Can We Design a Better Incentive Compensation System to Divide Value Created in a Fairer Manner?

Are you compensated fairly for the value you are contributing?

How does your pay (given your performance) compare to your peers in the same organization regardless of what department they work in? Compared to peers doing a similar job and performing at a similar level to you in other companies?

Many of us recognize that the current economic system does not allocate value-creation fairly.

This inequitable distribution does not just affect service professionals such as nurses, educators or social workers, although the disparity between value created and pay received is quite stark in those professions.

Even in the mainstream “for-profit” business world, some people realize much greater benefit than they contribute while others don’t receive an commensurate reward for their efforts.

This article is not a wholesale critique of capitalism. However, I do believe that our system can be improved. I provide my suggestions on a better mechanism of allocating value towards the end of this piece.

I have recently heard suggestions of building and implementing a “better, next-generation, software-driven” pay for performance system. Why not apply relatively unbiased machine learning to build algorithms that can more fairly link pay to individual contributions that produce the desired outcomes?

This seems like a natural extension of capitalism in its purest form. As Americans we believe deeply in the principle that “people deserve to be paid for the value they create.” By and large we are not upset that professional athletes, movie stars and musicians earn stratospheric sums from executing their “craft” at the highest level.

The American Dream of rising from rags to riches is based on there being a meritocracy — that all rewards whether economic (monetary) or social (status or power) will be earned based on talent, effort and achievement.

Most of us (myself included), at our core, accept the principle of a meritocracy as the fairest way to divide up the “value” created in a society. We believe that meritocracies will produce the best outcome for the most people — outcomes being measured not only in monetary terms but also across physical, emotional and spiritual health.

When meritocratic principles are violated — as they were with the college admissions scandal of 2019 when many super-rich parents paid extra to get their children into prestigious colleges and universities — we are deeply upset. We dislike that people broke the rules of what we hope is a meritocratic system. We are upset that the system is fragile enough to be “gamed”. Beyond wishing to punish the offenders, we strive to build systems that are harder to “game” and subject to greater scrutiny.

The conventional economic and business wisdom is that the desire for income (to be able to “live the good life” however each of us define it) is the primary motivator of behavior. From that belief it is a short leap to a conviction that compensation schemes that incorporate elaborate incentives and risk sharing are the best way to align behavior with value creating outcomes.

There are three key elements in this argument.

Right Metrics: If we pick the “right metrics” we can encourage people to work on things that create sustained long-term value for customers. An example of the “right metric” would be for customer care / customer success personnel to be paid based on CSAT or NPS rather than first call resolution or time spent with the customer or just the retention rate.

Sufficient Oversight: In a “work-from-anywhere” world, managers worry that they will not have enough oversight of their team members as compared to a world in which most everyone was expected to be in an office between 9am and 5pm. The fear is that without shared work hours and a common location, team members may slack-off while on the job. Being able to define outcomes that matter for value creation, measure them and pay against them reduces this fear.

More Sophisticated Attribution: With proper attribution driven by the next generation of performance management software, the hope is that one can divide up the business value created fairly between all participants contributing to the value creation — capital providers and all the different employees.

My experiences — in the workplace and in my personal life — have taught me that pay for performance, even implemented well, is not a panacea. Many incentive schemes miss the following truths.

Not everything that matters can be measured. Educators often help students find and develop their passions. Social workers assist clients with strategies to increase self-confidence and strengthen emotional regulation. These variables are hard to measure and hard to compare to a start point or what might have happened in a control situation.

Management is still necessary and crucial. Incentive compensation is often viewed as a tool to reduce the necessity of management and leadership. I don’t subscribe to that view. The human elements of performance including attitude and the impact people have on others on their team are not measurable merely through inspecting results.

Tight linkages and direct control over outcomes matter if incentives are to work well. Incentives are most effective when the results being measured are both closely linked in time to the behavior and directly controllable by the person performing the behavior. However, most business outcomes don’t actually have this characteristic. In my experience, sustained high growth and above average returns on invested capital are typically the result of complex team interactions over an extended period of timing.

Incentive compensation can reduce creativity and risk-taking. Risk-taking, and thus the potential for failure, must be tolerated and even encouraged. Excellence rarely results from timid or predictable behavior. In retrospect, great ideas seem obvious. However, building valuable businesses often requires taking risks and thinking differently from the conventional wisdom. Incentive compensation schemes paid out against near term results tend to reduce the willingness of groups to experiment with the big upside at the risk of failure and loss of potential pay.

An unrelenting focus on measuring and showcasing outputs reduces commitment to the mission and the passion elements of a job. People find it more satisfying to help someone just because they are giving rather than in return for some compensation. Purpose matters to all of us. Incentives schemes unintentionally reduce purpose in our work. As Daniel Pink has discussed, academic studies have shown the pay linked explicitly to performance, in knowledge work jobs, leads to the opposite of the desired outcomes.

Self interest may be the most basic human motive. But it is not the only human motive. My experience has taught me that the more we explicitly tie pay to specific results, the more we take the soul, purpose and humanity out of work.

I realize that I may seem a romantic. Some may even call me a naïve optimist. I do recognize that it is hard to create change where there is short-term pain with the gains only being realized over the long term.

Some of my suggestions will be difficult to implement. In lieu of more complex incentive schemes with metrics personalized for each individual employee or each function, here is what I would propose. I realize I don’t have a monopoly on good ideas and am interested in hearing from others with thoughts and suggestions.

1. Base Salary — Everyone must get a base salary which is market for that role or level.

(i) Be fully transparent on base salaries. I know the conventional wisdom is that compensation should remain private. However, the reality is most of the People Operations and Finance/Accounting team members already know all the salaries in an organization. I endorse pay transparency with the whole organization.

(ii) Ensure employees are motivated but not desperate. I have heard sales leaders say they like to hire sales people who have expensive lifestyles or are over-extended. The belief is that being over-extended makes them hungrier to close new business. I disagree. I do agree that some “stress” helps improve performance. But, I also believe that putting people under intense pressure mostly leads to poor results.

2. Company-wide profit sharing. Let’s all be aligned.

(i) Implement the profit sharing scheme as a % of base salary for all employees, with different target payout percentages for different functions and levels (e.g. manager, director, VP etc.)

(ii) Base the total profit-sharing pool on actual company performance, with some minimum threshold for profit sharing to be earned.

(iii) Pay out annually. Potentially, institute a small monthly draw to allow lower paid employees to have some extra income in the short term. An annual payout is long enough term to avoid gaming the system too much and short-enough term for people to be able to see a tangible reward as realistic.

(iv) Mandate pro-rata payouts if people leave or are terminated (unless for cause).

(v) Profit-sharing should be based on one metric for everyone. All employees are then aligned on results. I would choose to base the payout on “return on capital invested”. I envision sharing the upside created above the cost of capital (for each business) between shareholders and employees.

3. Equity incentives compensations need to be restructured. Reward people for value created, without forcing them to exercise (invest capital) and own an illiquid security in the absence of sufficient information

(i) Ensure that the time to exercise options is equal to full option life, regardless of when an employee leaves their employer, unless terminated for cause.

(ii) Cashless exercises must be allowed.

(iii) Vesting should pro-rata monthly from the hire date. Remove the 1-year cliff. I’ve heard Board members admit the 1-year cliff allows them to have a “trial” period for any senior hire issued a substantial option grant.

4. Management oversight remains critical

(i) Oversight is required to offset any free-rider issues. The free-rider fear is the biggest concern I’ve heard raised regarding my proposed shared reward system.

(ii) Oversight involves having the empathy and compassion to recognize that any of us may need and deserve a break at times. People may need to “free ride” for a period while dealing with personal or family challenges.

(iii) Severance and reimbursement of healthcare costs needs to be more generous. If the employer hires a person who does not “fit” or is under-performing expectations and is terminated, the cost of “failure” should be borne partially by the employer. It takes two hands to clap. We need to stop disproportionately penalizing employees.

Is this sort of a compensation scheme likely to be adopted in the business world? I don’t know. What I do know is that if we don’t dream about and talk about it, it will never be realized.

I have heard of some companies being totally transparent on pay and financial performance. And a slightly larger number making option grant terms fairer to employees. We do see some seeds of change.

I am confident that the net impact of my proposal on incentive compensation will be a healthier workplace. There will be less need to “play politics” and less favoritism. A system of shared rewards coupled with basic rules that share risk more equitably between the employer (more powerful) and employee (less powerful) should reduce perceived and real unfairness in our compensation system. And I believe their will be increased cooperation and feelings of empowerment among employees.

I encourage us all to dream and talk about the changes we want to see in our world.