The business debate: What makes a good bonus?

On Friday, Nigel Watson mounted a defence of the bonus, asking how what was historically an acknowledgment of outstanding achievement could suddenly become a hot topic. Now, here are his suggestions for approaching bonuses the right way.

The key to a good bonus is, as with everything, proper planning and simplicity. I generally recommend a five pronged approach to bonus design:

• Why do you want to offer a bonus?
• Who do you want to benefit?
• What behaviours are you trying to reward?
• What performance are you trying to measure?
• What targets need to be achieved? and
• Why do you want to offer a bonus?

Being clear about why you want to provide a bonus opportunity is crucial. What do you want to achieve for the organisation and for your employees? A cash bonus can function well as a motivator provided that:

• There is a clear link between the contribution of the individual and his or her reward;
• The bonus is worth having; and
• There is a reasonable chance of obtaining it at the required level of performance.

Who do you want to benefit?

People often believe that bonuses are only for very senior management as they make the greatest impact on results and should be rewarded for their efforts. That’s, quite simply, not true. Bonuses are appropriate at all levels.

What behaviours are you trying to reward?

There is a bonus to suit every occasion. Do you want to promote company success? In that case some sort of profit sharing plan may be best. Keen to make a top-level recruit? Signing-on bonuses would establish invaluable goodwill at the outset, perhaps as a result of buying-out old benefits from the previous employer.

What performance are you trying to measure?

Bonus schemes can be based on a single performance measure or a range of measures. Single factor bonuses allow particular emphasis to be placed on a key target or business objective.

This may be of ongoing importance, such as profits or productivity or, of particular relevance to the oil and gas sector, health and safety.

It is more likely that two or three measures will achieve the optimum solution, possibly even blended into a balanced scorecard approach, with profit being the most prevalent measure. Most companies will use a measure of profit that is most visible in their organisation. Common examples include: EPS, PBT, EBIT and EBITDA.

What targets need to be achieved?

Often, too little importance is attached to the target-setting process. This is a mistake. However well designed the bonus plan is, its effectiveness will always be undermined by a business which proves unreliable or unrealistic in its target-setting.

If the target numbers lack credibility and stray beyond the stretching but achievable, into the unimaginable, plan participants will likely disengage and the incentive value of the bonus will be diminished.

Legal considerations

A question that companies often ask me in relation to their bonus arrangements is, “Should we formalise them by adopting a legal set of bonus plan rules?”

Invariably, their existing bonus arrangements operate along loose policy lines or have as their constitution generic documentation such as an explanatory booklet. My answer is normally, yes you should. Legally, even bonus arrangements that on the face of it are supposed to be discretionary are, in reality, contractual.

The legal considerations surrounding bonuses are about balancing certainty with flexibility, which is essentially a trade-off between contractual and discretionary bonuses. For example, having a set of plan rules is beneficial to employees since it is then clear what the “red lines” are and what the decision-making process should be. A purely discretionary bonus arrangement (whether in relation to an individual’s good/bad leaver status or the bonus value) can have significant (and ultimately costly) legal implications, if the decision-making process and/or outcomes are inconsistent, irrational or perverse.

What does the future hold?

Clawback is becoming ubiquitous in large, quoted companies and I believe that over time most large organisations will adopt it. Clawback is a method to recoup variable remuneration such as cash bonuses.

It’s essentially a performance adjustment technique that allows companies to claw back variable pay as a result of later events calling into question the basis on which the original variable pay was earned.

A good example would be the recent Libor manipulation. It would be astonishing if the banks involved were not considering pursuing employees and former employees for repayment of past bonuses.

Clawback generally falls into two categories. Hard clawback, where the employee has to repay variable pay that has been taxed, and soft clawback (sometimes referred to as malus, being the Latin for “bad”), where negative adjustments can be made to variable pay that has not yet vested and so has not yet been taxed.

A corollary of clawback that I think will become more prevalent is the “downside target”. These will ensure that underperformance is recognised resulting in the scaling back of bonuses. If, for example, over the short to medium-term, there is a one-third drop in profits or a certain level of gearing is breached, this would result in a proportion of the bonus (both earned and unearned) being lost.

This is different from current practice where performance targets are normally framed in the positive and from clawback, which is normally triggered by serious misconduct or the misstatement of accounts.

If you think that this all sounds unworkable and likely to undermine the incentive value of the bonus arrangement, then I am sorry to disappoint. In the age of austerity such measures are likely to become the new normal. But who said the old normal was workable and fair in the first place?

If X happens you will receive Y, used to be the model. In the future, if Z then happens, you will lose Y. Provided Z is clearly spelt out (and it will have to be otherwise companies will find themselves in legal hot water) bonus arrangements will become more transparent and I believe ultimately fairer. The quid pro quo however is likely to be smaller bonuses.

Nigel Watson is a partner at the law firm Brodies LLP. He specialises in employee benefits, executive reward and remuneration.

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