“Gone are the days when a competitive salary was all it took to attract top talent,” reported Forbes in a recent article on the increasing difficulty of hiring and retaining top talent. “Today’s CEOs must grapple with a hyper-competitive job market and evolving employee expectations (and priorities).”
No wonder then that 66% of those in HR and 51% of those in operations say that employee retention is now their operational priority, according to a survey by Gallagher, an insurance brokerage and risk management company.
Annual incentive plans are becoming popular as part of the non-financial compensation (rewards, benefits) that employers are using to set themselves apart so they can recruit top talent and avoid losing the ones they already have.
But annual incentive plans are evolving.
While there are many still not familiar with the basic idea, even those familiar with it may not understand all the dynamics in today’s world. So, what is an annual incentive plan?
In what follows, we will answer that question, among others. We’ll cover:
- Annual incentive plan: Introduction
- Annual incentive plan vs bonus
- Common performance targets used in an annual incentive plan
- New trends in annual incentive plans
- Why should you use an annual incentive plan?
- How to create an annual incentive plan (Plus the role of gift cards)
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1. Annual incentive plan: Introduction
An annual incentive plan (AIP) is a compensation system that rewards employees who have achieved certain performance objectives within a defined performance period (usually a year). In other words, AIPs are a performance-based reward system.
AIPs have become a standard way to align the goals of an organization with those of the employees. When a company is looking to increase sales by 10%, for example, it will transfer this strategic goal to various specific (measurable and objective) performance metrics for its employees.
More often, AIPs are used for the company’s executives – those who have a direct obligation to achieve strategic goals. Consequently, it is seen as a good way to retain top talent by compensating them well.
Performance goals for AIPs can be financial (profit, revenue, etc.) or non-financial (talent development, environmental, health and safety, etc.). Generally, these metrics are objectively defined such that employees can know what to expect at the end of the period (usually a year).
There are different types of incentives for meeting performance goals. Payouts are often financial rewards – cash (often a percentage of base salary) and stock options. However, there are other non-financial rewards like free training and development, paid time off, more work flexibility, among others.
2. Annual incentive plan vs bonus
Whether there is a difference between these two depends on how we define a bonus.
According to Business.com, a bonus is “any compensation in excess of an employee’s base salary or hourly wage.” With this definition, an annual incentive plan will be a form of bonus.
Investopedia divides employee bonuses into incentive bonuses (signing up bonuses, referral bonuses, retention bonuses), holiday bonuses (handed out during the holiday season), and performance bonuses (annual cash bonuses, etc.).
Comparing AIPs to these specific bonuses can give us more insights into how they differ from them.
The major difference between bonuses in general and AIPs in particular is that the latter are mainly non-discretionary. While bonus decisions can be discretionary (who deserves it or not, as in the case of performance bonuses), AIPs are based on very specific and measurable objectives that are known in advance.
Also, while some bonuses are paid to all employees based on overall company performance (we exceeded revenue goals by 100%, for example), AIPs are often for executives who have met some measurable performance goals.
Furthermore, some bonuses are not tied to any specific results (the holiday bonus, for example). All AIPs are tied to specific results that relate to the company’s short-term goals.
3. Common performance targets used in an annual incentive plan
As we have seen, at the very heart of employee annual incentive plans are specific and measurable performance targets. These targets are in the form of objective metrics, which is why AIPs are traditionally non-discretionary (sales either improved by 10% or they didn’t).
Nevertheless, performance metrics are of various kinds.
Financial performance metrics
Financial metrics remain the most popular. According to FW Cook, an executive compensation consulting firm, financial metrics include profit, revenue, cash flow, returns, and others like cost/expense management and inventory turnover.
In 2022, 93% of companies that use non-discretionary (formulaic) plans used profit metrics, 57% of them used revenue, 29% used cash flow, 11% used returns (returns on equity and assets being the most popular), and 20% of them used other financial measures.
They also note that pre-tax profit measures like EBIT, operating income, or EBITDA are more common (61% of companies use them) than after-tax measures like EPS (used by 41%) and margin measures (12%).
It should also be noted that companies don’t typically use just one metric. They can combine multiple financial metrics.
Non-financial performance metrics
As the name implies, these metrics focus on performance indicators that are not directly measured in financial or monetary terms.
Some common non-financial metrics include:
- Health and safety goals
- Employee training and development goals
- Environmental, Social, and Governance goals
- Customer satisfaction goals
- Management by Objective (MBO) goals
- Key performance indicators (KPIs)
- Diversity and inclusion goals
- M&A synergies goals
The chart below by FW Cook also shows that non-financial performance metrics can be designed for individuals as well as for teams. The latter was even used more than the former in 2022 (58% to 43%).
Importantly, the chart also shows that 78% of companies that use formulaic plans employ non-financial performance metrics of one form or the other (individual or team-wide).
We noted above that companies can combine different financial metrics in an AIP. They can also combine various non-financial measures and even use both.
They do this through the weighing of metrics. For example, profit increasing by 10% can have a 50% weight while diversity and inclusion improving by 10% can have a 30% weight and ROE increasing by 10% can have a 20% weight.
The FW Cook survey found that financial measures tend to have a higher weight. In 2022, 80% of the total metrics were financial, with profitability measures dominating (51%).
Threshold, target, and maximum payout
It is only in very rare cases that employees must meet 100% of the target before they can get any payout.
Most companies set a threshold payout which is the payout that employees will get once they have met a certain percentage of the metrics.
As seen in the chart above, in 2022, 35% of companies will make no threshold payment while 34% will make a threshold payment that is equal to 50% of the target.
The annual incentive target payment is what the company pays for expected or typical performance. This is the payout they budget based on their expectations of employee performance.
Lastly, the maximum payout is the highest amount that can be paid and it is only for outstanding or maximum performance that exceeds expectations (target).
As seen below, the maximum payout is most often set at 200% of the target payout:
These three payout types are often represented in what is called a payout curve. Below is an example:
Source: HR Daily Advisor
4. New trends in annual incentive plans
We mentioned in the introduction that answering the question – what is an annual incentive plan? – has become complicated because of new trends.
Below are some of these trends that are redefining employee annual incentive plans:
Discretion
The Cook survey distinguishes between formulaic and non-formulaic annual incentive plans. Formulaic are the ones that have pre-defined metrics and weights. And as we have seen, this is often the feature that distinguishes AIPs from bonuses.
Non-formulaic AIPs include “completely discretionary bonus determinations, scorecards without assigned metric weightings or a determinative payout formula disclosed, or other plans with limited disclosure surrounding plan mechanics.”
These types of bonus plans are discretionary since they depend on the subjective examinations of those involved (often a compensation committee). Consequently, employees may not know what will in the end determine their payout.
Nevertheless, it is important to state that discretionary AIPs are still a small minority. The FW Cook survey shows that their significance is already in decline.
Competitor analysis and benchmarking
If one of the goals of the annual incentive plan bonus is to retain employees (especially top talent), then it is important to know what your competitors are doing in that regard.
For example, if an executive expects to earn $500,000 more from an employer for meeting the same performance targets you have set for him, then there is already a risk that he will leave (all other things held constant).
Consequently, there has been an increasing focus on competitor analysis and industry benchmarks.
Dealing with payout volatility
COVID-19 showed that business performance can be reduced for factors that are completely outside of the control of employees. If your company was closed for six months then it is very likely that your employees didn’t meet performance targets.
General economic or market conditions can also worsen, making it difficult for certain goals to be achieved within the defined period.
To deal with these situations and the payout volatility that results, companies are embracing “using non-financial metrics, individual performance, widening performance ranges and flattening pay curves,” according to AON, a human capital management company.
For non-financial metrics, we have seen from data provided by FW Cook that the percentage of companies using them increased from 70 to 78.
Expansion
Some employers have also been extending the scope of AIPs to include non-executive employees. In these cases, the performance metrics are streamlined to the particular roles that the employee plays.
Short-term and long-term incentives
Employers are now setting performance metrics that focus on the long-term goals of the business. Instead of focusing on a year, these types of incentive plans can set targets over 5 or even 10 years.
As expected, these types of incentive plans offer larger compensation to employees.
5. Why should you use an annual incentive plan?
We have already hinted at some of the benefits of using an AIP. Let’s make them explicit:
Goals alignment
An AIP ensures that your goals and that of employees are aligned. When your target for the year is increasing sales and customer satisfaction, for example, that priority can be reflected in increasing the weight allocated to those two items in your AIP.
This alignment of goals can ensure that employees and business owners are moving in the same direction at all times.
Motivating and engaging employees
There are many reasons why employees become demotivated and disengaged. According to Atlassian, a software company, these include:
- Unclear company mission and goals
- Employee goals unaligned with the company and team vision
- Unclear expectations, roles, and responsibilities
- Lack of recognition
- Lack of purpose or sense of challenge
The alignment of goals provided by AIPs can solve the first three problems. Also, the rewards provided by these incentive programs can solve the recognition problem while the performance metrics they provide can create a sense of challenge and purpose.
Profitability and success
Keeping your employees motivated and engaged is a business advantage.
After surveying the performance of different companies regarding employee engagement, Gallup concluded that “Business or work units that score in the top quartile of their organization in employee engagement more than double their odds of success (based on a composite of financial, customer, retention, safety, quality, shrinkage and absenteeism metrics) when compared with those in the bottom quartile.”
Furthermore, “those at the 99th percentile have nearly five times the success rate of those at the first percentile.”
Employee retention
Retaining your top talent is essential even if it is difficult. It is essential because replacing them is more expensive and it is difficult because other people have their eyes on them.
But difficult is not the same as impossible. “Employees who feel appropriately recognized and rewarded by workplaces are much easier to retain long term, but studies also show those employees will work harder and be more productive,” according to Forbes.
Well-designed and competitive employee annual incentive plans can help retain top talent (especially executives)
6. How to create an annual incentive plan (Plus the role of gift cards)
Whether an AIP will work to provide these benefits depends on how it is designed.
Tips for designing annual incentive plans
- Performance targets (financial or non-financial) should reflect business goals (short-term or long-term). Only then will the alignment of business and individual goals happen.
- Involve shareholders in goal setting: Shareholders are the owners of public companies and they must have an important role in setting business objectives. The goals they set will then determine the goals that will be included in the AIP.
- Define eligibility criteria: Which employees will be eligible for an annual incentive plan and on what basis will they be selected (lenght of service, where they are on the corporate ladder)?
- Performance targets should be reasonable and achievable. Expecting a 50% increase in profit in a recession is an example of an unreasonable goal. It is preferable if goals are SMART.
- Payout opportunities should not be monolithic. The ideal, as reflected in the payout curve, is to have a threshold payout, a target payout, and then a maximum payout reflecting payment for different performance levels. In this way, you can ensure that top performers are compensated appropriately while also not ignoring those who had a fair performance at the treshold.
- AIPs should not be static. If goals are not static, then AIPs should be flexible. This flexibility will be involved in a change in metrics or the weights attached to them.
- Use non-financial metrics: Non-financial metrics are very good for dealing with volatility. Moreover, they reflect the growing importance attached to environmental, social, and governance issues in today’s corporate world.
- Use team-based metrics: Team rewards can help achieve team cohesion. “When team members are collectively rewarded, it fosters healthy competition, boosts morale, and fosters a sense of belonging,” according to Vantage Circle, an employee engagement platform.
- Communication is key: Since AIPs are largely non-discretionary, employees must know what the metrics are and how they are measured. Communication must be ultra-clear, leaving no room for ambiguities.
- Get feedback and take it seriously: You can also request feedback from employees on what they think about your incentive plans. This feedback can help in redesigning the program to meet its stated objectives.
The role of gift cards in employee incentive programs
Gift cards are becoming more popular for employee rewards programs.
This is because they are useful (there are closed-loop gift cards for different retailers and open-loop gift cards that can be used in any online or offline store), flexible (different denominations), have broad appeal (the market is growing), and are customizable (brand identities can be added to white-label cards).
According to Fiserv, a fintech company, 80% of employees prefer gift cards for workplace bonuses and incentives.
Since employee satisfaction is key to productivity, then it is important to give them what they want. Given their interest in gift cards, you should include them as part of your employee rewards strategies.
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Takeaways
- Employees increasingly value nonfinancial incentive compensation, such as annual incentive or compensation plans.
- AIPs differ from general bonuses in that they are non-discretionary and based on specific, measurable performance measures.
- AIPs use both financial (profit, revenue, etc.) and non-financial metrics (health and safety, talent development, etc.), often combining multiple metrics to measure performance and determine payouts.
- Recent trends in AIPs include a focus on competitor benchmarking and dealing with payout volatility by incorporating non-financial metrics.
