At some point in our working lives (especially in the early years), most of us have believed that all performance-oriented problems can be fixed by an appropriately designed incentive plan. I’m sure some of these statements must seem familiar. “We need to incentivise the right behaviour traits.” “Our incentive plan is not driving the right behaviour.” “Our sales staff doesn’t believe this incentive plan can help us meet next year’s stiff targets.” “Our delivery folks need to be incentivised for driving account growth.” Yet, there has been a lot of debate on what incentive plans accomplish. For one, do they really motivate? And, if so, what is the causal linkage? Most importantly, do incentive plans really help to retain talent in a competitive market? Or, is the purpose more limited—basically, to align managerial remuneration with company performance (even if there is a limited causal relationship between managerial remuneration and company performance).

Well, there are no easy answers, if the many debates across several companies I’ve consulted with are any indication. Certainly, no one answer fits all. The core of the problem stems from the fact that most managers don’t understand that incentives merely reward certain outcomes. They don’t directly drive outcome. This might sound like a syntax issue to you, but it is a very fundamental difference. So, while it is important to reward the right outcome through incentives, doing so works only if you have the right person in the job and there is an ecosystem that supports the achievement of desired outcomes. If you have the wrong person in the job and the ecosystem doesn’t exist, all incentives are irrelevant. A manager’s main job is to ensure that she picks the right person and fosters the right ecosystem. But, this is the more difficult part. Which is why, most managers end up taking the easier route—putting an incentive plan in place that is tied to a predefined outcome, and hoping that it magically happens somehow.

To cut it short, an incentive plan can’t fix any real problems. You can use an appropriate incentive plan to cement and accelerate your momentum only after you have determined what the solution to your real problem is. It’s a common trend to have a greater percentage of variable pay in the pay mix, especially in industries and companies where salaries constitute a significant chunk of the total cost. Having a great variable play helps limit payouts in difficult times and preserve profitability. But, even when the underlying thinking behind a variable pay plan is really about linking costs to profitability, it is positioned as an initiative aimed at incentivising performance. As mentioned above, this is a weak argument as there isn’t a strong causal link between an incentive plan and results. Interestingly though, we’ve found that getting support for an incentive plan is easiest if you argue that it would motivate performance. Another reason for the existence of incentive plans is that rewarding for “results” is generally considered both fair and safe. Take the case of top management bonuses, for example, which are determined by company performance.

The quality of the individual and the rigour of the management processes cannot be substituted by a generous incentive plan. "

To be really fair, though, a company’s performance flows from the interplay of several complex factors. It’s extremely difficult for the board to assess how much the management influenced the performance by doing, or not doing something. How much of the company’s failure, or success, was actually influenced by factors totally outside the management’s control? Since the actions of the board are subject to scrutiny, the safest bet would be to attribute results (whatever they may be) to what the management did or did not do. No board will be blamed for slashing bonuses of top management when a company performs poorly, or will be questioned for paying high bonuses when they’ve performed well. Which is why linking payouts to outcome has for so long been considered a just principle to apply, and emulate.

Another reason for incentive plans to exist is that they’re believed to retain talent, especially for senior managers in midsize firms. Instability and churn at senior management level does not bode well for growth. In these cases, a board may come up with an attractive gain-sharing plan where a percentage of the firm’s valuation on exit is shared with the management team. It can be argued what drives the purpose of such a plan—to motivate the management team to create value, or to keep a good team stable. In most cases, retention is the primary purpose. Yet, a wrong team (or individual) won’t result in the desired outcome, however perfectly designed the incentive plan might be. The quality of the individual and the rigour of the management processes cannot be substituted by a generous incentive plan. High incentives are also used to attract talent when a company can’t afford to pay market compensation. Here, a good incentive plan can attract risk takers, especially if there is a credible chance of creating disproportionate wealth when the firm does well. In such instances, the upside has to be so significant that risk takers can be lured by the possibility of a pot of gold at the end of the journey. There are other examples where incentive plans can work very well.

The important thing to keep in mind is that the outcome should be directly linked to an individual’s efforts. Small and self-sufficient teams, with clearly defined goals that are largely under the control of the team leader, can be motivated by incentive plans. In fact, historically, incentive plans can trace their origins to these situations. But, the power to motivate drops off exponentially when there are complex dependencies, especially from other functions internally. People are willing to accept the vagaries and uncertainties of markets and customer behaviour, and how it impacts their results. They’re somehow less willing to accept linkages with other people’s efforts. For CEOs, it’s not often easy to fight the demand for commission plans, especially from the pre-sales and delivery teams who most crave these schemes. These teams often believe the sales people they support are making tonnes of money in commissions while they are not getting anything, even though they play a role in winning the deals. Such thinking is not surprising since pre-sales and delivery play an important role in any sale.

Still, in my experience, in most cases, this is an unreasonable demand which is based on an incomplete understanding of how commission plans work. Mostly, the entire sales commission plan is designed around a basic belief that you pay for “results”, not “efforts”. Therefore, a sales person could slog for years, do all the right things and still make no money in commissions. Or, could simply end up getting very lucky and make a huge commission without having necessarily been directly responsible for the wins. In other words, the sales person is taking a risk. As a corollary to this, the base pay of a sales person is often low. It could be between 40-60 per cent of their total on-target compensation whereas for the other functions it could be between 80-90 per cent. The sales person therefore depends upon earning reasonable commissions periodically to be able to send her children to a good school. The base pay can just keep the lights on.

Those people in other functions who crave for a commission plan do not want to take this risk. They would be unwilling to compromise on their base pay. They would want the commission plan on top of an attractive and competitive base pay (and their regular variable pay plan). To any logical person, this would sound absurd. At the end, an incentive plan is a great tool when well used in the right situation. But it isn’t a panacea for bad performance, or a forecast of achievement. Often, the reasons incentive plans are used can be tackled by managers conducting better reviews, having difficult conversations, or providing their teams direction and coaching.