Balancing Risk and Reward – Focus on Intelligent Incentive Design

Financial Incentives play an important role in a large number of Australian organisations; particularly at the executive and managerial levels, but increasingly for other personnel.

Incentive budgets vary widely, ranging from 1 per cent to more than 100 per cent of the fixed salary budget. They have increased in prevalence and quantum over the past two decades as organisation’s seek to capture the benefits of aligning employee and employer economic outcomes.

They have however recently faced criticism at the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry where the opinion that incentive programs can prompt unethical, even fraudulent, behaviour has been given wide coverage

Well-designed, intelligent programs coupled with strong, ethical and risk-appropriate cultures play an important role in the sustained success of forward thinking enterprises. It’s fundamentally democratic and dignifying to share the economic success of an organisation with those who provide the most precious commodity on earth – their time.

Financial incentives are a part of everyday economic life. But they certainly require careful design, rigorous governance and regular review in order to ensure they are meeting their purpose

In many organisations, financial incentives exist for a range of overlapping, complementary and occasionally contradictory reasons:

• Strategic goal alignment – using a reward mechanism to highlight organisational priorities and strategic imperatives;
• Market competitiveness – matching the earning opportunities available across the market;
• Ownership mindset – sharing the economic profits generated with key personnel to encourage performance, loyalty and growth; and
• Risk management – the ability to vary costs in line with capacity to pay. Reducing or eliminating incentives for a period may avoid a business having to cut staff during difficult times.

Commentators often seize on incentive as the catalyst for poor corporate behaviour potentially leading to flawed consumer outcomes. Correlations may exist, but the root causes of the problem may well lie elsewhere.

For example, the product design itself may be flawed. Add-on insurance products which comprise wide exclusions and high margins are one example and have been the subject of ASIC regulatory actions in recent years. The product design is the predominant cause of the problem  the incentive schemes supporting their distribution are perfectly well designed and suited for their goal; which is to ensure that the products are enjoyed by the widest possible group of users. There is no possible incentive design which can make up for a poorly designed or exploitative product.  When a company makes a decision to design and take to market a particular product or service the incentive plan merely acts as an amplifier. It is not the cause.

The culture of the organisation also plays a significant role in encouraging or dissuading particular behaviours.  Management direction and goal setting can have a meaningful impact on frontline behaviour. Financial rewards may be a very visible management tool for driving behaviour, but broader recognition, promotion and learning opportunities, with adherence to compliance measures, are all powerful reinforcers that cannot be overlooked.An incentive plan is not a substitution for people management; it should never be expected to fulfil the role that competent supervision is intended to fulfil.

Intelligent Incentive Design

Financial incentive schemes, designed well, and deployed wisely are highly effective for most enterprises. But organisations also require mature risk cultures to ensure that the opportunity to earn an incentive does not override good judgement, and compliance with ethical and legal obligations.

Intelligent Incentive Design aligns the opportunity for rewards with appropriate business outcomes which do not need to be at odds with good consumer outcomes.

Introduce a balanced scorecard

Incorporating non-financial targets into a salespersons’ metrics promotes more predictable and less risky outcomes. Metrics associated with customer satisfaction, embodying company values, compliance and governance requirements, and behaving in a way that is aligned to your company’s risk culture are important factors that contribute to whole-of-business success. These systems are often undeveloped compared to the financial measurement apparatus and require additional investment and focus.

Implement checks and balances around your sales metrics

While an employee may be reaching their targets, have they behaved appropriately? Have they sold their customers products and services that are beneficial for their circumstances and needs? And, importantly, have they inputted data correctly to ensure you have an honest view of their performance? Enhanced rigour and discipline is necessary to accurately assess the risk-taking behaviours of your employees. Focus your investment and resources in the areas that will have the biggest impact on your company’s compliance culture and performance.

Mandate that your Human Resources and Risk teams work together

Whether it is at a team level when developing targets and strategies, or at a board level when approving incentive plans, HR and Risk professionals need to be aligned on organisational goals and associated incentives. If your company does not have the level of expertise required to understand the way these two areas of business influence each other, then look to partner with experts as you refine your plans and programs.

Defer your incentives

Take a leaf out of Europe’s book, and defer incentives for up to five years. A fundamental principle of incentive design is to align payment with outcomes; in certain industries outcomes may take years to measure if we consider a good customer outcome the goal, rather than a transaction. For example reward your staff when the customer successfully meets the loan repayments, not when the loan is approved. Reward them when the client starts transacting on their new account, not just for opening it. Developing incentive KPIs which take the long view encourages employees and executives to also focus on more sustainable behaviours. This has the added bonus of encouraging loyalty from key staff who are encouraged by deferred incentive plans to remain with the business and focus on its long-term success rather than their short-term gain.

Use an incentive gateway

It is becoming common practice to use an incentive gateway before paying out any bonuses. Employees must meet certain behavioural and compliance standards in order to be eligible to receive incentives, irrespective of the results they deliver. These standards can be whatever you deem appropriate, but could include abiding by risk culture benchmarks. When enforced all the way to the top of an organisation, it can be a powerful behavioural driver.

Use your board

Boards have the discretion to adjust incentive payouts if there have been adverse outcomes as a result of risk-taking behaviour which was not envisaged in the design of the plan. This responsibility exists precisely to ensure that a holistic view of organisational health, conduct and performance is formed at the most senior level of the organisation. Also heed proxy advisors to ensure sustainable organisational value is linked to performance and pay.

Clearly there is no one-size-fits-all approach to intelligent incentive design – but rigour and good governance are non-negotiable. Deep introspection, and fresh-eyed expert perspectives are imperative to avoid the risks associated with flawed incentive program design or deployment. And being clear on what is a risk created by the incentive program, and what is a risk that just manifests itself there. Sales incentive plans are widely known in the industry as the “organisational drain hole” – they catch everything! Financial incentives and wealth sharing in organisations are a fundamentally dignifying and democratic concept. Let’s not lose that.

Many organisations will benefit from assistance in benchmarking and designing their incentive plans, hiring and recognising the right people and behaviours, and organising insurance for any instances where their outcomes are undesirable.

To find out how your organisation could benefit from a discussion with a risk or incentives expert, please reach out to Aon.