Feature – In depth: Variable pay on the up

With variable pay, base salary is not so high and in poor years staff need to re-earn bonuses, says Laverne Hadaway

Case Study: Severn Trent Water

Article in full

Variable pay does exactly what it says on the tin. Also known in some circles as non-consolidated pay, it contrasts with base pay, which is a fixed and traditional way of rewarding workers. Variable pay is something that employees can gain or are at risk of losing depending on how well they perform at work. Typically, it is designed to incentivise staff to perform better, produce more or reach certain targets. Variable pay can take many different forms, from simple financial incentives paid for accomplishing a particular feat, such as the completion of a project or the completion of work within a particular time scale, to team and company-based bonus, share based and commission based schemes linked to performance.

Steve Watson, director of consultancy firm Rewardworks, says: "Bonuses are like a pat on the back or a corporate cuddle." The big advantage of variable pay over base pay, is that a bonus is not guaranteed, whereas once a regular pay rise has been given, it remains in the employee’s salary and no longer incentivises them. Employees then receive that money for the duration of their working life, even if they perform badly or work poorly, whereas a bonus can be used to motivate year after year. As Mark Thompson, head of reward at Hay Group, points out, with non-consolidated pay, the base pay is not so high the following year and employees need to re-earn the bonus so it acts as both a carrot and a stick.

Pay can effectively decrease if performance targets are not met. Sales commission is typically based on clearly-defined targets. It is usually tracked at short-term intervals such as monthly or quarterly and the employee is paid a percentage of the volume sold. It is much more clearly defined than most bonus schemes in that an employee will be able to work out how much commission they will be paid according to the sales that they have made. Chantal Free, senior human capital consultant at Watson Wyatt, explains: "It’s a measurable formula paid at frequent intervals. It’s typically based on sales volume and it’s either individually or team based."

Company and team-based incentive schemes, meanwhile, pay out when the company or team perform well. But, this is not always as effective an incentivisation tool as it could be. Watson believes that effectively the organisation is saying ‘We’ve had success, here’s your share of it’. But he adds: "It’s not obvious what the employee has to do to get it. Nevertheless, it’s variable in that if the company as a whole doesn’t perform, then they don’t get the bonus." The problem is that, particularly in a large organisation, less senior employees may see their own role in the company’s performance as negligible. They may feel that they have been able to exert little or no influence on the performance outcome.

Robert Burdett, director of multi-disciplinary benefits firm New Bridge Street Consultants, suggests there is a general consensus that there is little point in giving long-term share-based schemes which are based on group profits to more junior employees, for example. "What influence can they have on the group’s profits? Even if they work as hard as they possibly can, their work is unlikely to have any effect, so they won’t be incentivised." The answer is to monitor individual employee performance and to distribute the bonus accordingly.

Another drawback of team-based incentives is that team members can come and go during the period being monitored. Similarly, this applies to senior executives, who are the ones most able to influence the company profits and results. Typically, bonus schemes set up for them are designed to encourage performance delivery over a three-year period. "It can be a good retention tool – a form of golden handcuff. If they leave before that three year period is up, they forfeit their share of the reward," says Burdett.

But in the public sector, variable pay can be a controversial topic. Traditionally, this is a culture in which the collective is important. Many of the unions are also inherently against differentiated and performance-related pay. Stephen Brookes, a partner at PA Consulting, argues that the public sector cannot measure performance properly. He was involved in setting up a performance-driven bonus system for the Atomic Energy Authority. However, it was difficult to work out the performance measure. "No one could tell us whether they were doing a good job or not. But if the outcomes were better, we could determine whether they were doing a better job this year than last year," he explains. That became the basis of the system. He also points to the distorting effect of setting arbitrary targets in the NHS, for example.

Patients are meant to be able to obtain an appointment with their GP in two days. However, to meet the target, surgeries will shut their lists so patients cannot get appointments at all, and appointments five days later are unobtainable because they would mess up the targets. Variable pay is being used increasingly in the UK, annual salary increases are on the way down and there is now a very small gap between inflation and pay rises. Watson Wyatt’s Free suggests 95%-97% of organisations now use some form of variable pay.

"The proportion it makes up of people’s remuneration depends on the industry and culture. But the concept is here to stay." Looking at the senior executive level, Burdett agrees. "Shareholders want as much as possible for executives’ remuneration packages to be performance linked. In FTSE firms, only half of their salary is fixed, the rest of their remuneration is to be received if performance is up to scratch." However, employers must ensure that their variable pay schemes are tailored to the needs of their own businesses. "The thing about performance-related pay is that employers must work out what they’re trying to achieve," says Brookes.

He points out that a volatile business, such as stockbroking, retail or anything sales orientated, wants variable costs. Consequently, fixed pay is less desirable. It is preferable for the salary bill to go up and down in line with performance. "So in volatile industries you tend to have low base salaries and highly variable bonuses. In a good year everyone does well. And provided you’re in line with the market, you don’t lose good people because your competitors will be having a good or a poor year at the same time as you," he adds. Variable pay systems also seem to be increasingly sophisticated, often tailored to individual businesses with a better alignment between business objectives and the kind of behaviour being encouraged.

However, Watson warns against unnecessary complexity because employees need a clear line of sight in incentivisation schemes. "The best incentive schemes are like listening to radio. If you try to listen to more than one or two, it sounds like white noise and you forget what you’re listening to."

Variable pay varies according to performance or other conditions. Once given, a rise in base pay is permanent and no longer incentivises employees. A bonus needs to be re-earned and can act as both the carrot and the stick. Team and company-based bonus schemes may mean that individuals believe their contributions have little impact.

Case study: Severn Trent Water

Deciding that its reward practices were way past their sell-by date, Severn Trent Water looked to implement a new variable pay scheme linked to individual, team and company performance among its 5,000 employees. Having had one failed attempt at putting in a performance-related pay scheme, Severn Trent Water enlisted the help of the trade unions. Before finalising the new scheme, conducted a trial of the performance assessment system. After that, performance was linked to variable pay. The pay was based on the delivery of three key performance criteria: profitability, safety and attendance. Extra percentages were available depending on the level of profitability starting with a minimum of inflation if targets are missed. There was a reportable accidents threshold set whereby the reward would be reduced the more the threshold was exceeded. Finally, the company wanted to highlight the attendance record and make workers think twice about absenteeism. A 5% absence threshold was set for sickness. Again, where that was exceeded, the bonus would be reduced accordingly. As a result of the new system, individual contributions are rewarded, as well as team and company accomplishments. There was also a 25% improvement in safety and a 15% improvement in attendance. Finally, there was also a shift in culture and pay practices.