The Relationship between Performance and Compensation: Does Better Performance Follow the Money?

By Gavin Appleby and Eric Schultz

For many years, Human Resources Officers have discussed, evaluated and largely agreed that improved performance is affected by compensation.  Whether the compensation relates to raises or bonus incentives is a secondary issue.  Either way, there is a relationship between performance and compensation.  However, better performance doesn’t always follow the money.  In fact, bad or unethical behavior may instead follow the money.  And, to make things even more complicated, the law may affect a good faith effort to connect performance and compensation.  Don’t give up though – done well, a compensation system does improve performance in many (but definitely not all) situations. 

Like most things in life, there are pros and cons related to developing a way to seek better performance through compensatory incentives.  No system is guaranteed to work perfectly.  Beyond the legal issues there are numerous other practical concerns.  Some workers prefer a bonus plan while others will work harder to get a raise.  More frustratingly, some workers won’t work harder or better despite the incentives.  Others will argue that the system is unfair and some will try to find a way to make more money without having to work more hours.  But let’s start with the legal side of the situation.

Legal Issues to Ponder

Be wary of legal risk created by tying compensation to performance.  Otherwise well-intentioned companies may unwittingly implicate anti-discrimination or wage-and-hour issues if they are not careful with their administration of such plans. 

Anti-Discrimination Considerations

First, companies may run into trouble trying to make sure that male and female employees receive even total compensation—a seemingly righteous goal—by fiddling with incentive benchmarks.  For example, a health spa operator that divided its locations by gender found itself in hot water because it paid male managers (who ran the men’s operation) a commission based on a higher percentage of sales than female managers (who ran the women’s).  Sounds like obvious discrimination, right?  The company argued, however, that the market for women’s memberships was simply larger than the market for men’s, leading to stronger sales in the women’s operation and thus larger incentive pay for female managers.  To bridge the gap and avoid uneven total remuneration, management raised the percentage-of-sales commission given to male managers while keeping the commission to female managers the same. 

The 6^th Circuit Court of Appeals found the company’s argument unavailing.  The Court reasoned that segregating male and female managers who were selling the exact same product—membership to a spa—while also applying a lower commission to one sex “effectively locked female employees, and only female employees, into an inferior position regardless of their effort or productivity.”  This violated the basic tenets of the Equal Pay Act of 1963, which demands equal pay for equal work.  Meanwhile, the Court emphasized that “there is no discrimination if two employees [of a different sex] receive the same pay rate, but one receives more total compensation because he or she produces more.” 

Overtime Concerns

Companies also encounter problems when incentive pay impacts overtime obligations.  Conscientious HR Officers must be sensitive to proper overtime computation, and aware that a seemingly minor misstep can result in major exposure (particularly since aggrieved employees usually are entitled to liquidated damages and reasonable attorney’s fees, in addition to back pay).  Calculating the correct application of overtime to be included with incentive pay, though, can be a challenge.  A large, Arizona-based contractor learned this lesson the hard way.  A Department of Labor investigation revealed that the employer “failed to include all production bonuses and commissions in employees’ regular rates when computing overtime rates.”  In other words, employees received less than they actually earned, resulting in six-figure exposure for the company. 

Incentive pay can implicate overtime requirements even where an employer thought it had none.  Many exemptions from overtime require that the employee earn a minimum salary of $684/week. Employers may satisfy up to 10% of this threshold through incentives.  But what happens if an employee does not meet the performance benchmarks to earn the incentives, dropping her under the minimum salary level?  Suddenly, the employee is not exempt and instead entitled to overtime for weeks in which she worked more than forty hours.  This is a contingency the employer may not have planned for—and if the employer did not track the employee’s time, it could be faced with the near impossible task of figuring how much it owes. 

Beware of Varying State Laws and Labor Agreements

State laws vary as to incentive pay systems, especially in regard to sales.  Some states dictate rules regarding commission plans, bonus plans and clarity as to how incentive pay will operate.  Other states may require that certain types of “accrued commissions” or “accrued benefits” be paid irrespective of substantial performance or poor performance.  Federal law, other than the wage and hour issues noted above, does not usually apply to incentive plans.  As a result, for employers that operate in multiple states, plan rules may vary, creating occasional or yearly headaches and modifications of the plan.  Union labor agreements also often include some type of incentive pay.  Done well, that can be a very helpful thing for employers.  However, not done so well, employees may well try to beat the system.  Long story short – plan carefully in establishing your incentive-based system.

Incentives May Differ by Position Level

Compensation and performance plans may vary by the level of the job.  Often a company may have a bonus plan for hourly workers, an incentive plan for mid-level managers and other exempt positions, and stock or other substantial compensation for executives.  Each approach has its ups and downs.

For hourly workers, a good incentive plan usually is built on key performance indicators (KPIs) or other similar applications.  The amount of incentive pay may depend on the number of widgets produced, the number of cars or clothes sold, and how many injuries have occurred or safety violations have taken place.  To be a true incentive, the KPIs should be makeable – employees may consider difficult-to-reach incentives that rarely offer much incentive money as not worth the hard work.   At the same time, KPIs that are too easy often create a different problem.  Once the KPIs are reached and, hypothetically, two weeks are left in the applicable month or quarter, the employees are likely to slow down production for those two weeks since their incentive level already has been reached.  Some of the better plans have minimal KPIs, extended KPIs and stretch KPIs in order to keep the incentives coming. Importantly, don’t underestimate the benefit of incentive pay for hourly workers.  Performance does follow the money if the incentive pay is meaningful.  Hourly workers in such a program are very knowledgeable as to what they need to do to make their incentives.  Not surprisingly, a not-so-good or fair program may disincentivize workers.   

Compensation and performance in lower management or exempt positions also can be helpful.  Again, the best answer is typically an incentive plan.  In some situations, the KPIs that are in play with the hourly workers carry over to the higher level.  For lower-level managers, how effectively they manage can make a great difference as to whether the incentives are reached (particularly stretch incentives).  At the same time, there are unintended consequences to be mindful of if the program is not carefully designed.  Managers sometimes ignore important duties and instead focus their time on reaching metrics that are more likely to enable them to earn performance incentives.  In fact, studies show that incentives can lead to unethical behavior.  (Article regarding 2018 study out of Virginia Tech).

Executive Plans Are More Complicated But Not Always More Effective

It’s a different world at the executive level, including in regard to compensation.  Stock options or other profitability tracking methods can be extremely lucrative.  Be aware, however, that flat stock values are a great invitation for executives to leave the organization.  There is considerable frustration in owning stocks that have no value.  Short-term incentive plans and long-term incentive plans may be more helpful in that they are tied to KPIs rather than stock market perceptions.  That may mean less money if the stock value is really flowing, but meeting the KPIs will provide incentive pay or bonuses even if the stock market is down.  Importantly, having stock options or executive-level incentive plans are helpful in convincing a solid candidate to join your company.  

Finally, Some New Players in the Field

In the last few years, some new monetary incentives have been created to deal with new types of performance – increased diversity and legal compliance.  Many companies are now creating diversity and inclusion programs, including becoming more diverse in regard to employees at some or all levels.  Some companies are paying incentives for recruiters who find more diverse candidates and for managers that hire “diverse persons.”  Done poorly, those incentives may result in a manager violating anti-discrimination laws, even if they help minorities or women obtain jobs that they historically have not been able to obtain.  The risk is less if recruiters are incentivized to find more diverse candidates.  Even then, however, HR and Legal should seek advice on how to create a diversity program without violating the law.  As for compliance incentives, the law is not such a concern.  Done correctly, compliance-based incentives should be helpful.  Safety, financial, proper manufacturing or developing of products and legal trade or use of certain products can affect an organization negatively, including meaningful financial penalties.  Incentivizing managers to maintain legal compliance is not a bad idea.  

Conclusion

With the exception of poorly developed programs, incentives that are off target, and programs that provide bonuses but miss the need to apply incentives in important areas, performance does indeed follow the money.  That may be true in single-person situations where that individual works hard enough to get a raise or a promotion.  It also applies to incentive and bonus programs.  But if you really want to see performance improve through incentives, make sure your plan is well thought out, legally compliant and effective.