If well designed, an incentive bonus plan can be an effective component of an organization’s overall compensation program. Many nonprofits avoid incentive plans, either because their mission makes individual performance measurement difficult or in the belief that bonuses aren’t appropriate in a nonprofit setting.
Nevertheless, where incentives are appropriate they can:
- Tie compensation expenses to financial results.
- Enhance the competitiveness of your compensation program without increasing fixed costs.
- Provide a stronger relationship between compensation and performance.
- Focus executives on specific board-approved goals.
The last point above is important. With rare exceptions, employees in nonprofits with incentive plans don’t work harder than they would if their cash compensation were all in the form of base salary. Nonprofit executives are mission driven, and if money were their primary motivation they would be working in the private sector. However, well-designed incentives can focus employees’ energies on specific goals and objectives, thus strengthening the organization’s alignment and performance.
Based on our experience with hundreds of nonprofit incentive plans, the following comments outline our thoughts on incentive plan design.
Our bias is that incentive plans are most effective when designed for the senior management group, or specific groups of employees (such as fundraisers). While there have been some notable and successful exceptions to this, the incentive value of bonus payments to employees below the management level tends to fall off rapidly after the first year or two of the program. The reason: in any sizeable organization, each manager has a stronger impact on the organization’s results than any rank and file employee.
Thus, in years when overall performance generates good bonuses, everyone is happy. But in years when either a bad economy or bad decisions by the management or the board result in no or low bonus payments, rank and file employees, who may have been working just as hard as they did in good years, feel cheated, and the program falls out of favor.
Another reason for limiting bonus participation to higher-level employees is that they are likely to have more discretionary spendable income than other employees, enabling them to experience ups and downs in their total cash compensation (salary and bonus) without undue financial stress.
Is it unfair to limit bonus participation to upper management? Not if your overall compensation strategy is equitable. For example, let’s assume your target is to pay median cash compensation in years of good performance for all employees. You might target upper management salaries below the median, with incentive opportunity that brings their cash compensation to the median in good years, and target base salaries for all other employees at the median. This way, the target cash compensation for all employees is the same (relative to the market median), although in different form for different levels of employee.
How Large Should Bonuses Be?
As a general rule of thumb, target incentive bonuses should be at least 5% of base pay – targets less than 5% aren’t large enough to provide a meaningful incentive.
In our experience, target bonuses for nonprofit chief executives are generally in the neighborhood of 20% to 30% of base pay; targets for executives reporting to the CEO are typically from 10% to 15% of pay. These figures assume that the target is what the organization intends to pay in a good year (when goals are successfully met) and that actual payments will be greater or less, depending on performance. Thus, the target incentive percentage is not the maximum incentive payable.
That said, it is advisable to set a maximum limit – often 150% and sometimes as much as 200% of the target incentive – to clarify expectations for the board and the executives involved, and to avoid excessive payments such as might occur in the event of a financial windfall totally beyond management’s control.
Incentive Plan Performance Goals
Here are our thoughts for setting effective incentive plan goals:
- Do not rely on a fully formulaic approach. Measuring an organization’s effectiveness over a year is always difficult, especially so in the nonprofit world. Incentive goals should be combination of goals that can be measured by clear metrics (such as growth in membership or completion of a project on a certain date), and less measurable goals (such as improvement in board-management relationships or influencing significant legislation).
- Set from four to seven goals that will be used to fund the bonus pool (the amount that will be paid in relation to total target bonuses). These goals should relate to the strategic plan, represent significant accomplishments, and include both operational and mission based goals. At least one of these goals should be financial (such as achieving a specific operating margin).
- When the goals are drafted, ask yourself whether each of these goals is truly important in terms of what the organization needs to accomplish in the coming year, and whether any important objectives are missing.
In our experience, the worst incentive plans we have seen are ones that tied all payments to specific numerical formulas, without the ability of the board to adjust payments based on unforeseen conditions. The programs we design contain special adjusting provisions that:
- Allow the board to adjust the size of the bonus pool (or eliminate bonus payments entirely) if factors not included when the plan’s goals were adopted require such an adjustment. For example, this would allow cancellation of bonuses in a year when most goals were met but when a severe publicity problem threatened the future of the organization.
- Include a financial threshold that must be met for any bonuses to be paid. This might be a requirement that the operating margin be a certain percentage of revenues, or that operating reserves not fall below a specific percentage of the annual budget.
- Allow the board to adjust the bonus pool up or down on a discretionary basis to reflect qualitative factors knowable only at the end of year, not when the goals were set. For example, if achieving key goals turned out to be much more difficult than anyone expected, the board might want to increase the formula-calculated bonus pool. Or, if a revenue growth goal was met only through a totally unexpected windfall, the board might decrease the pool.
Obviously, these discretionary adjustments should be used carefully, only in unusual circumstances, and with open and clear communication with management. But they can be a great help in keeping the bonus program effective and fair.
Frequency of Payments
Incentive bonuses are almost always are paid annually, usually shortly after the end of the organization’s fiscal year. Shorter payment cycles do not provide enough time for major objectives to be achieved, and it is very difficult to set good performance goals two or three years in advance.
Some effective incentive plans defer a portion of the payment for from two to five years, funding the future payments through a 457(f) plan, thus combining the benefits of a performance-based incentive bonus with a retention plan. This can be an effective approach, but given that a portion of the bonus is delayed and at risk, you need to be careful to insure that the target incentive amount and the portion paid in cash, combined with base salary, are competitive in the marketplace.
For more information on incentive plans, please contact us at firstname.lastname@example.org.