Bridging an Incentive Compensation Plan Change

08 Jul Bridging an Incentive Compensation Plan Change

One of the most vexing challenges when transitioning from one compensation plan to another is how to handle payouts for deals that occurred under the old plan. So, if your new plan starts on July 1, then all deals that close on June 30 should be paid according to the rules of the old plan.

Where things can get tricky is when the crediting point or payout timing changes from the old to the new plan.

·       Example #1:  “Crediting point:  Long to Short” changes occur when you used to calculate incentives when payment was received (a long horizon) but you are now going to calculate the new plan based on delivery, shipment, or contract signing (a short horizon).  In this case you have a positive overlap – where the old plan will payout over the new plan.  This may make management feel this is an opportunity to skimp out on paying out the remainder of the old plan but DON’T DO IT. You expect your people to abide by the rules and so should you.  If the rules were that you paid out when payment occurred, whenever that was, then follow those rules…even if it means you are paying out for some loads under the old plan several months into the new plan.  If you are bothered with the administrative burden of this, then pay off the remaining loads in a lump sum and be done with it.  If you can statistically validate that you have a 90% collection rate, then perhaps you can justify paying 90% of the balance, but even this is nitpicky and will not gain you loyal employees.  What you gain in dollars you lose 10-fold in trust and loyalty.

·       Example #2:  “Crediting point: Short to Long” is more difficult – when you change from an earlier crediting point to a later crediting point.  This creates a negative overlap with a gap to bridge.  You will need to carefully consider how you handle this so your employees can still meet their monthly bills.  Your pay mix (the ratio of salary to incentive) will determine the magnitude of your problem.  If the staff gets more than 50% of their pay from their incentive compensation you MUST bridge the gap as they will not be able to meet their financial obligations if they are left with anything more than a two week shift in income. You bride by providing an extra payment that is not calculated under either plan and instead is typically calculated as the average of the preceding X number of payments. You should provide adequate notice of this change so the staff can adjust their income expectations for the transition period.

·       Example #3:  “Payout timing: Long to Short.”  This is typically not a problem as most people are usually happy to have their incentives paid more frequently (though I have heard of odd times this caused problems and it usually involved ex-spouses or lack of healthy relationships with current spouses, such as one hiding money from the other).  Under most normal situations, however, shifting from paying annually to quarterly, or quarterly to monthly is typically not a problem in and of itself.  If you get push back, this means that something else is changing that the staff perceives will make it harder to be successful, such as too short of a time allotment to reach stretch goals.

·       Example #4:  “Payout timing: Short to Long.”  This causes a double wammy.  First there will be a gap.  If the staff had been being paid monthly under the old plan, and is now going to paid quarterly, there will be a 3 month lag between the last payment under the old plan and the first payment under the new plan.  This can cause significant financial hardship if the pay mix is variable (lots of pay coming from incentives).    You will need to provide ample notice and plan for a bridge payment in this situation that essentially amounts to double paying for the gap period, similar to what we did in example #2 above.  The second issue that usually arises in this scenario is the impact of taxes.  Fewer, bigger, payments are typically taxed heavier than many smaller payments. This is a short-term problem but one that can impact cash flow.  If too much tax is deducted then the staff will get the extra payments back when they file their return in the spring.  However, they may not be pleased with the notion of a forced savings account held by Uncle Sam.  Talk with your payroll staff as there may be ways you can code the additional payments so they are taxed for a longer period of time (e.g., paid 1x a quarter, but taxed as if the payment is for 3 monthly pay cycles).  Not all companies can (or are willing) to do this, so check first and understand the impact on administrative costs and possible under withholding risks for your staff.

If you are changing the pay mix to be less variable by raising the salary, you will mitigate some of the problems from scenario #2 and #4 as now they have increased fixed income in their regular payroll check.  If you are decreasing the base salary (first, DON’T…but if you are) then you have made the problems in scenarios #2 and #4 worse.  If you are shifting using scenario #1 you have a little bit of a cushion from the double incentive payments that will happen for a short-time.  If you are changing using scenario #4, you may also gain a little bit of cushion as the reduction in salary will be offset by more frequent incentive payments, but this rarely works unless you are paying the new incentive at least monthly (shifting from annual payments to quarterly payments will not offset a salary reduction).

One unusual situation that comes up occasionally is shifting from straight commission paid as bi-weekly incentives to monthly incentives based on goal attainment. This can create significant timing issues because the end of a month may fall at such a point that it makes payout farther than 14 days away from the next bi-weekly pay cycle.  A potential solution to this is to use a “4 week month.”  There will be 13 of these periods during the year (13 x 4 = 52) and every period will have 20 business days.  This also means that the end of a “month” (4 week period) will always coincide with the end of a bi-weekly pay cycle, so payment for the most recent period’s performance can occur with the next bi-weekly check. You have a short (2 week) gap to bridge with this transition, but that is far easier than trying to (1) calculate performance against a 2 week goal – if you are shifting to goals (the shorter the time period the more volatile the results – think of the stock market), or (2) maneuver a calendar month close to align with a bi-weekly pay cycle.

As we discuss in other blogs, you MUST model out the impact of plan changes both in aggregate and at the individual levels, and if you are changing pay mix, credit timing, or payment timing, you need to also model out the impact on cash flow for the initial transition period.  If you don’t…proceed at your own risk.