What is variable pay? What impact can variable pay have on an organisation?

Variable pay is defined as direct compensation that does not become a permanent part of base pay/salary and which may vary in amount from period to period. Other names for variable pay include: incentive compensation, incentives, bonuses, commissions, cash awards and lump sums. Variable pay can be in the form of short-term (one year or less) or long-term (two years or more) incentives or bonuses and employee ownership programs. Most organizations have a combination of variable pay plans that are used together or separately, in an effective manner, as compensation instruments for communicating the linkage between individual performance and an organizations business objectives, as well as for driving higher performance. Variable pay supplements and enhances the organizations Total Rewards value proposition. It leads to employee engagement, higher motivation to perform and better retention. Hence, it has been a key area of discussion and application, particularly during the downturn, since it helped organizations to manage their compensation costs by keeping the fixed components within limited budgets and using this aspect to drive business performance. What the variable pay also does is that it increases the commitment of the employee towards his or her performance because he/she has the onus of increase his/her own earning capability. What is the difference between short and long term variable pay plans? Short Term Variable Pay This comprises of incentives payable on achievement of preset individual performance targets which are measured over a time period of one year. The amount is formula determined, paid in lump-sum annually and is taxable. Short Term Variable Pay might also contain cash bonuses where the performance criteria or amounts may or may not be specified from the beginning. Though the broad basis is organizational/departmental/business unit as well as individual performance, the amount could be also be discretionary at times (example, a retention, sign-on, promotion bonus). Sales commissions and spot incentives would also be part of short term variable pay. Long Term Variable Pay Variable Pay that is paid out to an employee by measuring performance over a period of years and not one performance cycle, is defined as a Long Term Incentive. This consists of Stock Options, Stock Units, Phantom Stocks and Restricted Stocks. Apart from being used for rewarding performance, long term variable pay is also often used as a retention tool or even as a retirement benefit when it consists of deferred shares. What are the key elements to consider when designing a variable pay plan? Prior to designing the variable pay plan, an organization would need to undertake some important steps that provide insights for the plan itself. 1. Assessing the effectiveness of any current variable pay plan(s) to identify gap areas that need to be addressed in the new plan. 2. Analysing any previous employee feedback on variable pay plans that has been captured. This also ensures that employee inputs have been considered while developing the new plan. 3. Evaluating the best practices and provisions pertaining to the comparator basket that the organization competes with talent for. 4. Earmarking the budget for the overall variable pay spending for the financial year and allocating it under the various programs (current and new). When designing a variable pay plan, the key elements that need to be borne in mind are as follows: Purpose and Eligibility: It is important to define what is the intent of the of the variable pay plan. While performance is the primary reason for such programs, there could be a dual or secondary purpose of retention, recognition or enhancing the retirement benefit element of the package. The organization will also need to determine who is eligible for the program and whether this is a group/team based reward or an individual incentive.

 Performance Metrics: The parameters and their definitions need to be developed. This is an important exercise since employees need to have clarity on what defines performance measures (qualitative and quantitative) and what types of demonstrable behaviour will be evaluated. The parameters should also signify the alignment of individual goals with overall organizational goals. Type and Frequency: The purpose will lead to the identification of which type of variable pay plan needs to be rolled out short term or long term. At this stage planning the frequency of the plan (for example, annual, quarterly and so on) is also important. Differential Payouts: It has been seen that during the downturn, a large number of organizations started focusing on differentiated rewards which worked towards providing the high performers and potentials with significantly high variable pay as compared to the average performers. Hence this payout matrix which will define the threshold values as well as differential amount needs to be calculated using a logical and fair approach. Measurement of ROI: Building in a mechanism to ensure how the business impact and return on investment can be measured on the new variable pay plan, is imperative. A review of the actual pay outs is also important to track the planned budget. Communication strategy: While designing the plan itself, one of the key elements to be factored in should be a structured communication plan which should seek to provide clarity on all aspects such as eligibility, provisions (how it is calculated, when payouts will be made) and other details to the employees. The communication plan should use internal platforms and methods which allow for dissemination of information such as the intranet, company newsletter and mailers as well as those which allow for discussion such as open houses and help desks. There should also be adequate training provided to the immediate managers to answer queries from their teams, pertaining to the plan. If there are significant changes that are expected in the organizational culture, those can be addressed via the right communication strategy as well. What are stock options? When are they most appropriate to use? Stock options are a form of Long Term Incentive and a non-cash component of pay, that organizations provide to their employees, typically at the senior and middle management levels (there are certain organizations which are an exception and provide the same across the employee population). A stock option is actually defined as a right granted by the organization to its employee wherein, he/she is allotted a defined number of equity shares of the company that he/she can purchase at a pre-determined grant price (this is determined by the compensation committee and is usually the fair market value of the share). These shares typically are staggered or cliff in their vesting process, that is, they may become exercisable in parts over a period of years or in a lump-sum after a fixed number of years( e.g. if there are 100 shares, with uniform staggered vesting over a period of 3 years, then 33.33 shares become exercisable after each year. However if these shares have a cliff vesting after 3 years, then all 100 shares become exercisable only after a period of 3 years). Stock options will have a defined exercise period within which they can be exercised, once vested. Exercising the option actually means exercising the right provided by the organization, to the employee to sell the vested shares at the exercise price (which is decided by the Compensation Committee and is typically not lower than the grant price). Organizations building stock option plans must ensure legal, accounting and tax pertinent compliance. The purpose of such plans is to promote retention, create a sense of ownership and provide the employees with incentives that stem directly from company performance (linked to share price). What is Phantom Stock and when is it used? Phantom stock is a long term incentive plan which works similar to a deferred cash bonus plan. As the name suggests it might not involve actually giving company shares to the employees and hence phantom, but only providing the employee with the benefits or financial gain that is made due to stock price appreciation. This amount that the organization commits to pay typically the value of the company shares calculated on a certain number of shares or the increase in the value over a period of time.

If an organization wants to provide a long term incentive, but would like to provide a straightforward way of calculating the same and without regulatory requirements, this kind of plan might work well. This kind of plan can also be rolled out if the company wants to prevent dilution of stock price, on account of ownership due to multiple stakeholders. It is usually given by family-owned, closely or privately held companies, though some publicly listed organizations might also use it to incentivize their employees. Even non-profit or government organizations might provide the same, since they would not be operating like companies. What are some challenges associated in implementing variable pay? How best can they be addressed? Some of the major challenges associated with implementing a variable pay plan are as follows: 1. Setting the right performance measures: The organization needs to identify and apply the correct set of performance parameters which ensure that there is a line of sight that the employees have pertaining to the linkage between their individual goals and the business objectives. This can be best addressed by a detailed diagnostic prior to the design of the plan on what factors drive the success of the organization and how these can be percolated down to the various employee levels. What can also help to meet this challenge is a proper training for all managers on the goal-setting and communication process so that employees can understand their contribution to the organization. 2. Plan Communication: Sharing the plan and its features with the employees in a concise yet lucid manner is a challenging exercise. Another associated challenge is important to ensure that the fairness and objectivity of the plan is communicated in the correct manner. Therefore, there are several tools and communication vehicles that organizations should build in those which disseminate information and respond to queries related to the plan, such as helpdesks, company intranet and newsletters. Alongside this there should be those channels that share the strategic intent and cultural impact of the plan, such as top management sharing sessions, open houses with the HR / Compensation team. 3. Budget Distribution and Payout Calculations: While variable pay plans primarily reward performance, driving retention and engagement are also important objectives of some plans. Hence distribution of payouts based on the varied purposes that a plan might have, from a limited budget in order to suitably reward high potential talent is challenging. This can be addressed by firstly ensuring that the payout matrix is fixed in a manner to ensure clear differentiation between average and high performance. In order to meet this challenge it is also important to prioritize alongside maintaining a balance. 4. Measuring plan effectiveness: While from a financial perspective it is typically easier to measure plan effectiveness since employee performance is linked to business returns, it is also important to work out the effectiveness of the plan in terms of its value to the employee. Hence regular tracking of the business relevance as well as value to the employee aspects of a variable pay program are critical to its sustained success. While these challenges apply to long and short term plans, there are some unique challenges related to long term variable pay plans which are equity/stock-based. 1. Choice of plan: Choosing the right LTI tool is important to drive what the organization stands for whether it is stock options for performance and engagement or restricted stock for retention and so on. 2. Valuation: There are standard valuation methodologies for stock-based incentive plans and typically organizations use consulting firms which apply a proprietary approach based on any of these methodologies, to value the LTI plan in financial terms. While these approaches are present, getting a comprehensive understanding and also ensuring that the employee understands the valuation are difficult actions. These can be simplified by sharing examples and sample calculations, when being explained. Another challenge could be identifying which approach is better or more relevant for your organizations plan. 3. Insufficient benchmark data: From an India market perspective, benchmark data on LTI plans, their typical values as applicable by job size and plan provisions, is insufficient and limited. In this situation, it might be challenging to use this data for decision making purposes. 4. Tax and Legal implications: These plans are fairly complex from a tax calculation and legal perspective. Hence organizations must ensure that they validate these with their legal and accounting teams.

What is employee retention and why is it important? Employee retention refers to the overall process of initiating programme and practices as well as creating a culture that fosters the commitment of valued employees and ensures that they stay with the organization. It is an important aspect of overall talent management. Managing employee retention is essential for organizations since it makes critical business impact. The high performing employees, who are contributing to the organization's growth, are the drivers of business success. Hence, any organization that has a long-term, sustainable growth trajectory as compared to short-term focus, will seek to invest in an employee retention approach. Employee retention is also important to achieve a return on the investment made by the firm, into employee development and career management. Retention efforts typically target an organization's top talent and this process is to help experienced employees reinvent themselves as necessary to continue to add maximum value to the organization. It is critical to recognize that top performers stay or leave for a variety of reasons. Therefore, it is essential to thoroughly research the inherent motivational factors affecting the local as well as the global workforce before a retention programme is designed. What is employee turnover and which kind of turnover should the retention strategy seek to address? There are a variety of reasons for employees leaving organizations another job, movement to another location, further education or any others. There are others who are asked to leave the organization. Hence it is important to categorize the different kinds of turnover into voluntary and involuntary. Voluntary turnover is an employee's decision to leave the firm. Involuntary turnover is typically driven by the organization and changes within it or performance issues that require employees to leave. While both these kinds of turnovers result in exit of employees from an organization, it is voluntary turnover which is typically measured and analyzed for decision making purposes. Also within voluntary turnover there are several reasons for employees to move out and each of those do not have the same organizational implications. Hence the organization's retention strategy will have to prioritize which kind of turnover it wants to manage and address. Also, as per SHRM's approach, there is a key differentiating factor within voluntary turnover - functional and dysfunctional voluntary turnover. Dysfunctional turnover needs to be managed and reduced since this entails exit of high performers, employees with missioncritical skills and so on, as a result of which the replacement costs might be significant. Essentially the strategy's focus should primarily be on dysfunctional voluntary turnover which takes place due to reasons such as moving to another job due to factors such as low satisfaction, role stagnation, rewards or going for further education (in the event, it is education that might be possible for the organization to provide). This ensures that avoidable turnover which an organization can influence is what falls within the purview of the strategy. How can the drivers of employee retention be identified? As we analyze why employees leave, it is equally important to analyze why employees stay with the organization. Hence identifying the drivers of employee retention is critical. We can start identifying the drivers by first creating broad categories of what impacts an employee within the organization. Job and Career development What elements about the job can retain the employee: the size, the diversity of the role, the learning opportunity, the career path and so on. Organization Positive work environment, employee friendly policies and practices, inspirational leadership, employer brand, employee empowerment and so on. Team and Immediate Manager - Level of interest shown by the immediate manager in the employee's development, team support and connection, recognition by team and manager for performance and so on. Once the categories of drivers and elements within them are identified, some approaches in which these drivers can be identified are shared below

1. Exit Analysis by analyzing data that is collected during exit interviews. In order to get valuable information through this route, the exit interviews should be well designed, structured and transparent. 2. Employee Engagement surveys which can be conducted on an annual basis to gauge the organizational climate and obtain formal employee feedback on why they would stay or leave the firm. 3. Individual employee discussions these would be typically the one-on-one conversations that employees have with their managers wherein during the discussion one can measure what drives or motivates the employee, whether he or she is currently engaged and so on. 4. Interviews with high performers/potentials who have continued to stay this will enable the organization to pinpoint a lot of drivers specifically applicable for this set of individuals. 5. Other observable behavior (this could be a more informal channel) how they speak about the firm internally and externally, whether they refer other potential employees for the firm, if they take initiative in participating in new interventions or respond enthusiastically with new ideas for the organization's growth. What are basic elements that are essential for an employee retention strategy? Retention practices should span all key HR functions such as recruitment, on-boarding, learning and development, compensation and rewards, employee engagement, since employees (and potential talent) remember their experiences, big and small, with respect to the firm. Hence, a comprehensive strategy will have all the touch points defined. The basic elements that are essential for an employee retention strategy are as follows1. Clear understanding of who (top talent or other employees) is leaving and why they leave and stay, as applicable to the organization. 2. Well defined retention goals and objectives based on a comprehensive cost analysis of aspects such as exit and replacement spend. 3. Department/function/team wise analysis of which kind of unique retention challenges exist within each and the set of possible solutions. 4. In-depth market information on best retention practices (by general industry and by competitors) to compare one's competitiveness. It is also important to assess the turnover rate in similar sectors/industries. 5. A basket of retention tools that have a long term focus and are not short term, one-time efforts is essential. It is also important to identify which of these tools will focus on a broad-based generic approach and which ones will be for targeted specific application. 6. Evaluation based on regular tracking of turnover, return on investment for the retention programs is a must for an effective strategy. Some typical retention tools Some retention tools which are typically used are provided below. This is an indicative list and not exhaustive. 1. Financial and non-financial instruments such as pay practices above the market median, retention or hiring bonuses, recognition or spot bonuses, high yield variable pay plans, long term incentive plans, retirement benefits, recognition and so on. 2. Organization specific such as empowered work environment, flexible practices, employee friendly programs, open channels of communication, transparency, aligned value system, organizational brand, leave policies and so on. 3. Job specific such as promotion and career development opportunities, training programs provided