Creating Performance-Based Compensation

April 20, 2015 by and

For many businesses and employees, the standard business model is for the employer to pay the employee a fixed salary based on a basic understanding that the employee will perform certain tasks. Compensation might be altered based on some variables like overtime, time not worked, annual pay raise or perhaps a periodic bonus system. This system works reasonably well and will likely be used in the foreseeable future.

Of course there are many exceptions to this system, most notably producers that get paid based on commission. Others that might get paid on a per-work-handled basis could include production line workers, doctors, telemarketers and home-based piecemeal workers.

The employee salary model works because it is easy to understand and implement. Its success, however, relies on the law of averages. That is, on average, employees are satisfied with their pay, and on average, employers are satisfied with the employees’ performance. Problems show up at the detail level — individual employee dissatisfaction with pay and individual employer dissatisfaction with performance.

Another key problem is that there is not a clear and immediate connection to what the employee does and the success of the business. The employee expects to get paid whether the business is making money or not. Also, most employees expect to get paid whether or not they performed their best.

In general, salaried employees expect an annual pay raise of around 3 percent to 5 percent, plus some sort of bonus. Bonuses are often subjective, but might be based on reaching goals or profitability of the firm. Typically, this approach means that compensation costs will go up every year, regardless of employee productivity or growth in sales. This compensation model is often referred to as “merit” based compensation, but despite a regular pay raise, it is not always reflective to its merit.

A related problem is that owners and managers tend to lose track of individual employee performance and focus on the big picture and annual results. If things are OK and the work is being handled, who cares who does it, right? Unfortunately, this leads to poor performers blending in with the rest of the employees. The high-performers often tend to feel frustrated or taken advantage of, which impacts morale. Management does not have great leverage to correct performance because pay increases, bonuses and employee reviews are once a year. Besides, it is a hassle to fire people, even if they are not doing their job.

Performance-Based Compensation

For some businesses, a good alternative is to incorporate performance-based compensation into the overall compensation model. The concept is that the employee receives monetary compensation for performing very specific measurable tasks.

The theory is that if the employee does A, B, C and D, then their overall job will be done properly and the business will be going in the right direction. This business model requires the designing and tracking of certain key performance indicators (KPIs), which eventually indicate the overall health and direction of the firm. What gets measured gets done.

Management needs to shift from only a big picture approach to incorporate individual performance, because they will be involved with tracking the numbers. It is also a very valuable exercise for business owners and managers to analyze the business and decide what the KPIs should be for each job. The good news is that the exercise will clearly show what steps need to be taken for the agency to be successful.

It also requires the business to hire employees that are willing to buy in to this model. Variable pay will not sit well for some people, especially at first. However, if designed correctly, performance-based compensation will allow top performers to shine and underperformers to go away. Not all people will fit in, so expect some attrition with the staff.

What Does It Look Like?

Some insurance agencies are already doing a little of this approach by offering incentive programs for the staff to sell new business or cross-sell existing customers. These incentives can either be a flat dollar amount or a percentage of the commissions. When the employee does X, they will earn Y.

The next level of performance-based compensation is to freeze salaries at the current level and then provide periodic (monthly, quarterly or annually) bonuses based on reaching goals or specific KPIs. This approach helps stabilize the cost of compensation and rewards behaviors that should then lead to an increase in revenue and profits.

The agency can afford to pay more when it makes more. It will also reward those that contribute to the success of the agency to make more money. Those that do the bare minimum will stay at the same compensation level.

For example, a CSR’s salary can be set at $50,000 based on handling a $250,000 commission book of business. If that book of business were to grow to $285,000 at the end of the year, the CSR would earn a $5,000 bonus. This means that if they were to do more work, they get more pay. If the book decreases, there is no bonus. The $50,000 salary stays flat the following year, but revisions to the measurements and bonuses can occur.

Measuring workload by the commissions handled is a simple approach, but it does not factor in outside influences on the result, such as the role of the producer, insurance companies, the economy, etc. It is much better to set some, if not most performance standards based on tasks that are generally in the control of the employee. Keep in mind that the purpose is to encourage behavior that generates desired results. Therefore, it is a good idea to also factor in department and agency-wide performance into the equation. Teamwork is part of the overall success of any business.

What Are KPIs?

Here is where designing the right KPIs will make the business successful. The three primary parts of business for an insurance agency are sales, customer service and backroom/administration.

Employee KPIs should include one or two from each of these areas. KPIs for sales could include actual sales results, as well as cold calls made or referrals received. Customer service could include feedback from the customers, account retention rate, and thank you notes sent out. Backroom/administration could factor in accuracy in records, average turnaround time for specific tasks, or compliance with agency policies and procedures.

A benchmark is set for these KPIs with an allocation of the compensation the employee can earn. In many cases, it is best to have a scale and not an all-or-nothing approach. This way, the employee can still earn decent compensation even if he or she misses the mark in an area or two, like getting only 85 percent of the quotes done on time.

If the current salary is frozen and this approach for performance compensation is adopted, it will seem a bit more like a way to measure performance for bonuses, which is a good start. The next level — where only part of the current compensation is fixed (e.g. 50 percent or 75 percent of current level) — and the rest of the employee’s compensation is based strictly on performance. This will require a leap of faith for some. However, it is a really good way to separate the performers from the non-performers.

Some agencies are even moving toward a system where 100 percent of the compensation is based on performance results. This requires a change in thinking for employees, managers and owners, as well as a real commitment to follow through by everyone in the agency to ensure success. However, it will create a clear understanding of what needs to be done to generate the results that make the business successful, and reward those that perform.

The Downside

Tracking employee performance will add some complexity to handling the payroll. Depending on the KPI, it might be calculated from the agency management system, an Excel spreadsheet or even can be self-reported. This all needs to be compiled, and payroll needs to be calculated from the results. The upside of regularly tracking employee performance is it also tracks the key measurements that drive the business, which helps management make better decisions.

There are some options to simplify the process. First, use KPIs that are easy to track. Next, use something like an Excel spreadsheet to enter the data and make the calculations. There are even third-party options. One company, Catalyst Insurance Systems, has created a software system called Symphony where employees enter their KPI results and the system compiles the data and then calculates the payroll. Once it is set up, management just monitors the overall results.

There is some belief that performance-based pay might actually lead to the opposite of its intent for cognitive (not physical) work. In the book, “Drive: The Surprising Truth About What Motivates Us,” Daniel Pink discusses studies that show the carrot-and-stick approach is outmoded when it comes to jobs in the 21st century. He cautions against pay based on performance, for cognitive type jobs, which service work might be classified as. However, his assumption is that the performance-based pay system is structured to appear like a reward/punishment system.

Therefore, it is important to foster the philosophy of “intrinsic motivation” into the new compensation model. Employees need to feel the joy of doing the task itself in order to be motivated. A well-structured performance-based compensation model will create the atmosphere of self-determination that is important to today’s employees. It will give the employee control over what they do and the results they get, helping them achieve a richer life. Performance-based compensation, when done properly with the right people, will be the elixir to great employee motivation.

Summary

The old business model treats employees as an expense, while treating machines and furniture as an asset. It is time to explore new options and develop a new business model. This includes creating a compensation system that aligns the employees’ performance and goals along with those of the business.

A performance-based compensation system will create a new culture for the business. Employees will gain a new sense of control and empowerments as they can directly see how their work impacts the success of the business and their fellow workers.