The boardroom battle over John Thain's 2008 bonus as CEO for Merrill Lynch is over. It will not be as lucrative as years past for the Thain family; the Board has awarded Mr. Thain and other top executives zero. The board deliberations over Thain's bonus are an unusually public manifestation of discussions held all over Corporate America this time of year over who gets how much?
These discussion are always heated and stressful for the organization. Teasing out the contribution individuals make to results is often impossible as many goals are team-based, depend on contributions made over a period different than the bonus year or depend on factors exogenous to the individual (e.g., market forces). Allocating bonuses has a further, emotional, complication because most individuals work hard and make every effort to contribute to their organization's success.
The annual bonus exercise does not need to be like this. What follows is a broad bonus "philosophy" that simplifies the process, removes much of the organizational angst and separates the pay discussion from the performance and coaching discussions.
Start with the notion that from an owner's perspective, it would be ideal if everybody's pay was 100% variable based on the organization's profitability. That is clearly not common practice as everyone needs some measure of predictability in compensation. Further, as you reach lower into the organization, the administrative costs of managing a bonus outweigh the financial and incentive benefits.
So begin with mid- to high-level jobs in the organization where you would put at least 10% to 20% of compensation at risk. Divide the target bonus into two categories. Base one portion of the target bonus on goals that meet three criteria:
the results of the goals are measurable;Call this the "Incentive Bonus". Call the remaining portion of the target bonus an "Allocated Bonus".
the results are likely to vary from year-to-year;
the impact of the individual on results is measurable.
For some jobs, like a sales job, the Incentive Bonus will be all or a very significant element of the total bonus. For other jobs, such as those at the senior level or many staff jobs it is difficult to come up with goals that meet the Incentive Bonus criteria.
By definition, the Incentive Bonus is easy to define upfront and explain to an employee when paid out.
For all goals that do not meet the definition of Incentive Bonus - the Allocated Bonus - pay out the bonus based on an an allocated share of corporate-wide, division or team results depending on the employee's job level.
While the allocation methodology could be based on broad definitions of individual performance it should primarily be allocated based merely on job level. After all, if the individual contribution could be accurately measured, it would probably fall into the Incentive Bonus category.
Their are several benefits to this approach:
employees know upfront what their bonus will be based on;So how would this apply to the Thain bonus? It would clearly fall in the category of being an Allocated Bonus. It is impossible to quantifiably separate his individual performance in the areas of leadership, decision making, ability to motivate a team from from market factors when it comes to how well Merrill Lynch does. If the board directed upfront that his bonus was to be based on results such as EPS, profit or ROA, he would be entitled to zero bonus. Not based on his performance, hard work, dedication, etc but merely based on results.
the process is more mechanical and less emotionally loaded;
a significant portion of senior-level compensation remains variable;
there is a greater separation between ongoing performance or effort and annual results.
