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Incentive Compensation: be careful what you wish for& it will come true
Incentive compensation plans are now being used in all walks of banking life. From the internal audit department to various sales forces, incentive compensation is a primary motivational and behavior guidance tool. The problem is not that it doesn’t work, but rather that it often works in unintended ways which do not align team member activities with shareholders’ interests and bottom line results.
For example: one retail incentive compensation program I’ve seen is designed to achieve deposit growth. Bankers and branch managers are paid for quarterly net deposit growth. However, not all deposits are created equal, yet this plan treats them as such. Consequently, over 70% of the deposits generated were CDs. While overall deposits grew, checking accounts and money market balances declined. The result: deposits did grow, as per the plan’s objective, but shareholders and franchise value lost.
In another instance, a commercial lender program rewarded the lenders for loan volume only. They grew loans rapidly, but were not held accountable for documentation errors, rapid loan deterioration, special mention loans, etc. The result: the loans did not hold as well during the most recent recession as previous credits.
Incentive programs are extremely effective in focusing staff’s attention and motivating the right behavior. They also bring the most creative side of people, which means, unfortunately, that some team members will inevitably figure out the easiest, most expedient way to maximize incentives, and often this is not the result originally intended by the program.
The primary goal of incentives is to motivate individuals to change behavior in a way that will create value for your company. It’s also the single most effective tool to communicate your priorities to the team.
Incentives are a social contract between you and your team: if they do this, they will get paid that. Therefore, transparency and simplicity are essential to an incentive compensation success.
Below are several principles that I’ve used over the years, and that are still being used today, that have yielded highly effectgive incentives (in other words, the team performed well against stretch goals that carried incentives with them).
1. Make incentives meaningful. Incentive plans work because they make a difference in the financial life of those who are eligible for them. Calibrate the amounts to the base annual salary of the team member to assure you don’t over- or under-pay. Make the amounts significant; in other words, 5 or 10% total opportunity are unlikely to create sufficient excitement or motivation to meaningfully change the behavior of most of your people. Since you’re paying for performance, there is less downside for larger payments. If the program is structured right, the more you pay, the more your shareholders make and the happier your customers and emoloyees.
2. Make it simple. Some programs are extremely complex, because they attempt to avoid the pitfalls mentioned above, or aim at very specific behaviors. Even if the formulae are clearly spelled out, there is a significant error rate in calculating incentives if the program is complicated. Any time you need to correct mistakes, it diminishes the effectiveness of the program. Remember, simple is better. I have an ambitious rule: one page numbers, one page words make for an excellent incentive program. Put all the rest in an appendix, and the meat upfront.
3. Focus on what really matters. Is it behavior? Is it a specific balance sheet item or product? Is it a controllable desired outcome? Think through in your own mind what you’re trying to achieve first, then build a plan around it. The more factors that enter the plan, the less focus it will provide and the more confusion you’ll experience with the troops who are executing your plan.
4. Don’t change your mind in the middle unless the stakeholders have been told this might happen Plans do not always work as planned; however, they are an important social contract between management and the team. If the team delivers and management is faced with overpayment, one is almost always better off paying and changing the plan at the next plan period. I always included a line in the plan saying “management reserves the right to change the plan monthly”. This way you have the flexibility to make continuous mid-course adjustments and fine-tune the program. Nevertheless, frequent changes create confusion and suboptimize your incentive dollars.
5. Incent for the leading indicators. Often, when final results are managed, they are reached in the wrong ways. The total deposit growth example is an instance where providing incentives for the final result was insufficient to channel the right behavior for the staff. Occasionally behavior is more important than the final result, for instance, as you bring about cultural change; in addition, achieving the right behaviors will get you the results you’re looking for. Therefore, incentivizing results only may be insufficient. For example, including prospecting (number of calls, appointments etc) in a commercial lending program nay not bring bottom line impact today, but it is very likely to do so tomorrow.
6. Put the plan in context for the team. Explain the purpose behind it (we need more loans because deposits are growing faster; we need more relationships with our customers because we have too many single service businesses or households, etc). People are more likely to do the right thing when they know what it is! They will also understand how the plan works better if they have the appropriate context for the various incentive components.
7. Acknowledge mistakes. Incentive plans, much like everything else we do, are subject to continuous improvements. We all make mistakes, and that’s OK unless you bet the bank. Acknowledging that the program didn’t work as anticipated, and connecting the changes you’re making to address the issues, are important steps in the communication process and in building acceptance to plan changes.
8. Don’t change too often. Some people believe that frequent incentive changes are healthy and keep the troops on their toes. I feel it is important to build continuity of purpose and skill sharpening. This is especially true for behavior change and skill building. For example, if prospecting is a stated goal, you will need at least a couple of quarters to get your people executing effectively what you’re looking for. Similarly, if the sale of complex products is a component of your plan, shifting quickly to another product will not give your team sufficient time and opportunity to learn the sales techniques of the product and get real good at selling it. Last, frequent changes imply lack of strategic context and continuity. Your people may wonder if you know your mind and are committed to a specific strategic course. Consistency (but not stagnation) is important.
Building effective incentive programs in today’s “Great Resignation” environment is essential to motivate all team members, line and staff alike, to change behavior and align toward a shared goal. Defining and ensuring they achieve the intended results is the first step to success.
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