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Pay, Performance and Prosperity: The Virtuous Cycle November 16, 2007 Brian Dunn CEO, Global Compensation

Pay, Performance and Prosperity: The Virtuous Cycle

November 16, 2007

Brian Dunn CEO, Global Compensation Aon Consulting

Copyright 2007 – Aon Corporation

Brief Description: Properly constructed, compensation is nothing more than a way of dividing income between employees and the shareholders in a way that maximizes the return to both. However, it rarely works this efficiently, largely because managers have tried to reduce this complicated set of decisions to a formula or a standardized process. Unfortunately, for many companies, compensation has become a process that has less to do with maximizing income and more to do with ensuring equity, consistency and/or efficiency. In this article, Brian Dunn, CEO of Aon Consulting’s Global Compensation practice, outlines the ten common elements of successful pay systems.

The Virtuous Cycle

Brian Dunn, CEO of Aon Consulting’s Global Compensation practice, has been studying compensation plans for 25 years. In his study of thousands of companies’ pay philosophies and practices, he has found to ten common elements in the most successful plans.

Properly constructed, compensation is nothing more than a way of dividing income between employees and the shareholders in a way that maximizes the return to both. However, it rarely works this efficiently, largely because managers have tried to reduce this complicated set of decisions to a formula or a standardized process. Unfortunately, for many companies, compensation has become a process that has less to do with maximizing income and more to do with ensuring equity, consistency and/or efficiency.

I have found that the most pay practices have features in common:

They are small and independent (or act small and independent)

They emphasize results over process

They not only tolerate, but encourage, wide dispersions from the mean

Compensation is treated as an investment to be managed, not an expense to be controlled

Pay is disproportionately allocated to those that manage and please the customers over those that play a support role

Senior management does not delegate decisions to a system, subordinates or HR, and

The connection between pay and results is obvious to everyone.

Where does that leave a large multidimensional global enterprise where everyone has grown up and become comfortable with a job evaluation system to determine salaries, target bonuses to govern incentives and long-term grants derived by formula? It leaves us with lots of work to do. I am not naive enough to believe that we can abandon years of practice and rules to the perceived anarchy of totally discretionary pay. But, we can start with a fundamental mind shift; that pay is the single most important management tool to communicate priorities and drive performance consistent with those objectives.

Where Do We Start?

There are a number of steps an organization can take to begin the process of recapturing the power of compensation to drive the business forward.

1. Investigate how compensation is currently allocated across the organization. For example, you can divide the population into categories such as management, sales, customer service, production/manufacturing, operations, technology, finance and other support. This will provide a very interesting perspective on the priorities of the business. If the strategy is to be a customer-focused, technology-driven company and you spend two-thirds of your compensation dollars on management, production, operations and finance you have learned a very valuable lesson in how your customers perceive you. Most compensation consulting firms are very helpful at telling you if you are paying at “market” for a given position, but offer little in the way of insight into the total spend for a function and how your percentage spend by function matches up with your competitors. In order to provide this level of insight, your consultants must collect total compensation spend for you and your competitors. With this aggregate spend you can then benchmark your relative priorities and understand how you are making the tradeoff between having fewer highly compensated staff versus relatively more lower paid employees. Recently, we met with a client who had consciously employed a strategy of having more employees but paying them “below market.” Our analysis contradicted the results of a traditional compensation study that showed they were “below market” and needed to increase pay. We found, in fact, that their total spend for delivering their product to market was actually equal to or higher than their competitors. If they had followed the conclusions of their compensation survey and increased per capita pay, they would have found themselves at a real competitive disadvantage.

2. Understand your pay mix. Just as you can look at how you allocate your compensation dollars across functional areas, you can examine how much of your compensation is delivered through fixed vehicles (e.g., salary and benefits) and how much is delivered in variable forms (e.g., long and short-term incentives). This analysis will speak volumes about your ability to change behavior through the management of incentives. This is particularly true as you get down to a second degree of granularity and understand by level and role how much of the total compensation expense really drives behavior. For example, if more than 50 percent of the compensation for sales people is fixed, you are not maximizing the incentive impact.

3. Make yourself small; fund locally. Large companies have some inherent challenges in demonstrating the link between individual contributions and rewards because there is so much noise in the system. As a result they are less likely to provide the upside opportunity that small companies do and run the risk of losing their truly exceptional performers to those companies that can and do make such differentiations. This is compounded by the fact that large companies have an insatiable desire to add complexity and bureaucracy to the decision making process, making it more difficult to achieve the same level of performance. To overcome these challenges, large companies must think and act small. The distance between the individual and the measurer/evaluator of performance must be shortened and the link between results and pay must be firmly established. A very simple matrix relating incentive funding to a percent of profits establishes that direct connection. The ability to tell employees “if we make more money; you make more money” is a very powerful motivator. I have heard the argument that such

plans will make employees too parochial. My response is that parochial thinking which results in expense control, extra effort, innovative thinking and a growth orientation is not a bad thing. The downside, of course, is a reluctance to invest, a limited interest in broad company-wide initiatives and a “what’s in it for me” attitude. These are real dangers, but ones that I believe can be addressed through active management and the application of a discretionary allocation of the funded bonus pool.

4. Eliminate the merit increase process. Why do we retain the notion that every employee should be considered for a salary increase every year, when it makes no practical business sense? What should drive the decision to change an individual’s fixed level of pay is one of two things—a significant shift in the market rates of pay and/or a material increase in the level of contribution that an employee is making. Rather than an annual merit cycle that supposedly includes the previously mentioned factors plus some recognition of performance, I would suggest that we separate the pay delivery into two distinct pieces: a bonus to recognize the “merit” or performance component, and a periodic salary increase to recognize real changes in job responsibility and/or market rates of pay. These latter factors clearly do not take place every year for each employee. By recapturing these surplus merit expenditures, a company can provide significantly more money to fund the incentive pool. Properly applied, greater incentives will drive superior results providing more money for incentives and so on. It is truly a virtuous cycle.

5. Manage by ratio. As an owner of a company (or better said a portfolio of companies), I would be pleased to share a percentage of the profits with my employees. In that way, I would be assured of a profit before anyone was paid incentives and I would have a common interest with my employees—grow profits and compensation will grow as well. The contract is simple and linear. By extension, I should be equally happy to make that same arrangement with business units of a single company. To make this work, however, requires being truly able to determine profits and to arrive at the appropriate sharing rate. While determining profits is “just accounting” (a gross simplification), coming up with the sharing rate is more of an art. After years of observation and semi-scientific study, we have determined that the two biggest factors that drive the relationship between profits and incentive pay are: (1) The amount of assets deployed by the company to generate income (i.e. the greater the assets the lower the sharing rate) and (2) the degree of individual versus institutional prominence in the creation and generation of new business (i.e. the higher the individual prominence the higher the sharing rate). These rates are observable within industry segments because of the efficiency of the labor markets. Another ratio that is easily determined is total compensation and benefits as a percent of revenue. Every public company must report this information and while it is not a good mechanism for funding bonuses, it will tell you if your spending patterns are roughly in line with your competitors.

6. Encourage employees to “buy” equity. We have all heard the truism that people have a greater interest in something they own as opposed to something they are given. Another truism is that everyone loves a bargain. Putting together these two factors have the makings of a very powerful compensation device. It works like this; all senior employees (e.g. those earning a bonus greater than

$100,000) are required to take a portion of their bonus in stock (e.g. 25 percent). Because they are deferring their own compensation, they are effectively purchasing the stock at a discount (e.g. 20 percent). In this way senior employees are transformed into vested owners of the company. Because such programs typically have a three-year pro-rata vest on the deferral and a three-year cliff vest on the discount they have the added benefit of providing a degree of “golden handcuffs”. It has been our observation that employees that purchase their stock assign it a higher value than those that are “granted” stock. This again contributes to the virtuous cycle where employees with an ownership stake act in a way to enhance corporate value which in turn raises the value of their stock, which in turns makes them more invested in the company and so on.

7. Celebrate not eliminate the outliers. Many of the analyses conducted by managers, consultants and HR professionals are centered on determining which employees fall outside the “norm” of their pay grade, grant guidelines, target awards, competitive benchmarks, etc. This indicates a desire to regress to the mean. In other words, we seem adamant on pulling everyone back to the norm instead of truly differentiating those that are exceptional on both sides of the curve. In life there are those that truly excel. In sports, music and sales we are quite comfortable with the “winner take all” phenomenon. So why in business do we do our very best to create all kinds of systems and policies to ensure that we overpay our under-performers and underpay our superstars? The most common answers I get when I ask this question are “we don’t have an effective performance appraisal system to identify who our best performers are” and “if we truly differentiate these people, our important but unexceptional standard performers will get mad and leave.” For me, neither of these excuses holds water. First of all, any manager who can’t tell you who the best performers are isn’t close enough to the business and should be relieved of his/her management responsibilities. Secondly, if you fear that your rank and file will leave because you pay the best performers more than the average performers, you are not facing reality. It means that you probably aren’t being honest about who is performing well and who isn’t. Thirdly, you are assuming a lack of intelligence on behalf of your competitors by believing they would pay your average performers more than you are and that there is an infinite market for this kind of thinking. Finally, you have distorted your priorities in such a way that you are more worried that you will lose your average performers because you recognize the superior performers rather than worrying about your stars leaving, because your smart competitors will pay them what they are worth.

8. View compensation as an investment and require an ROI (1 and 3 years). Many managers view compensation as an expense to be managed rather than an investment to be maximized. When I am buying a new machine to produce widgets, I make a determination of whether or not I will get a return greater than my investment over the duration of my investment. Why not do the same thing with people? We should be happy to add staff or to increase individual compensation as long as that investment in compensation dollars will add to our net return. Instead we have controls and policies in our organizations that prevent us from increasing pay to existing and contributing employees, but allow us to hire new employees at a higher rate. Why is that? It is because we like controls and we have different controls for merit budgets than we do for replacement hires. Therefore, we must liberate managers from the shackles of personnel policies and

make them accountable for their compensation investments. This is easily done, by reverting back to our previous discussion about sharing rates. Make a manager aware that every dollar of expense he adds will be an offset against the incentive pool if it does not increase profits. More often than not you will have to encourage them to invest in people rather than over managing how they allocate their compensation dollars. Using the investment mind-set allows companies to make rational, not programmatic, decisions about pay.

9. Force management to get involved—cascading pools with a feedback loop. Pay is the single most important tool management has to communicate what they believe is important and to direct employee behavior. This cannot be delegated to policies, staff or junior management. Managers MUST take an active role in setting pay levels and in determining incentive bonus levels. It may be a tedious and contentious process, but it is critical to the success of the enterprise. As discussed earlier, a pre-established funding rate at the lowest level where profits can be reasonably determined is an excellent starting point toward determining the magnitude of the incentive awards. This should then be proportionately distributed to the sub-units on the basis of their needs and results—not all of which can be measured financially. An iterative process should then take place when bottoms up needs are reconciled with a top down availability of funds. At the margin, negotiations will be pursued. This active back and forth cannot be shortcut or shortchanged. Senior management must be active participants and must stick to it until it is finished and must be open to input. Middle management must be active advocates and serve the interests of their business by balancing the needs of their employees with an appropriate return to shareholders.

10. Measure, communicate, and pay: they are all connected. Effective compensation management is all about connecting the dots for employees. Management needs to clearly tell employees what they want them to do, reinforce it by monitoring and measuring progress toward those objectives and provide the motivation to move in that direction through recognition and pay. The old adage “if you don’t know where you are going any road will take you there” applies here as well. If we don’t clearly tell employees what we want them to do and how to do it— they won’t know where they are going. If we don’t give them signposts along the way they may become confused or discouraged and turn back. Finally, if we don’t give them the motivation to get there they may fall short of their destination or take too long to get there. If we properly define the goals, measure progress and provide the incentive we have a very good chance of achieving our objectives.

The Virtuous Cycle Does Work

You may say this is all sounds good on paper, but it will never work in reality. Many believe that their organization is too large and complex and employees are not all motivated by the same things. I agree that the devil is in the details, but, don’t believe for a second that it can’t be done. There are literally thousands of entities—both freestanding companies and discrete business units—that put these tenets into practice every day. It is easier if the entity is small and single purpose, but that doesn’t

mean it isn’t possible in large and more complex organizations. It simply means that the organization has to be creative at making things small and actively manage the friction points across different parts of the organization. The virtuous cycle does exist. Better performing organizations attract better people who in turn perform better, driving higher profits allowing for greater compensation spend to attract and motivate even better people. To break into this cycle, you must start somewhere along the curve. You must also simplify the environment by shortening the distance between the individual and the result. Let them know what to do, how they are doing and clearly define the connection between performance and pay.

It does work.