While most human resource professionals have eradicated the word “bonus” from their vocabularies in favor of “variable pay” or “at-risk pay”, popular culture still holds onto the term and sadly applies it liberally to many forms of variable pay, most of which share little in common with a true bonus.

Webster’s dictionary defines a bonus as “something in addition to what is expected or strictly due: such as money or an equivalent given in addition to an employee’s usual compensation.” Fifty years ago, most instances of variable pay probably met that definition as the bonus was offered without formal construct as a discretionary award designed by top management, but modern companies have realized that unexpectedly rewarding past performance has far less business value than motivating future performance with transparent potential to grow earnings.

Even companies move away from treating variable pay like bonuses, many have allow the name to persist causing employees to consciously or sub-consciously undervalue the reward and leading employers to fall short of receiving the impact they deserve.

Differentiating variable pay from bonuses

All reward elements impact employees in at least one of three ways:

  • Attracting candidates to become employees and join the company
  • Encouraging employees to stay with the company (retention)
  • Motivating employees to contribute at the highest possible level

Some rewards accomplish multiple objectives while others serve a single purpose. For example, a signing bonus attracts people to join a company but does not motivate or retain them once any clawback periods to expire. However, healthcare benefits, when significant, can both attract and retain employees, though the benefits generally have little impact on motivation.

A true bonus such as the discretionary “Christmas” bonus still referenced regularly in movies, is a reward instrument that has value in retaining people, but negligible value attracting candidates or motivating employees to perform at maximum potential. The inability to confidently assume granting of an award and even less clarity around how the amount of the award if granted make it difficult for employees to justify working harder and certainly offers no incremental attractiveness to potential candidates.

Contrast this traditional bonus with a typical variable pay reward element where the payout is guaranteed based on clearly defined performance target measured in in objective terms. The latter clearly has motivational value as an employee knows exactly what is required to increase his/her earnings. Furthermore, it also supports the attraction of candidates by providing a clear way to objectively value to the total offer.

Moving the mindset from variable pay to “at-risk” pay

Though designing rewards programs with transparent and predictable variable pay instruments instead of bonuses is a good start, it does not maximize the impact of variable pay expenditures for employers.

The difference between variable pay and at-risk pay is subtle, yet powerful. Variable pay compensates an individual based on predefined performance criteria. Generally, there is a range of potential payout (commissions are a different form of variable pay and need to be addressed differently) and an expectation for performance. Often employees neither expect to earn 0% nor 100% of their potential earnings and increase or decrease their level of effort to optimize their personal earning and effort required.

“At-risk” pay, in contrast, is presented as pay expected to be earned, but at risk of not being earned when underperforming. In other words, rather than thinking about earning more than 0% reflecting some degree of over-performance, earning less than 100% becomes a reflection of some level of underperformance.

Fundamentally, the earnings calculation need not change between a variable pay and an at-risk pay program, but the messaging to employees evolves. The performance indicators and earning potential can remain the same, but the change in philosophical approach has powerful impacts on human behavior.

Consider an employee earning a $100k salary with a 20% variable pay target. If historically people in this role earn 75% of the variable target, this individual would be logical to think of her expected earnings as $115k for the year. As she compares her current situation with other opportunities, this is the number she uses as a reference. Furthermore, at the end of the year she’s likely to be satisfied with her own performance earning anywhere between $115k and $120k.

If instead, this same employee working for a company that describes her remuneration as $120k expected earnings with $20k as at-risk pay distributed as a lump sum at the end of year based on performance, her mindset would be different. Though this company would not pay her any differently for her efforts, she is likely to use $120k as the reference in comparison to other offers and she’s likely to hold herself accountable to achieving all the $20k at-risk compensation as opposed to being satisfied with the status quo of $15k.

With no added compensation risk, the second company added both retention and motivation value to the compensation package simply by reframing the expectations.

As simple as this change is, companies should be wary of simply adjusting the framing of existing programs. Once an employee has established expectations for how a program works and how they value and pursue their remuneration, it is difficult to change that. However, employees do expect compensation programs to be updated from time to time and during a large-scale compensation program refresh, companies have a unique opportunity to reset the mindset of their employees from bonus to variable pay or variable pay to at-risk pay.

Choosing the right variable / at-risk pay program elements

Variable and at-risk pay elements come in a variety of constructions with different natural purposes and pros and cons for each. Before making decisions to include certain elements, companies much understand or develop their specific objectives and goals in the context of business needs and employee/candidate profiles. (More information on this can be found in the related reading suggestions.) There are a variety of different classification of variable / at-risk rewards which have different advantages and disadvantages.

Each unique combination of specific employee population, company culture, and business environment will combine to create a unique profile, but for simplicity a representation of the most common impact profile is reflected below.

Rewards based on individual performance are typically appealing to employees (at least the good ones who are feasible to motivate) because they want to directly control their earnings.

Objective-based performance measures are great for employees because they involve the least uncertainty, but that lack of uncertainty locks employers into paying for performance based on what the company expected at the time it sets objectives which may be different from what it ultimately needs as the year unfolds. Furthermore, employers run the risk that when faced with a trade-off between completing core tasks and tasks that contribute towards the variable or at-risk component, employees may take the less optimal option for the business because it is more lucrative for the employee.

On the opposite end of the spectrum, companies prefer to share success at a broader level with employees because it encourages employees to behave with the broader company objectives in mind. While this can foster a greater sense of teamwork through shared, aligned ambitions, it can also alienate or frustrate employees whose personal contributions exceed the relative success of the company.

Creating strategy for rewards programs

Often companies blend multiple variable and/or at-risk rewards into individual rewards programs. Off-setting the weaknesses of one reward type with another can work to send a message of seeking balanced, sensible behavior by employees or it can backfire by introducing too much complexity cause disengagement of the employee.

Effective program design begins with recognizing that no program will perfectly address all objectives and risks associated with business and individual performance. Companies can either aggressively drive the pursuit of upside or guard against the potential for downside but rarely drive both. Once decided, the clearest message that the company delivers to its employees about that strategy comes in the form of the rewards program it designs and implements.

Additional Reading Suggestions

White Paper: Creating Competitive Compensation

White Paper: Are Your Goodies Good Enough?