Limiting Payouts Under an Annual Incentive Plan—Why Some Companies Use Payout Caps

I have likely designed well over 100 annual incentive plans for sales forces, operating and staff managers and executives over the last 30 years. Many of these plans are goal-based in design and are generally built to reward the participant for meeting and exceeding management’s expectations (i.e.: their goals).

Goal-based incentive plans are often designed to pay increasing amounts of incentives for increasing performance. In most cases, the participant is paid for partial progress between stated levels of performance (e.g.: threshold, meets expectations, greatly exceeds expectations, WOW…). A typical payout vs. (say sales) performance function looks a bit like the chart shown below.

 

Limiting Payouts Under an Annual Incentive Plan—Why Some Companies Use Payout Caps

 

As you can see in the above chart, a $20,000 incentive is earned beginning at a performance level of $1,000,000 (at threshold)—nothing is earned below that level. At the expected or goal level of performance ($1,600,000 in the example) a $40,000 of incentive is earned. And at a level well above goal (or $2,200,000 in this example or 150% of expected performance), a $60,000 incentive is earned. $60,000 may be the top level of incentive to be earned by a participant in the plan, or not.

There are dozens of ways to design such a plan, but my chart describes a very common structure and practice. The payout vs. performance relationship is commonly called an “incentive table.” But, what happens when performance exceeds $2,200,000? Is it “capped” at $60,000 in annual incentive? Would that be de-motivating to the participant?

When such questions regarding incentive payouts and limits are asked (and they often are), the answer is not always a clear yes or no. In truth, it depends. So let’s spend a few minutes talking about why we have found that some companies have chosen to limit annual incentive payouts at the top of the table.

Generally, there are three primary causes:

  1. The company has difficulty in setting reliable performance expectations (goals) based on history, experience or information available at the time.
  2. The company regularly experiences “lumpy” demand for its products.
  3. The plan participant has limited impact on the end results for which they are being paid.

The three points stated above also represent reasons why (and situations where) goal-based incentive plans do not work. Let’s briefly discuss each of the above in turn.

  • Difficulty in setting reliable performance expectations or goals—This may mean that the company has been historically unable to set performance goals whose outcomes cannot be predicted with some reasonable probability of success. For example, a company may not have a transparent portal into its sales process and customer base. Consequently, its sales results may fluctuate unpredictably up or down from year to year and only the sales force seems to know why—not the company. Or, the participant may have historically been allowed to understate what they and their account base is capable of producing in any given year to assure that goals will be comfortably met and consequently incentive payouts will always be well over target payouts.  In either case, it is quite likely that there will be all-too-frequent cases where the achieved performance levels cause earned payouts at or over the top of the incentive plan “table.”

    In a well-designed goal-based incentive plan, maximum payout levels should be only be earned 5-10% of the time (yes, once every 10 years or more). But, I have seen cases where the reverse is true. As a result, companies that do not have confidence in these probabilities of achievement will often impose incentive limits to avoid payouts that are strictly an artifact of bad or unreliable goal setting.

  • Irregular “lumpy’ demand is experienced—I once had a client who sold specialized printing supplies to 10,000 or so small art and print shops. It was a very predictable demand environment where the typical supply buyer purchased $2-5,000 in supplies annually. The supply orders were relatively small, ordering was frequent and the underlying business demand was very transparent—to anyone that looked. It was a great new-customer environment where new accounts (and price increases) made for predictable increased supplies revenue.

    The territory sales reps were paid an annual incentive based upon achievement of revenue versus annual goal and could potentially earn two times target annual incentive for achievement of up to 120% of goal—not an unusual performance/incentive range in a highly predictable demand environment.

    But there was a wild card. The sales force also sold capital equipment in the form of printing presses and drying/curing units to their customer base. The average purchase could be anywhere from $10,000 to $50,000 per unit. So the presses represented a very large “lump” in the routine revenue plan. It did not take too much more than a couple of printing presses to drive a sales territory well over its goal for the year, and often off of the incentive table. The sales force also claimed (with some support) that it was quite difficult to predict press orders—”they are only replaced when they break down.” Plus, the profit margins on the presses and equipment were much lower than those of the mix of supplies. When presses entered the calculation of incentives, this client chose not to pay more than the maximum plan incentive at 120% of sales goal.

  • The impact of the participant on the end results is limited—It is not uncommon to see annual incentives paid for group or collective results, or for results not directly within the control of the plan participant. An example of this is having an annual goal-based incentive for company managers and employees based upon enterprise or business-unit profit contribution. This is often done to provide a collective focus on (or responsibility for) the key measurement of enterprise success. But, no single mid-level manager or employee is likely driving company profit one way or the other. Clients will often limit incentives earned under these type plans. Why? –because it is felt that the participant is benefiting from and not driving performance. However when performance is truly exceptional, the CEO or Board will often step up and elect to pay more than the plan’s posted limit. And as employee gestures go, that is generally a pretty good one.

Are these good reasons to limit or cap incentive payouts? Is there ever a good reason? Some CEOs and Boards think not. What do you think?

When looking at incentive plans and payout potential, use this simple rule of thumb to consider whether you should consider caps: If you, the CEO or Board believe that you will ever be put in a situation where there is a perception that an incentive paid (or to-be-paid) is not an incentive earned, be assured that such feelings and discussions will surely become broadly known and that will be very damaging to individual relationships and company culture. The last thing you want to do is have your incentive plan and practices create such conflict. If you think this can happen, it is time to rethink the design and pay-out limits of your incentive plan. 

Questions: Has your organization ever chosen to limit incentive payouts? Why have you chosen to do so? If for different reasons than mentioned above, please tell us and we will pass it along to our readers.

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