In the wake of COVID, most business leaders want to be optimistic about the future, but they’re not completely over this years’ experience yet. As a result, they have concerns about building the compensation component of their employee value proposition for next year without having a better handle on what the economy will be like—and therefore, how their cash flow will be impacted. What they do know is that the coronavirus economy revealed significant flaws in their current compensation approach, and they certainly want to avoid making the same mistakes going forward.
What mistakes? Generally, they fell in two categories:
- Too much emphasis on guaranteed compensation (salaries).
- Too little flexibility in their pay offering (no where to pivot when cash flow dried up)
What happened to most companies when the economy shut down was that the financial component of their employee value proposition gave them few options for dealing with the cash flow crunch they were experiencing. As a result, their only alternatives were to ask their people to take lower salaries, furlough employees or lay them off. Chief executives felt like they were between a rock and a hard place. Every choice was a bad one.
That said, the economic chaos of the past several months has given us some valuable lessons, has it not? Among them is that businesses can no longer expect that what worked in the past is going to work in the future. This is true both for how they approach their go to market strategies as well as how they manage the employee experience of their workforce. Smart company leaders will draw on the lessons COVID has taught to form a new way of thinking about their businesses going forward. And part of that “new way” must include how they think about and develop their company’s employee value offer in general and their rewards offering more specifically.
A close examination of what has and hasn’t worked in the past reveals essential ingredients that will make a for a successful pay strategy in the future. Here, we’ll refer to them as “secrets”—only because so few enterprises have learned these elements will be essential next year if they expect to survive no less thrive in the new economy. Although there many potential facets to this kind of examination, I have consolidated them here into five categories.
The 4 Secrets
Even prior to the onset of the coronavirus economy, many organizations had figured out that “old school” approaches to compensation need to be phased out. The competition for talent demanded they look carefully at their employee value proposition to make sure it enabled them to attract and retain great people. Despite a spike in unemployment, that need has not evaporated (this economy is not comparable to the Great Recession that hit us in 2008). Instead, all of the issues that guided pay plan creation before COVID still exist today—only now an added a layer of flexibility is needed to make sure our strategy is easily adaptable to any business environment we may face in the future. So, let’s consider how we might accomplish that.
Secret #1—Define Value Creation
A business should be able to tell its people the threshold that must be reached before it considers financial value to have been created by those employees. What kind of threshold? Typically, it’s profit or profit margin, but we will dive deeper into that question in just a second. First, we must begin with the premise that shareholders have a capital investment tied up in the business. Among other things, that investment represents a foundational value upon which the company has relied to first, start the company, and subsequently drive whatever growth the enterprise has been enjoyed today. It also represents a substantial risk to owners. They are willing to assume that risk only because they believe in the purpose of the company and have confidence their investment will be rewarded through company growth. As long as owners have that investment tied up in the business, they are entitled to have it protected and to generate a sufficient return to justify keeping it the company. So a threshold that acknowledges that expectation needs to be reached before value-sharing with others (such as through incentive plans) should be considered. Defining value creation is the process of establishing what that threshold should be.
Owners are focused on profit because that is the fuel of business growth. And since their investment in the business carries an opportunity cost or risk (the inability to use their equity to invest elsewhere), they are entitled to place a charge or assessment on profits before they deem added value to have been created. Our clients use anything from eight to 30% as a capital account “charge” in making this calculation. The difference between profits and the capital assessment is considered productivity profit. It represents earnings that are attributable to the performance and productivity of employees at work in the business (as opposed to value created by owner assets).
Calculating productivity profit is one way of defining value creation. And that definition can help you formulate your compensation philosophy.
Secret #2—Articulate and Communicate a Clear Pay Philosophy
Your value creation definition should make it easier to determine your belief system about compensation. In other words, your pay approach should ultimately be guided by what you believe employees should be paid for—meaning the financial outcomes they help produce. It’s a matter of determining with whom and in what form value should be shared based on the value that has been created. So you need to know where you stand, belief wise, on key compensation issues: How should salaries be determined? What is the right balance between guaranteed compensation (salaries) and variable compensation (value-sharing)? Should that balance differ by employee tier or salary grade? How much emphasis should be placed on rewarding short-term versus long-term performance? Should that also vary by employee type or tier? What form should performance-based value-sharing take—stock, phantom stock, performance units, bonus pools…something else?
All of these questions should be answered in a written compensation philosophy statement. Starting with your value creation definition, this document should spell out the belief system that will guide how rewards programs are created, what form they will take, who will participate in them and so forth. It is essentially the company’s pay “constitution.” In other words, anytime a new rewards plan is envisioned, or a current program is examined, leadership should look at the company’s philosophy statement first to determine if what’s being considered is consistent with leadership’s belief system about pay.
The company’s compensation philosophy statement should take two forms. One is a comprehensive document that spells out all the details of the organization’s belief system. This is for use by enterprise leaders in making important pay decisions as just indicated. The second is a more abbreviated version that can (and should) be shared with employees.
When you effectively communicate a compensation philosophy to your people, you find that most complaints about pay go away. Why? Because you have given employees the rationale that drives the nature your pay offering. They may like or dislike that rationale, but the important thing is they know what it is. And if they can’t or don’t support your pay philosophy, it’s probably a signal they are not a fit for your organization.
Secret #3—Make Your Pay Strategy Agile but Enduring
During the economic crisis brought on by COVID, one of the biggest flaws business leaders found in their compensation strategies was that they were not flexible enough. In other words, once the company’s payroll became the enemy of cash flow they had nowhere to pivot. The reason this occurred was because their pay offerings were too rigid. For the most part, they were comprised of salary, an annual bonus and benefits. So, when things got bad economically, their only choices were to freeze incentives, cut salaries, furlough employees or lay people off. None of those were attractive alternatives, but business leaders were stuck. And now that the economy is making its way back, many of those companies are scurrying around to replace people they “had to” let go or they are hoping they can get former employees to come back.
An agile approach to compensation planning means you develop a balanced offering. Think about your pay approach as you would an investment portfolio. Each individual program represents an asset class. For an investment portfolio to be stable and drive the long-term performance you’re looking for, it needs to invest in a broad range of assets that are complementary not identical. And the range of investments cannot be too restrictive. Each has a role in the portfolio and the choice of your asset scope and mix is driven by your investment philosophy. When the economy shifts, you don’t throw out all the asset classes and replace them with new ones. Nor do you necessarily start limiting the number of investments in your portfolio—because that actually increases the overall risk of your portfolio. Instead, you rebalance. You shift more weight to one asset class and remove weight from another based on economic conditions you’re dealing with.
Your compensation “portfolio” should be no different. You need to adopt a balanced approach if you want to maintain maximum flexibility. Each pay plan you offer is like an asset class in your investment portfolio. The range of offerings is what gives your value proposition stability and ensures you have options when different economic cycles arrive. For example, even if you only add a long-term incentive plan to your mix, that element immediately creates greater agility in your compensation strategy. Companies that had such plans when COVID hit could offset salary reductions or bonus plan freezes with addition contributions to their long-term value-sharing plans. Given the nature of most such programs, the enterprise could afford to do that because long-term plans don’t affect this year’s cash flow (because, by nature, benefits are not being paid out “this year”). So, organizations could maintain the total compensation value an employee received—or even add to it—without creating a negative impact on cash flow.
Secret #4—Make Sure it Creates Growth Partners
In 2021, your employees will chose to either become growth inhibitors or growth partners. And your pay strategy will have a lot to do with which of those they become. Growth partners are employees who have an accountability mindset. They approach their roles with a sense of stewardship. They take ownership of the outcomes their roles exist to produce. They focus on results and don’t make excuses.
Employees become growth partners when they are treated as such. It’s not just a cute term you pull out and use when you want to rally the troops. It is a description of how you actually view your people. And you will never convince your employees you view them as growth partners if the way you pay them communicates otherwise.
Here’s an example of what I mean. Picture yourself in a planning meeting with your top 10 to 20 people. Envision yourself making the case for what you believe the company can achieve over the next two to three years. Among other things, you say you believe the company can grow revenue by 50% and improve your profit margin at the same time. You tell those gathered in the conference room that they are the ones who can make it happen—and that you have complete confidence in their ability to do so. Then you send them on their way to…well, make it happen! (Go troops!)
Meanwhile, these people have a compensation plan that pays them a salary (granted, a fair one) and a modest bonus in years you hit company or department targets. They participate in a good medical plan and can contribute to a 401(k). At what point do you suppose it’s going to dawn on this group that you do not view them as growth partners—despite what you said in the conference room? When do you think they will figure out that there is no part of their compensation package that rewards them for growing revenue and improving profit margin over the next two to three years? And once they make that realization, exactly how committed do you think they will be to achieving the goals you’ve put them in charge of?
The best way to turn your employees into growth partners is to make sure your pay offering is complete and compelling. You make it compelling by ensuring you have included all the right “asset classes” in your compensation “portfolio.”
So…if you want to avoid pay strategy disaster in 2021, do not ignore these four secrets. They are no longer secrets to you—so if things don’t work out next year, well…don’t say you weren’t warned.