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Variable Pay: Maintaining Flexibility and Rewarding Performance in Tough Times

Many employers face a dilemma. They have kept raises in check out of economic necessity.

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Yet modest improvements in the employment environment in many locations mean the best (and most marketable) employees whose pay has been stagnant might bolt at the first opportunity to earn more if they feel unappreciated.

At the same time, locking in higher wages and salaries to prevent attrition can be unaffordable or futile even if it is affordable. That's where variable pay can fit in.

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In fact, most employers already offer some form of variable pay but do not think of it as such. A common example is profit-based discretionary 401(k) contribution matches.

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If employers don't think of this as variable pay, neither will employees, because it isn't being communicated, it isn't designed properly, or the variability is simply too small to notice.

According to compensation consultant Thomas B. Wilson, variable pay, when properly designed, aligns employees with your company's strategy. It's not just about managing cash flow, but more importantly, improving performance.

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Purposes of Variable Pay

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Wilson -- CEO of Wilson Group and author of five volumes on compensation -- lays out five common purposes for variable pay plans in his book, "Innovative Reward Systems for the Changing Workplace," published by McGraw Hill:

• Giving employees a stake in company performance• Spurring a focus on performance by individual employees or teams• Supporting "change efforts"• Increasing compensation competitiveness• Shifting more pay from the fixed to the variable column

He also lists some of the many forms variable pay can take. Those not specifically designed for senior executives or sales people include:

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Profit-sharing plans: Probably the oldest and most common type, these are popular because of their simplicity. Profit-sharing plans usually are most effective in small companies in which "people can relate their performance to the profitability of the organization," Wilson states. Individual bonus plans: Tailored to goals for particular employees. Lots of variations. Goal-sharing/team incentives: Payout is based on the performance of a team, department or facility. Gain-share plans: Typically involve "operational employees" and reward performance levels above a baseline. Their function is similar to profit-sharing plans but rewards are linked to a "direct economic outcome" such as units of output or decreased costs. Project-based incentive plans: As the name suggests, these are based on project-specific metrics, and the program ends when the project is completed. Key-contributor incentive plans: These typically focus on individuals "regarded as special talent to the organization" but still focus on group performance factors. They are often used for new product development teams and technical staff.

The Right Time?

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Before trying to craft a variable pay plan, employers need to be sure the time is right and that they are properly equipped to get the results they hope for. Among other issues to consider is whether the employees you want to target with a variable pay plan actually have control over the factors that determine their performance. While no employee or group has total control over all the variables, the greater the control, the greater the impact of variable pay.

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Another consideration is whether clear and reliable performance indicators exist for the employees in question. However, in assisting companies, Wilson often uses the plan design process "as an opportunity to develop concrete, controllable performance measures."

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Also, a variable pay plan should not be placed on top of a fixed compensation plan with fundamental deficiencies until they are addressed. Examples include lack of internal equity and external competitiveness.

Along similar lines, getting the most out of a variable pay plan requires having good managers in place who can, among other things, "provide an effective sense of purpose and direction based on the overall objectives of the unit and supported by the incentive plan," Wilson said.

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When no such impediments exist, you can begin designing a variable pay plan. It's a task that cannot be rushed. Wilson has much to say about the topic. Some of the basic steps he recommends include:

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Define the plan's purpose. What are the key goals? For example, is it about the company's financial performance? Attracting or retaining talent? Boosting output? All of the above? In what order of priority?

Establish benchmarks. Your instinct might be to use performance measures that you already have in place. But Wilson suggests taking a fresh approach, look at what your customers want from the company, then "establish measures that reflect these factors.“

Set the payout mechanism. This requires, among other considerations, allowing employees to see a direct relationship between their performance and their variable reward, making goals challenging yet achievable, and making the timing tight enough that employees can stay focused on the goal.

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