How employers can use deferred bonus schemes

Bonus payments have hit the news for all the wrong reasons, but deferred bonus schemes may offer employers a more ethically acceptable and economic solution, says Sarah Coles

If you read nothing else, read this…

• Deferred bonuses are increasingly appearing on employers’ agendas.
• These can simply consist of cash deferred to a later date, or can be switched into shares.
• Such arrangements save cash on the balance sheet.
• They can also be linked to performance in subsequent years.
• Deferred bonuses need to be introduced with care, especially if employees have established a contractual right to bonuses.
• Introducing a scheme retrospectively can be particularly problematic for employers, but cash-poor organisations may have no choice.

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Bonuses have rarely been out of the headlines recently, whether for the evils of short-termism that they create, or for demands that companies claw back the huge sums handed out, apparently, for failure. But there is a more acceptable version of this black sheep of the reward package – the deferred bonus.

Such arrangements form the backbone of the Financial Services Authority’s (FSA) guidelines on bonuses, as well as of systems being imposed by high-profile banks such as UBS and Morgan Stanley. Simon Garrett, director of UK executive reward for Hay Group, says deferred bonus arrangements are now attracting more attention.

Deferred bonus schemes come in various guises. At their most basic, they simply pay cash bonuses further down the line. Some do this through a bonus banking system. Garrett explains: “At the end of year one, an executive may be entitled to £100,000, so £50,000 may go into the bank and £50,000 is paid out. In year two, he or she may be entitled to £80,000, so that goes into the bank and half of the bank total is paid out – £65,000. Each year it rolls forward.”

There are a number of advantages in deferring cash for employers. It can help to retain staff, because they are hanging on for the rest of their bonus payment, and it has a smoothing effect on the size of bonuses each year. “Employers can avoid spending cash right now, which has major attractions in the current environment, where cash on the balance sheet is so important,” says Garrett.

A popular approach is to convert deferred payments into shares. This holds particular appeal for companies that are trying to preserve cash. David Conroy, a principal at Mercer, says: “It also helps to align employees with shareholders’ concerns.”

This broadly ties future reward to performance, because if staff build value in the business, the share price should rise, and their reward will increase accordingly. But Conroy warns: “The problem with equities is that when the share price is going south with general market movements, it can be a disincentive.”

The link to performance can be more explicit. For example, cash in the bonus bank can be increased in year two if performance is good, and reduced if it is disappointing. This reduction is known as a malus. This is the approach UBS has adopted for both cash and shares. Its scheme measures risk-adjusted performance over a longer period. At the end of that period, a maximum of one-third of the cash part of reward will be paid out. The rest will be held in escrow in a bonus account. If future results are poor, the amount in the account will decline. It will also decline if regulations are grossly violated, unnecessarily high risks are taken, or if individual performance targets are not met.

But Garrett says: “I understand the logic and the desire to operate this way, but there are a number of potential issues. There is a question where the malus is bigger than the amount brought forward. Do you carry a negative forward? Is it legal in the jurisdictions you operate in? In some countries, it would be illegal. There is also the question of how motivational the structure is going to be. If you have a particularly bad year and a negative carry forward, do employees stick around or go elsewhere where the bonus pot starts at zero? Also, if you have a process where leavers are paid out, do you encourage people to leave when they see dark clouds ahead?” Such a scheme must therefore be drafted and introduced with care. Traditionally, organisations honour existing arrangements for the current period, and introduce a deferred bonus arrangement for future years. But this may still cause problems. Monique Fry, a partner at Norton Rose, says: “Employees may have accrued entrenched legal entitlements to awards even though, in theory, the awards are discretionary. As a result of custom and practice, they have become part of their legal compensation entitlements.”

Even more problematic is the growing practice of bringing in deferred bonuses to apply to the current period. “People are trying to look at awards payable now for cashflow reasons and if they do not have the cash, it can cause huge HR and legal issues,” concludes Fry