We don’t always test the future outcomes of our compensation programs as thoroughly as we should. When it comes to variable compensation we tend to be optimists. Through our rosy glasses somehow long-term incentive programs tend to have tough goals that will stretch the employees, but are completely attainable. I often tell my clients that every goal seems difficult up until the moment it is achieved. We always seem to be amazed when someone knocks a goal out of the park. On the flip side, when goals are not met, there is also surprise. It’s as if no one considered that failure was an option. I have seen these reactions with all types of compensation programs. Stock options often pay far more than expected or absolutely nothing at all. We express similar surprise in both cases. Short-term and long-term incentive programs often payout too soon, or at too high a level. Ironically, it is common that they pay far less than was expected. Regardless of the results, we are taken aback by these developments.
When I speak to companies who are pleased with their programs, they point out that they generally use four categories of projections. When I talk to companies with complaints about variable pay, they tend to project the potential value of compensation programs using only one or two categories.
The Four Horsemen of Successful Compensation Value Projection
Best-Case: We assume the best and construct the program as if the best will happen. Best-case scenarios are great, except when even better than best occurs. We often reduce our best-case models so we don’t look overly optimistic. We then discuss the lower number as if it all that can be achieved. Understanding the true high-end potential for a program may allow to you save money by incorporating caps on value or other limiting provisions.
Mathematical models: Don’t get me wrong. Math is great! (I have to say that, my brother teaches math). But, mathematical compensation models seldom create results that are later mimicked in real life. These models must be used to satisfy regulatory conditions or finance staff members, but we should not expect that they will result in reality.
Worst-Case: No one loves to imagine a worst-case, but they happen all the time. Understanding how your compensation program will react to a worst-case allows you to put contingency plans in place long before things fail. These projections may also allow you to create a type of “succession planning” for your compensation programs. If you see things going south, you can be prepared to overlay a new program to pick up the slack of the failed program.
Expected-Case: This is what we really think will happen. It’s funny that so many compensation professionals have a pretty good feel for what will really happen, but so few include these expectations in their planning or communication. When I have spoken to people about this, it seems like they feel expected case projections are a bit self-indulgent. Many trust their instincts, but lack either the confidence or willingness to speak out. Trust me, this is your place to shine! If you’re right you look like a genius. If you’re wrong, you are seldom worse off than when you started.
The next time you and your team of stakeholders sit down to create a new performance-based compensation program, take a ride with the four horsemen. You may be surprised how additional modeling can change how your compensation plans react to the ups and downs of the real world.