Is setting annual incentive goals each year a requirement?

Is setting annual incentive goals each year a requirement?

As long-time readers probably know, I am a strong believer that an employee, manager or executive should have annual performance metrics and objectives, and these should be measured against annual expectations or goals for each defined performance metric. Our rationale for such goals is that if you do not employ such performance metrics and expectations you cannot tell if you are winning or losing. And, winning is the name of the game in a successful company.

We often advise clients to link their annual incentive or bonus plans (or portions thereof) to achievement of an employee’s annual goals. Hence, the company will pay the employee, manager or executive based on performance. (Now, that also has a familiar ring.)

In such a reward environment, it is generally a requirement to set (and reset) annual goals and expectations each year—across the organization. However, it is also possible that employee expectations can be stated on a multi-year basis and results can be measured on a longer-than-annual cycle. However in truth, you will usually “settle up” on an annual basis for purposes of bonus payouts.

We like goal-based annual plans because of their clear communication value regarding pay and quantifiable performance. The linkage is clear. But with that clarity comes increasing complexity in the form of goal setting, payout tables, calculations, reporting, communications and measurement. This clearly takes management’s time and attention and is one of the main reasons we often see push back from senior executives regarding the use of annual goal-based incentive plans. And, recall that simplicity is one of the top design criteria to achieve in the design of any effective incentive plan. During the last few months we have been involved with the evaluation and design of a different type of annual-incentive plan that is simple in nature and may not (always) require the use of explicit annual incentive goals. Let’s talk about it.

The annual incentive design we refer to is the creation and sharing of a cash bonus pool that is allocated among managers or key executives. In our experience, these pools are mostly created as a percent of enterprise or unit profit—however defined. These types of annual-pay arrangements (pool-participation plans) are most often reserved for executives or very senior managers—including the top operating executive.  But, they can work at lower organizational levels, if properly designed.

They generally work something like this—

  • A pool of cash is created at the end of the year based upon pre-determined levels of (say) pre-tax profit. The pool is then created as some agreed-to percent of the annual pre-tax profit. (e.g.: 10% of $2 Million) There is sometimes also a threshold of performance below which the pool is not funded, and incentives are not paid.
  • The pool is then allocated among a select group of executives or managers based upon rank, responsibility or performance. “Pecking order” is too strong a term to describe it, but it can work that way. For example, the Vice President of Marketing may get 10% of the pool, and other executives or managers will get more or less determined a priori.

OK, so what are the differences between this and an annual goal-based plan? The main difference is that you might not have to set or reset your goals each year. For example, you could decide that a profit pool be set up for multi-year period (say 3 years) with same percent(s) of profit, same thresholds (if any), same metrics, same executive allocations; each year. Technically you do not have to reset your annual incentive goals in that circumstance.

In fact, what you have just done is set a “goal” that will last for (say) 3 years and made an agreement with the owners (or management) regarding how much they are willing to share with the executive team for that same multi-year period—at various levels of performance. While you have actually set a goal, you are just not changing it every year. Of course if the deal is to just pay the participants their share of a set percent of all profit, the only goal or expectation established is that the company makes money.

Is a goal-based plan or a profit-participation plan better? That is like asking whether you like a blue or red car better. It really depends on the application and circumstance.

The profit-participation plan is generally much simpler to understand and explain. Further, it clearly links the interests of the management team with the owners—simply more profit equals more pay.  On the downside, you should certainly expect more from an executive than what is described in a single collective metric like pre-tax profit. We believe profit-participation plans are best applied when combined with other annual incentives and where goals, thresholds and rates reflect ownership expectations on an annual, or generally timely, basis.

So must you set annual incentive goals every year? No, it is not necessary. But, if you do not, we believe that you are leaving important tools from the manager’s toolbox lying on the table.

Share this!