints, and brainstorming about the whys and hows, you can design a system that is both fair and objective. Firm leaders obtain this input in a variety of ways, including anonymous surveys, departmental meetings, focus groups, and one-on-one conversations.

6. Avoid side or one-off agreements. When recognizing and rewarding superior performance, do not have special agreements; they create different classes of citizens in your firm. Every employee within a specific role should have the same bonus opportunity or potential. Superstars should work well under a good system because they generally receive annual bonus payments far above the average performer. Remember, however, that one great year does not make a superstar. Over time, a real superstar’s base compensation should increase substantially over that of the average performer’s.

7. What behavior does the organization want to reward? Owners and employees should be rewarded for doing the right things right. There are two outcomes of an individual’s behavior: his or her performance—what he or she achieves or fails to achieve—and how he or she does it (which is reflective of firm culture).

8. Identify measures, define targets, and track performance. Measures need to be identified (for example, a measure could be new business development). A target for an owner could be 3–5 new clients with total revenue from $50,000 to $75,000. Then, achievement toward the target is tracked and reported monthly.

9. What is the role of performance appraisal in the organization? How important is performance appraisal and why? Who will conduct the appraisal? If you have an entitlement system, you don’t need much of a performance appraisal system. However, if you are planning to pay for performance, then you will need an effective performance system in place.

10. How will compensation decisions be made? Who will be involved in these decisions: team members, department heads, team leaders, compensation committee, executive committee, or managing owner? What decision guidelines will need to be developed? What will be shared with employees?

11. How does the firm use benefits to maximize the effectiveness of the compensation plan? We saw in chapter 6, “Why You Need to Reward Different People Differently,” that firm benefits mean different things to people at different stages of their careers. What is the desired mix between benefits and compensation? Can the firm maximize some low-cost or no-cost benefits to its advantage?

12. How and when will the new compensation plan be rolled out? Many firms will take at least one or two years before moving completely into the new compensation design. Firms will run the old plan and new plan side by side for the first year, or they may agree to make adjustments at the end of the year for unknown elements or events that happen during the year.

13. What is the firm’s communication policy? How is the organization going to communicate the compensation plan to owners and employees once it has been developed? Is the organization prepared to evaluate the effectiveness of any such communication? If so, how? Implementing a new or revised compensation plan requires constant and detailed communication with existing employees and during orientation sessions for new employees. Ensure you allocate sufficient time to involve everyone in the design of the program, explain the program, answer questions about the program, and allow individuals to see how they would have been affected by it had your firm been on this plan last year.

14. How will the organization manage change to the compensation plan once it has been developed? Once a good system is in place, you won’t want to make major changes to it but rather incremental changes. What systems need to be in place to implement any changes, including deciding when change is necessary and who will make these decisions?

15. Budget for bonuses. Nothing is as disappointing as working hard to achieve goals, meeting the goals, and receiving absolutely no bonus for your efforts. On the flip side, it is difficult for the firm to distribute significant bonus dollars when it has not reached its desired profitability goals. Therefore, we suggest a modest budget to ensure deserving individuals receive bonuses but that deserving individuals receive significant bonuses only to the degree the firm reaches its goals. If all owners and staff in a firm achieve their goals, the financial results should be there, and paying bonuses will not be a problem.

Take time to consider the preceding questions and how you would answer them. If you do this and the other things we suggest in this book, you will develop a better compensation plan. The ultimate goal is to create a compensation plan that supports your firm’s strategy and goals and gets you the behavior you want in terms of performance and culture.

Six Major Obstacles and How to Avoid Them

Before we end this chapter, we want to share the major obstacles we have encountered in our consulting engagements, with the hope you may avoid the same mistakes in developing your plan:

1. Plans are not well-understood. As basic as this may seem, our work with firms has shown that owners and employees do not really understand how their compensation plan works. In one case, we asked the owners of a midsized firm (17 partners) to describe to us their understanding of the compensation plan. The responses ranged from “I’m not sure how it really works,” to a fairly detailed description of the plan. Some owners simply said they did not have the time to understand how the plan worked, others said they received conflicting information, and others said they were happy with their pay and did not care.

   For owners and employees, it is necessary they understand the workings of the plan. Avoid this obstacle by having an annual owners’ meeting to go over the plan and any changes that may have been made or will be made for the coming year. The firm should hold a similar meeting for employees but segmented by position level.

2. Goals are not set or are unrealistic. From our experience, firms that have good compensation systems also have a good performance management and goal-setting processes. Firms often talk about owner goal setting but often fall short in actually doing it. We admit that it takes time to do it right, but without having this foundational building block in place, we find it hard to see how a firm can create a good plan.

   Avoid this obstacle by employing a written goal-setting form and agreement between the owner and firm. We like to borrow Dr. Stephen R. Covey’s terminology and call it a win-win agreement because it is a win for the firm, as well as the owner. A win-win agreement outlines measurable desired outcomes over the next evaluation period, the standards to be followed, resources available to the employee, and how he or she will be rewarded if the agreement is achieved. Doing this keeps the owner from developing unrealistic goals or setting himself or herself up for failure because the agreement has to be agreed upon by the firm and owner.

3. Plans are not aligned with business strategy. As we mentioned several times in early chapters, owner and employee plans need to be tied back to the firm’s strategy. If the firm wants owner A or employee B to accomplish something during the year, the owner or employee needs to see its relevance to the firm’s goals. If that can’t be traced, then the goal may not be worth pursuing. Avoid this obstacle by clarifying vision, defining strategy, and setting measurable objectives at the firm, department, and individual levels.

4. Results are not measured and communicated. Sometimes, a firm will select certain objectives or measures that cannot be tracked. Every goal or objective on the win-win agreement must be measurable, tracked, and ultimately communicated to the individual. Avoid this obstacle by consistently using a template for your win-win agreements.

5. Appraisals are not provided. We mentioned in the second obstacle that one of the major issues is that goals are not set. However, we also find that even when firms do set goals for owners, there are often no appraisals during the year. To avoid this obstacle, you can’t wait until the end of the year to provide feedback to your owners and employees. At a minimum, you need to provide feedback every six months. Chapter 11, “How to Manage Performance Effectively,” provides a detailed process for conducting an effective performance feedback session.

6. Management override. One of the most disheartening events is for management to override the system. This does not mean there should not be some subjectivity built into your plan, but management needs to ensure that underperformers are not rewarded the same as performers based on evaluator subjectivity or lack of courage. Everyone should be rewarded based on their results against their goals, not on personality or other issues. Avoid this obstacle by creating an oversight committee or assigning the HR owner or leader to ensure all appraisals and compensation decisions are based on objective measures rather than subjective measures.

A good compensation system will provide people with a solid base compensation and give each team member a chance to earn a higher income based on individual and team performance. It may offer an exemplary performance reward for outside-the-box ideas and results. It provides for a stable business and secure employment. In the end, it provides the firm with a competitive advantage because you are focusing on strategic initiatives, and it significantly increases the chances that your firm will execute better than competitors.

Final Thoughts

We trust you’ve learned some easy steps for developing your own compensation plans and overcoming some of the obstacles you’re sure to face. In the next chapter, we share with you the key elements or components of an effective compensation plan.