Key elements in Incentive Compensation

Incentive compensation is a double edge sword: it motivates employees to do what the plan asks for. In the process, it causes 'creativity' among employees to the point that they find ways to achieve incentives that the plan authors never contemplated. In other words, they get their incentives by doing things other than what the plan intended for them to do.

Incentives act as a motivator for changing behavior only when they are clear, predictable, simple and controllable. Otherwise, incentives become a reward and recognition mechanism, given after the fact. In other words, if an employee cannot figure out in advance how much money they'll get paid, incentives will not motivate their behavior because they are not sure exactly what they need to do to make a specific amount of money.

Incentives are very powerful. It is 0065tremely important that they are designed in such a way that employees are crystal clear on what they should and should not do, and that rewards are given to those who achieve results consistent with the shareholder value that is to be created. A long list of questions and variables need to be answered as such plans are constructed to ensure that incentive dollars are well spent:

1. PLAN GOALS. Determine in advance what the plan is meant to achieve. Too often it is unclear even to the plan authors what is the definition of success here, what we are trying to achieve. For example, incentives can be given to volume (number of units or dollars originated), activities (number of prospecting calls), profitability, customer retention etc. The plan must clearly identify what it is designed to achieve of the options above or other possibilities. Also, if the bank proclaims to be a needs-based selling institution, yet the incentives are given for specific product sales, that apparent contradiction needs to be reconciled prior to plan publication.

2. VOLUME VS. VALUE. Be sure that your goals will not yield lots of activity and sales but little shareholder value. For example, as you compensate for unit sales, are you getting real sales or product splitting (i.e. selling 5 CDs of $1,000 each instead of one CD for $5,000)? There is no incremental value to the former yet the incentives are five times higher than the latter.

3. PRODUCT GOALS. As mentioned, goaling product unit sales has its pitfalls. While easy to measure and track, which is why so many banks use it, such goals do not necessarily align the customer's interest with the employee's, nor do they assure value creation. Last, they often fly in the face of the bank's stated philosophy to customer value. Go into product goals with your eyes open.

4. NET VS. GROSS GOALS. Most incentive plans goal for growth by targeting a specific amount of volume of sales, i.e. 50 new loans or $50 millions of new loan originations. However, the actual volume of loans on the books might decline even if employees achieve the incentive goals if customer attrition exceeds expectations. Gross goals (pure volume vs. net volume) result in little attention paid to existing customers, and might result in greater attrition. Again, a bank might end up making the incentives and achieving the goals while the shareholder is worse off.

5. GOAL FOR COMPENSATION AT RISK. Do you have a clear understanding of your compensation philosophy? Are you interested in increasing the percentage of at-risk compensation of total compensation? Are you paying enough incentive dollars relative to the base pay? This is an important philosophical issue, whether to increase at-risk pay vs. base pay, and it needs to be given thought and clarity.

6. CROSS-SELLING. Cross sales are a popular word these days, as banks strive to stem customer attrition by improving cross-sell ratios. The questions are abound, though: what counts as a product for calculating the cross-sell ratio? The biggest banks count everything and the kitchen sink; do you? It works for comparison purposes to others, but it has the downside of encouraging folks to sell products you don't want them to sell, say ATM cards (vs. debit cards). Further, do you target cross-selling to only new households, an easy measure? Or do you also goal existing households? If so, those need to be goaled separately, since their numbers will vary greatly from new household cross-sales (as they already have products with you). I believe it is important to goal both, since neglecting existing households in favor of new households is not only a huge lost opportunity but also results in increased attrition. Also, how long do you keep the sales session open for the cross-selling calculation? Is it only the one time the customer visits the bank, or would it be extended beyond that moment to encourage bankers to contact new customers after they have been boarded to see whether their needs have been fully met and if other products might be of interest?

7. CONTROLLABLE ELEMENTS. If you intend to use incentives to motivate employee behavior, you need to provide incentives only for elements the bankers can control through their own activities. Otherwise, incentives become de-motivators, as folks can't reach them not due to their own failings but due to an allocation process or other elements outside their own control.

8. FREQUENCY OF PAYMENT. Again, the tradeoff is difficult: incentives are not a part of base pay, and employees should not count on them as such. At the same time, if they do not receive them in job-appropriate frequency, they find them de-motivating (the closer a reward is to the activity, the more motivating it is). Most pay tellers and bankers monthly, branch managers and loan officers quarterly, and senior management annually.

9. TEAM VS. INDIVIDUAL GOALS. Team goals are great, since they intend to make the whole greater than the sun of the parts by encouraging folks to work together toward a common goal. St the same time, they permit non contributing members to get their unfair share of the pie, which is a strong de-motivator to star producers. Consider both benefits and risks as you develop your own plan, and be explicit regarding your approach to the issue.

10. HANDLING RETENTION. Many incentive plans do not address existing customer retention. It is a serious issue for all banks, including growth oriented institutions, since it directs attention almost exclusively toward the customer acquisition activity and away from customer relationship building and cementing. Is it possible to include a retention component in acquisition-oriented plans? Many do.

There are many more variables that determine whether an incentive program works, including senior management support, effective launch, enforcement of ethics, accuracy of payouts and others. The key ingredients, though, are:

• Simplicity
• Clarity
• Predictability of results (if I do certain things, I'll make a certain amount of money)

Consider these and the other issues associated with your plan to assure that it directs your employees to do what you want them to do. Otherwise, the plan will work, but shareholders will not benefit.