The merits of incentives plans, variable pay plans and bonuses have become unquestionable. However, organizations need to be aware of the pitfalls to incentivizing performance this way

If there was one lesson to be learnt from the global financial crisis, it was the negative effects of poorly designed pay plans. While much has been written about the financial crisis itself, more can be said about the bonus plans which caused the meltdown. Unfortunately, the unquestioned merits of incentive plans, variable pay plans and bonuses have become a part of management wisdom. There may, however, be many pitfalls to incentivizing performance this way.
First we should consider the history of incentive plans - they began in the industrial era and were a primary source of improving productivity on the shop floor. They consisted of simple mechanisms of linking pay to production volume. The problem started when organizations starting applying the concept to the more complex phenomenon of managerial work. Application of such concepts itself was not an issue, it was the over-reliance which caused the problem.

Leadership, values and character can’t be substituted by pay plans.
The key difference between the shop floor and management is the scale and complexity of subjective judgment. Managements across the world are trying to reduce this to a few simple metrics which can then be used as a foundation of pay plans. In my view, this approach is unlikely to work. Doing the right thing for your business in an ever-changing environment requires insights, courage and values. A fixed set of rules stemming from a variable pay plan can get in the way of doing the right thing. There can be many occasions when maximizing individual payouts will not align with maximizing organization performance and sustainability. The only thing that then stands in the way of shorted-sighted behavior is quality of leadership and strength of character. Over-reliance on incentive plans makes it increasingly difficult to bring these factors into play.

Poorly designed plans can threaten the social fabric of the organization
In many organizations individual performance is celebrated and highlighted but this is not necessarily a bad thing. However, when individually-driven incentive plans are added to such a culture, it can become an explosive mix. System theory tells us that maximizing parts of the business may not lead to maximizing of the whole. Nowhere is this more evident than in an organization. When we focus on incentivizing parts of the organization as if they were standalone entities we create a dysfunctional relationship between individuals, teams and departments. Some conflict is always healthy, but when taken to an extreme it starts tearing the organization apart. Incentive plans which over-incentivize performance of some parts of the organization or choose a measurement system which exclusively focuses on local performance, run the risk of not just delivering poor performance, but also creating a dysfunctional culture which can take a long time to repair.

What is good for an organization may not be good for an economy
Over-reliance on incentive plans can also impact a nation’s economy. Studies have shown that when incentive plans become a large component of the overall compensation for a large component of the workforce, it can induce economic volatility. The logical explanation is easy to follow. In good times, higher payouts drive increased disposable income which leads to higher consumption. This pushes the business cycle to greater highs; however, in times of economic weakness, the exact opposite occurs. Depressed payouts, leads to shrinking consumption, which in turn leads to a downward economic spiral.

What should be done?
There are several actions that leaders in organizations need to think about.
Firstly, establish a reasonable mix of compensation. Ensure that your incentive plan as a proportion of your total compensation has not grown out of control. It is indeed tempting to move towards variable pay because it brings about better cost control. While this is an attractive concept, the risk it poses to your quality and character of leadership, collaboration and sustainable performance must be considered.
Secondly, choose your performance measures well. Choice of measurements can cause distortions in two ways. The first is time horizons, when organizations focus primarily on short-term measures; they tend to put the long-term at risk. Choosing lead indicators and deferred pay plans are possible solutions to the problem. The second is the types of performance measures, when organizations focus primarily on financial measures, they put critical dimensions like customers, operations and staff at risk. Organizations need to focus on creating a multi-faceted balanced measurement system which addresses all stakeholders.
Thirdly, create some form of group incentive. Encouraging collaboration in a complex organization is not just important, it is critical. Ensure that your plans have a significant component based on group performance. It is best to weave this into the plan at multiple levels. Leadership could consider doing this at a team, department or organizational level. Parts of the organization where inter-dependencies are especially important should be given particular attention.
When used with the right degree of emphasis and the right design, incentive plans can become a key driver of growth. However, if left unchecked, they have the potential of taking on a life of their own. They can cause damage, which can go beyond an organization and impact an entire economy.
Incentive plans are an issue that should be discussed in boardrooms and should be a priority area of research for the academic community. Thankfully, the types of dangerous pay plans we saw on Wall Street are still limited to the financial industry. One shudders to think what the consequences would be if similar thinking on incentive plans was applied to the wider economy.

Gopal Nagpal, Principal - Mercer Human Capital