Risks of Poorly Made Incentive Plans
The joke goes that the majority of incentive plans are drawn up by the company president and sales director hastily over cocktails and written on a napkin. While most incentive compensation plans have a bit more thought put into them than this, there is a kernel of true beneath the folk-lore, and the place this is most often evident is in the plan document -- the piece of paper which is given to the employees to explain how they are going to be paid. The risks of having poorly documented incentive compensation plans range from your employees not understanding the plan and therefore not being motivated by it (leaving your sales director scratching his head as to the lack of results, and possibly his lack of job!), to legal battles with former employees who are claiming they are owed back incentive pay due to vague, inaccurate, or misleading wording in the plan document.
At a minimum, well-written incentive plans must have the following components
Plan Overview: This part describes the plan objectives, tells who is eligible, gives the time frame the plan will be effective, tells what the target incentive amount is at 100% performance, and lays out the various elements of the plan, their weights, their pay frequency and calculation timing, and their performance period.
Element Details: This section thoroughly explains each plan element or component, and details the method used to calculate results (e.g., "Gross Margin is calculated by subtracting the cost of purchased transportation services from the customer payment excluding adjustments for discounts and fuel surcharges"). Wording must be precise to prevent misunderstanding. Include commission rates, commission tables, bonus payout tables, or any other information that will enable employees to quickly and easily calculate their incentive payments. Be sure to also document any qualifiers that must be met before pay will be earned (e.g., "minimum gross margin % must be 10% to earn incentives under this measure"). If modifiers are part of the plan, include them in the plan document at this point as well (e.g., "if your on-time % falls below acceptable levels, your incentive for the performance period will be reduced by 50%"). Include information about any quotas that will be used to determine pay, and provide a calculation example so the employees can follow it step-by-step.
Plan Policies and Practices: This is the very important legal disclaimer section that is often completely omitted. Things to include in this section are policies about payment when an employee transfers, is on leave, or is terminated. Preparing this plan document section will force you to think about how you would handle incentive payouts in each of these cases before they happen which could save you a lot of money after they happen. Also be clear about when incentives are earned. Are they earned when a load ships, is delivered, is invoiced, or is when it is paid? If an employee terminates and a load that shipped while the employee was active is paid after termination, will that employee still be entitled to a commission on that load? Check with your lawyer on this, as local laws governing commissions vary.Also include disclaimers that the incentive plan is not a guarantee of employment, that management has the right to modify the plan at any time and for any reason, with or without notice, and that management may adjust sales credit and/or payout in its sole discretion to preserve fairness to the company and the employee. Credit splitting and adjustments must be clearly outlined either here or under the pertinent Element Details section. If you have not documented your policies in these two areas, now is an excellent time. Consider the situation if two parties work the same load, handle the same customer, cover for each other when one is on vacation or out to lunch, etc. Also, what happens if there is a major adjustment after you've already paid the incentive? What about bad-debt write-offs? Is there a cut-off point beyond which a load will no-longer be eligible for incentives (e.g., must be paid within 60, 90, 120 days)? The list goes on. If there is any possibility of collusion or kick-backs, either between your staff and customers or carriers, or among your staff, be sure to include a clause that such behavior will result in immediate termination. Include a confidentiality clause, and a funding clause that allows management the right to suspend payment on the plan if overall business conditions are unfavorable (although we recommend using this clause as a last resort only; if it is invoked for reasons other than impending insolvency, then you have a disincentive plan rather than an incentive plan). Finally, review the whole Plan Policies and Practices section to be sure your intentions are accurately and unambiguously stated; if you do not state your intentions clearly, your ex-employee will likely make an interpretation in his/her favor, and this could land you in court.
Once your plan document accurately reflects your intentions to the best of your ability, have it reviewed by your legal counsel. It will be seen in many jurisdictions as a contract, and is worthy of a legal review. While your lawyer’s contribution is important, you may want to consider reminding him or her that this is supposed to be a motivating and exciting document, understandable by the eligible employee, and confining the “legalese” to the final section to the extent possible. The thought required to develop each of these sections will result in better plan designs, will prevent costly challenges, and will help ensure your employees understand how they will be paid under the plan. A well-written plan document will help ensure your well-designed plans focus sales effort on the results your business needs.
This excerpt was originally published in the February 2010 issue of The Logistics Journal when Beth was a Principal of The Cygnal Group (member login required).