The Short vs. Long-Term Pay Dilemma

In his recent Strategy+Business online column, Ken Favaro said this:

Peter Drucker once wrote that the manager’s job is to keep his nose to the grindstone while lifting his eyes to the hills. He meant that every business has to operate in two modes at the same time: producing results today and preparing for tomorrow.


But “preparing for tomorrow” really means investing in the future, an expensive and uncertain proposition. It demands taking an incremental hit to today’s performance in exchange for an unguaranteed payoff. Meanwhile, you have to meet your previous promises of big gains to have the wherewithal to continue investing. But that wherewithal will soon be lost if meeting those promises means forgoing new investments that are essential to future results. Drucker’s dictum is not only an acrobatic feat, but a managerial one as well.

The dilemma posed here plays itself out in every dimension of the business, including compensation planning. When it comes to pay, business leaders face the same balance issue: What blend of short-term and long-term incentives will support the growth we're seeking without sacrificing current performance? The ability to answer that question is critical to any company wishing to align compensation with the organization's vision, business model and business strategy. Here are a few principles to consider.

  1. Incentives are most effective when defined and executed as value sharing plans. This means the company figures out what value creation means in financial, ROI terms and what portion is attributable to non-human capital at work in the business versus that which is considered "productivity profit." When this approach is taken, incentives become "self-financing." Value is only paid out when, if and as it is created.
  2. Value sharing plans should ultimately be split 50/50 between short (12 months or less) and long-term (12 months plus) performance. Short-term plans such as annual bonuses should reward the maintenance of key financial drivers in the business model. Long-term plans should reward sustained results based on growth targets. Value sharing plans tied to sustained success are designed to prevent "bad profits"--those that erode shareholder value--by tempering decisions that maximize short-term compensation at the expense of customers, margins, innovation, etc. Good profits come from sustained, value creation execution and outcomes.
  3. Both short and long-term plans should reward the right combination of company, department and individual performance. These factors will vary by employee "tier." For example, senior "tier" management might have incentives that are based 75% on company performance, 0% on department performance and 25% on individual performance. A middle "tier" employee, on the other hand, could have his value sharing based on 25% company performance, 50% department and 25% individual results. And so on.

Aligning these principles with relevant pay plan design requires an effective blend of art and science. Financial forecasts, market pay analysis and other "scientific methods" help define value creation thresholds and organize pay grades and job families. A pay philosophy statement helps define what the company is willing to "pay" for, such as: what the company believes about how value should be shared; how the organization will balance guaranteed versus variable compensation; what blend there should be between short and long-term incentives, and; what types of short and long-term incentive plans are most appropriate. Philosophy has to do with the "art" of compensation planning.

Thinking about compensation in these terms will dovetail effectively with what Favaro describes as the "strategic five" questions that should be answered in developing an organization's strategic anchors for growth:

  • What businesses should we be in?
  • How do we add value to our businesses?
  • Who are our target customers?
  • What is our value proposition to those customers?
  • What capabilities make us best at how we add value to our individual businesses and how each business delivers its value proposition?

Compensation needs to align itself with these anchors if it is going to be a strategic tool that helps fuel growth rather than a distraction and drain that diminish it.

To learn how to develop a pay approach that will help you accomplish this, tune into our upcoming webinar entitled, "What is a Total Compensation Structure--and How Do I Build One?"


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