An annual bonus plan is one of the most effective tools for motivating employees to deliver short-term business results. Because the payout is based on performance over a year or less, the immediacy of the reward can be extremely effective in driving and reinforcing behaviours that help a business to achieve its goals. Bonuses are typically paid out in cash, but many public companies now reward their most senior executives, who have the potential to earn very high bonuses, in a combination of cash and shares.

But as well as being an important motivational tool, annual bonuses can also help employers to control employment costs. Unlike base salary increases, bonus payments are not consolidated year on year, and are only made when someone hits their performance target.

Annual bonus plans are particularly useful in mature economies such as the UK and Western Europe, where relatively low growth has curtailed employers’ ability to effectively differentiate performance using base pay increases. Because bonuses are typically distributed based on employees’ contribution, and are funded directly by improvements in business performance, they can motivate the best performers even when base pay budgets are small.

But for bonus plans to be successful, human resources (HR) professionals need to engage the business in their design in order to tailor them to the business’s needs. The structure of plans will vary depending on the organisation, but there are some features that are essential to a successful scheme.

Determining eligibility for a bonus plan

Bonuses are traditionally awarded to those executives and managers who are deemed to have the biggest impact on the organisation’s performance. But determining the cut-off point can be very difficult. It is useful to consider the following factors when attempting to decide who to include in the bonus scheme.

• Workforce segmentation: target the bonus scheme at the individuals who are most able to create value for the business.
• Size of the business: smaller companies tend to have a relatively large number of people who influence results, so will have a higher proportion of potential participants in a scheme than a bigger organisation.
• Performance measurement level: if a company can measure performance below corporate level (at business unit or team level, for example) a greater proportion of employees can be included as line of sight between contribution and business success goes further down through the organisation.
• Market practice: several surveys provide information on annual bonus eligibility, and these can be used as a guide as to which employees to include. Mercer’s Total Remuneration Survey (TRS) 2007 suggests that most organisations – 98% – extend their plans right down to junior management levels.

How much is enough?

The annual bonus award is normally expressed as a percentage of salary, and the more senior someone is, the higher the proportion of their remuneration tends to be ‘at risk’.  For example, a finance director’s annual bonus may be targeted at 25% of salary, with a maximum of 50%, while a more junior manager may have a target of 10% of salary and a maximum of 15%.

Target awards are made for delivering target performance and maximum awards for maximum performance, with the target bonus opportunity usually being about 50% to 60% of the maximum. Companies typically pay the maximum bonus when someone achieves 110% to 120% of their target. The overall bonus is usually capped (at ‘maximum’ level) in order to discourage the kind of short-term decision-making that could compromise the business’s longer-term health.

Individuals normally have to reach a ‘threshold’ – typically around 80% to 95% of their target – to trigger a bonus payment. Employers tend to pay between 20% and 50% of the target bonus opportunity for ‘threshold’ performance.

Measuring performance

An organisation must take into account both annual budgets and strategic business plans when setting performance measures for the annual bonus plan, to ensure that these measures are consistent with the long-term objectives of the business. Participants must also be able to directly influence the selected measures, and be able to measure them over the performance period, so that they can track their progress against targets and potential bonus levels.

In most organisations, the primary performance measures continue to be financial, with between 70% to 80% of the bonus linked to measures such as revenue or profit. The remaining 20% to 30% of the bonus is typically linked to a combination of individual and business unit objectives. Increasingly, however, organisations are beginning to factor in a greater proportion of non-financial measures that they consider to be lead indicators of value creation. These include, for example, business development activities, measures of key internal processes and people management measures. Where multiple measures are used it is increasingly common to calculate payout against each measure separately to determine the total bonus (an ‘additive’ approach), rather than using non-financial measures to modify financial performance.

Performance calibration: determining the relationship between performance and reward

Performance calibration refers to how performance measurement is linked to the reward opportunities, and can be the most challenging aspect of annual bonus design. Companies need to strike a careful balance between, on the one hand, not setting performance targets so low relative to the level of reward that participants are over-rewarded for poor performance; and, on the other, setting targets so high that good performance is under-rewarded and participants are demotivated.

Annual bonus target setting is often directly linked to the annual business budget setting process. As such, the organisation should directly involve the business units in the target setting process in order to secure participants’ buy-in to the bonus programme. 

The following chart illustrates a fairly typical performance scale, which recognises that an individual should earn a disproportionately greater reward for exceeding the target than for achieving it. In determining the performance scale employers usually factor the cost of bonus payments into required performance levels in order to ensure that the plan is self funding at every level. 

Conclusion

An annual bonus plan can be a very cost-effective way of motivating employees to meet and exceed business plan targets and to align reward with business performance without increasing fixed employment costs.

But organisations should think carefully about the way they design such schemes in order to ensure that they drive and reward the results the business is seeking, while avoiding unintended consequences. Such consequences might include, for example, generous payouts unsupported by significant performance improvements, and failing to pay out even though an individual has worked hard and effectively. But a carefully designed and modelled plan can help an organisation attract and retain the best talent and maximise the return on its reward investments.

Issued in the United Kingdom by Mercer Limited which is authorised and regulated by the Financial Services Authority. Registered in England No. 984275. Registered Office: 1 Tower Place West, Tower Place, London, EC3R 5BU.