INCENTIVE COMPENSATION: BE CAREFUL WHAT YOU WISH FOR; IT WILL COME TRUE

Incentive compensation plans are now par for the course 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 real problem is: it works&but often 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. The problem: 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.

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. Unfortunately, they also bring the most creative side of people. 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.

How to avoid this problem? Here are some thoughts:

1. Make incentives meaningful. Incentive plans work because they make a difference in the financial environment 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 bonus opportunity will not 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.
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 that are complicated. Any time you need to correct mistakes, it diminishes the effectiveness of the program. Complex programs make the opportunity for more mistakes. Simple is better.
3. Focus on what really matters. Is it behavior? Is it a specific balance sheet item or product? 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 you told them you will). Plans do not always work as planned& However, they are an important moral agreement 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.
5. Manage 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, as you bring about cultural change. In addition, achieving the right behaviors will get you the results you're looking for. Therefore, incenting for 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). 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 that, 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 environment is essential to motivate all team members, line and staff alike. Making sure they achieve the intended results is the first step to success.