Options for Variable Compensation

Table of Contents

1 Overview
1.1 Introduction
1.2 Compensation Components

2 Drivers of Employee Motivation
2.1 Why Stimulating Labour by Motivation
2.2 Behavioural Theories
2.2.1 Maslov’s Hierarchy of Needs
2.2.2 Herzberg’s Hygiene-Motivator Theory
2.2.3 Adam’s Equity Theory
2.3 Application of the Models

3 Variable Compensation
3.1 Overview of Variable Compensation Options
3.2 Principles of a Successful Compensation Plan
3.2.1 How to Build a Prosperous Compensation System
3.2.2 Aligning with Organisational Objectives and Strategies.
3.2.3 Clear Communication and Appropriate Messages
3.2.4 Linking Pay to Performance
3.2.5 Creating a Performance Culture
3.2.6 Creating an Efficient Compensation System
3.2.7 Successful Performance Rewarding
3.3 Critique on Variable Compensation Plans
3.3.1 The Range of This Critique
3.3.2 Variable Pay Does Not Always Benefit
3.3.3 A Question of Common Justice
3.3.4 The Horizon in Human Behaviour

4 Practical example: Variable Components in the Executive Compensation of the TUI AG
4.1 Company Profile of TUI Group
4.2 Compensation Components of the Supervisory Board
4.3 Compensation Components of the Executive Board
4.4 Principles of the Executive Compensation System

5 Conclusion

Appendix 1 Article 18 Charter of TUI AG

Appendix 2 Integral Total Management (ITM) Checklist

Bibliography

List of Abbreviations

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List of Figures

Figure 1: Compensation components

Figure 2: Examples for benefits

Figure 3: Detailed overview of the compensation components

Figure 4: Variable compensation options

Figure 5: TUI Group Financial year 2006

Figure 6: Remuneration of the Supervisory Board

Figure 7: Remuneration of individual Supervisory Board members for 2006

Figure 8: Development of the number of phantom shares

Figure 9: Value changes of the phantom stock portfolio of the Executive Board members

Figure 10: Compensation of individual Executive Board members

Figure 11: Pension entitlements/transfers to pension provisions or funds

Figure 12: Overview of the compensation structure of TUI’s Supervisory Board

Figure 13: Overview of the compensation structure of TUI’s Executive Board

1 Overview

1.1 Introduction

To meet business challenges today and tomorrow, companies must maximise the potential of their workforce while increasing efficiency. In a highly competitive business environment, companies can differentiate themselves through their employees. Employees understanding the business carry out operations, mitigate risk, and build strong brands. Today, there is much more concentration and focus on the strategic outcomes of human resource activity than ever before. The area of compensation is no exception. Compensation can be used to recruit and retain qualified employees, to increase or maintain morale/satisfaction, reward and encourage peak performance, achieve internal and external equity, reduce turnover and encourage company loyalty.

As a result, pay-for-performance systems using variable pay components are becoming more and more popular to reward for exceptional job performance. There is far more interest in more closely linking the reward mechanisms to the achievement of corporate objectives. Performance pay as one component in the total employee compensation can be assessed based on individual or team contribution, on business unit results or a corporate profit or share price. It can be rewarded through traditional salary adjustments but also through variable pay techniques such as lump-sum bonuses or stock options.

There are no standard schemes or rules on how and to what volume a company should integrate variable pay into its total compensation systems. It not only depends on what the company focuses on but also on the company’s employees, their attitude to work and to the company as a whole. But employers should have in mind that a compensation plan that fails to motivate employees can stagnate a company as fast as any other factor.

1.2 Compensation Components

Compensation can be defined as reward package that employees are given in exchange for their job performance.¹ A reward package consists of two main components - direct and indirect compensation - that can be further subdivided. The following figure underlines that the paycheck is only part of the compensation, although most employees only think of their paycheck as their compensation:

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Figure 1: Compensation components

Direct compensation in general is the money paid for the employee’s work. It can be subdivided into base pay and incentive pay. Base pay comprises wages and salary. Wages are hourly rates, that means employees are paid based on the amount of time they work. Salaries are compensations based on an annual or monthly basis, that means the actual time worked on the job is not a pay determinant.² Professionals and managers are traditionally paid salaries. Both – wages and salary - are paid without consideration of the degree of job performance. Incentive pay is the variable compensation component that is paid as bonus on an individual basis according to the level of job performance.

Indirect compensation is the benefits proportion that is offered not only to individuals but to all employees.³ Benefits are used to attract employees and improve the satisfaction level of the work force.⁴ They have to be divided into two parts: Benefits required by law and voluntary benefits. Benefits required by law are fixed by a country’s government and have to be paid by the employer. The volume of such benefits differs from country to country. In contrast, voluntary benefits are offered voluntary to the employees to attract, motivate and retrain employees. The volume of voluntary benefits differs from company to company. The following figure gives an overview of the most common benefits. For demonstration purposes, the difference of benefits required by law is showed with the help of Germany and USA:

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Figure 2: Examples for benefits

As a result, compensation is the sum of all the financial rewards and benefits provided by the company in exchange for the employee’s contribution.⁵ It can include cash and non-cash rewards such as base pay, health insurance, childcare allowance, superannuation contributions and bonus payments:

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Figure 3: Detailed overview of the compensation components

According to Patricia Buhler “an effective compensation plan ensures that employees are rewarded appropriately for their contributions to an organisation.”⁶ As a result, morale and job satisfaction are affected by compensation. Often there is a balance (equity) that must be reached between the monetary value the employer is willing to pay and the sentiments of worth felt be the employee.⁷ Compensation might impact employer’s ability to attract, motivate, and retain employees. It can ensure optimal levels of employee performance in meeting organisation’s strategic objectives.

2 Drivers of Employee Motivation

2.1 Why Stimulating Labour by Motivation

Why should a responsible manager motivate his subordinates? Indeed, the understanding of motivation as a key to stimulate employees’ performance up to their potential, is not very old. In larger industries, especially in Europe, workers unions have a long tradition in enforcing equal terms for equal work. And respectively for a long time, psychological pressure was thought to be the most effective stimulus.

However, Le Chatelier’s Law of Resistance⁸ can also be applied to working performance, meaning too much pressure causes too much resistance, thus the power needed to do a job will lower as part of it is necessary to withstand the pressure. Hence, it appears more rewarding to pull than to push, to motivate than to press. Despite the fact that in some situations some additional pressure might well be applicable.

But what motivates an employee to release all his or her potential for work? It takes a closer look into Behavioural Science to answer.

2.2 Behavioural Theories

If you want to explain how and why a human being reacts in a specific situation, you will have to take the complexity of human psyche into account. Any explanation will be only a simplified and abstract model on what really moves people to do one thing or another. Though, these models provide useful insight that can be applied to motivate co-workers doing their job.

Buhler lists six theories which all have one aspect in common: human beings react in response to their needs, and human needs are both complex and structured. She refers to Maslov’s hierarchy of needs, Herzberg’s two-factor- model, McClellands theory of learned needs, the equity theory of John Stacey Adams, as well as Vroom’s expectancy theory, and the reinforcement theory described e.g. by Keller and Skinner.⁹

She does not fail to underline, that these theoretical models do not explain every observed behaviour, but as balanced mix, they can help finding appropriate explanations and respective stimuli. As for variable compensation schemes, the theories of Maslov, Herzberg and Adams are most interesting.

2.2.1 Maslov’s Hierarchy of Needs

This is the most famous, and most cited theory. Maslov creates a pyramid of five basic needs that will come up one after the one before is satisfied. These five needs are, in order from basic to elaborated:¹⁰

1. Physiological needs (such as air to breath, food, water, i.e. the basic survival)
2. Safety needs (the possibility to feel save and relax)
3. Affiliation needs (be in company with others)
4. Esteem needs (get respect and recognition from outside)
5. Self-actualisation (develop oneself, inner progression)

Buhler suspects that an employee will only develop his full potential once he has the chance for the fifth level, meaning people who try to develop engage all their inner possibilities. On top, one can move this hierarchy up and downwards, thus any compensation system or plan should consider in which situation the respective employee is in, and what are his most relevant needs he wants to be satisfied.¹¹

2.2.2 Herzberg’s Hygiene-Motivator Theory

Herzberg’s theory points to the fact that not every stimulus will be motivating the individual under any circumstances. He bases on the fact, that an ongoing stimulus is switched out from conscious recognition, and that only its sudden missing will be recognised. For positive factors, which presence is being taken for granted, their absence therefore can be de-motivating. Such factors are called “hygiene” whereas factors that directly stimulate towards a certain action are called “motivator”.¹²

After almost 50 years, the question, whether money as compensation is a “motivator” or a “hygiene”, is still being discussed. The fact that ongoing stimuli become something granted and therefore hygiene is also important as the fact that extra money which is not permanently granted in certain amount, can be motivating.

2.2.3 Adam’s Equity Theory

To our understanding, this should be more understood as “equilibrium” theory as it describes the felt equilibrium between two people as in terms of compared input and output. John S. Adams goes far further than that¹³, but as for compensation, an employer or his HR manager should make sure that he or she applies the same measures to all employees, and that differentiations between two people doing similar things are well understood. Also, if one offers a certain extra as a motivator, it needs to be available to everyone at the same level.

The basic idea in the relation between employer and employee is that a common understanding is found, which inputs (work results) are required for which output (salary). This balanced equity in both dimensions is important for social peace within the workforce as well as setting free the working potential of the employees.

2.3 Application of the Models

The idea is that the atmosphere in a company and especially at the work place needs to be motivating for the respective employees to unleash their full potential and contribute as much as possible. At best, to even develop more potential. For motivation, not only money is important, but also other compensation which reflects the specific needs and situation of an employee, as well as current results and potential development.

In any case, safety needs i.e. a safe position, and a communicative relation to superiors as well as colleagues with the potential to reward desired output and engagement needs to be reflected. As Buhler points out, the individual employee might be best motivated by a mix of “creative compensation” including free access to social events, free family services and additional securities.

3 Variable Compensation

3.1 Overview of Variable Compensation Options

Everyone who performs the same job is not necessarily paid the same amount. Variable compensation means performance-based pay, or incentive pay, that is designed to reward specific employee performances.¹⁴ Pay-for- performance systems tie compensation to performance that means employees who perform at higher levels (regardless of time on the job) receive greater compensation than their poorer performing counterparts.¹⁵ The pay differentials reflect performance differences. The better the performer is, the greater the rewards (pay).

Pay for performance can be used for individuals, groups or the company’s employees as a whole. The emergence of performance-based pay programs reflects a development away from entitlement pay where pay increases are based on seniority. Pay for performance does not consider seniority. Variable compensation systems tie to more closely link the reward mechanisms to the achievement of corporate objectives. Motivation for superior performance by setting incentives is the goal.

Very often, performance-based pay is an additional component to the fix base pay and could increase an employee’s compensation. There are only a few companies that solely pay on the basis of variable compensation: Some insurance companies for example only reward their employees according to the number of insurances they sold without paying any fix base pay. There are many types of performance-based pay that measure individual, group or organisational performance. The most common one variable compensation components are stated in the following:

Pay-for-performance systems at individual and/or group level can include the following variable components:

- Commission/Piece Rate Pay
- Merit Pay
- Year End Bonus
- Skill-Based Pay
- Competency-Based Pay
- Gain-Sharing Plans
- Profit-Sharing Plan
- Employee Stock Ownership Plans (ESOP)
- Employee Stock Options
- Employee Stock Purchase Plan (ESPP)

Commissions / piece rate pay use objective measures of performance on an individual level. For example, the number of pieces a worker produces determines his or her compensation.¹⁶ Salespeople would be paid a commission per item sold. Commissions and piece rate pay are examples of variable compensation without any fix base pay. Main advantages of this pay are increased productivity and reduced labour costs as there is no base pay. From the employee’s perspective it is necessary to define what will happen if he or she is not able to work, e.g. in case of illness. Here, the employer could pay a certain base pay. As not any employee is selling or producing a product, this kind of variable pay is not applicable to all types of positions.

Merit pay gives increases to the base pay contingent on performance appraisals and is paid on an individual basis. If an employee is awarded an increase in merit pay one year due to a high rating on a performance appraisal, he or she will receive the same amount the next year even if the performance rating is not high because the change was in base pay.¹⁷ The main disadvantage is the employees in these programs may be awarded year after year base on one year’s performance. This is the reason why merit pay is not that often used as pay-for-performance.

Year end bonuses that are often also called lump-sum bonuses have been used in place of merit pay. Instead of increasing employees’ base pay year after year, lump-sum bonuses award employees with an end of the year bonus that is not added onto their base pay.¹⁸ Year-end bonuses can be granted on an individual or group performance. The main advantage is that employees must perform well every year to receive valuable bonuses.

Skill-based pay ties pay to the number of job-relevant skills an employee masters, regardless whether these skills are actually used in the current job.¹⁹ An advantage is that skill-based pay can help create a multi-skilled workforce with increased flexibility and improved job satisfaction. A main disadvantage is that this kind of pay can cause increase labor, training and administration costs. Labor costs increase as the base pay rate is higher than in a non- skilled-base pay practice. An increase in training costs results from the increased need for development and from the fact that production is lower due to employees in training. The work required to record skills, track skills and pay for skills leads to an increase in administration costs.²⁰ Due to its nature, skill-based pay is granted on an individual basis.

Competency-based pay is based on more general skills than skill-based pay but also awarded on an individual basis.²¹ A set of core competencies are defined as key areas where competence is required to ensure the success of the company.²² Individual competencies are based on the core competencies and state the necessary characteristics needed to be successful in the given job. Some theories think that competencies should be general personal traits whereas others think that competencies should be specific skills or behaviours.²³

[...]

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¹ cf. Buhler (2002), p. 220.

² ibid.

³ ibid.

⁴ cf. Buhler (2002), p. 232.

⁵ ibid., p. 226.

⁶ Buhler (2002), p. 16.

⁷ cf. www.hr-guide.com, 02.11.2007.

⁸ Le Chatelier formulated a principle in physical chemistry, that a closed system being put under pressure will immediately generate a force working opposite to encountered pressure, called resistance. It describes mainly, why a certain amount of force will not succeed in the system to react with the same strength, and that with each additional increment of pressure, the system will incrementally less react, until pressure and resistance come to a balance, and the system to a complete stop. This principle was published in 1888 and belongs to basic set of technical or natural laws.

⁹ cf.Buhler (2002), p. 189 ff.

¹⁰ cf. Maslov (1943), 370-396.

¹¹ cf. Buhler (2002), p. 191.

¹² cf. Herzberg, (1959).

¹³ This theory is more complex and has definitely more implications.; cf. Adams (1965), p. 267-300.

¹⁴ cf. www.cpt.fsu.edu, 04.11.2007.

¹⁵ cf. Buhler (2002), p. 222.

¹⁶ cf. www.cpt.fsu.edu, 04.11.2007.

¹⁷ ibid.

¹⁸ cf. www.cpt.fsu.edu, 04.11.2007.

¹⁹ cf. Buhler (2002), p. 222.

²⁰ cf. www.cpt.fsu.edu, 04.11.2007.

²¹ ibid.

²² ibid.

²³ ibid.