The foundation is clear communication of expectations.
Designing an effective incentive scheme is critical for driving performance and achieving organisational goals. Such a scheme should be thoughtfully crafted, combining behavioural science insights with practical, trackable, and meaningful reward systems. Here is how to build an effective incentive scheme based on best practices and principles.
The foundation of an effective incentive scheme is clear communication of expectations. Executives and employees need to understand what is expected of them and how their performance will be measured. If performance requirements and metrics are not clear, individuals will struggle to gauge what is required to earn rewards. According to Vroom’s (1964) expectancy theory, the intensity of work depends on the perception that effort will result in a desired outcome. Therefore, setting clear, understandable goals is crucial.
Goals must be realistic and within the control of the individuals tasked with achieving them.
Behavioural science suggests that setting unattainable goals can demotivate employees. If people believe that a target is out of reach, they are likely to disregard it altogether. McClelland’s (1961) research on achievement motivation highlights that people with a high need for achievement focus on goals that are challenging yet attainable within their capabilities.
Regular feedback is essential for maintaining motivation and focus. Frequent and relevant feedback can have a more significant impact than the value of the reward itself. This is because continuous feedback helps individuals understand their progress and make necessary adjustments. Therefore, it is important to implement mechanisms for tracking progress and providing timely updates, even if some metrics, like those related to long-term projects, take time to gather.
The rewards offered must be meaningful to the employees. What constitutes a meaningful reward can vary greatly among individuals and should consider their financial status and personal preferences. For executives, a sizeable portion of their base pay should be tied to performance incentives — typically at least 30% to ensure sufficient focus. The reward should be substantial enough to drive the desired behaviour but also realistic and attainable.
Incentive schemes should consider potential negative outcomes. If employees are incentivised purely on meeting targets without considering how those targets are met, they may engage in unethical behaviour. To combat this, incorporating malus or clawback provisions can be effective. These provisions allow companies to withhold or recover rewards if the performance was achieved through harmful practices. Additionally, using modifiers instead of strict measures can help adjust rewards based on the quality and riskiness of the performance.
Post design considerations
How do we go about evaluating existing incentive schemes? We should regularly evaluate existing incentive schemes to ensure they meet the desired criteria incorporated in building the incentive scheme including whether the incentive scheme clearly communicates expectations, sets achievable and influenceable goals, tracks progress and provides regular feedback, offers meaningful rewards, and accounts for and mitigates potential negative outcomes.
If the current scheme falls short in any of these areas, adjustments should be made. It is also essential to prepare to communicate and justify the scheme to external stakeholders who may not be as informed.
Best practices and fads
The concept of “best practice” in incentive design is often debated. While best practices can offer guidance, they can also be overly prescriptive and not suitable for every organisation. It is crucial to differentiate between practices that are genuinely effective and those that are merely fads. Best practices should address specific organisational needs, be adaptable to the company’s unique context and culture, and be based on empirical evidence and proven to enhance long-term value creation.
Boards should avoid blindly following best practices without considering their applicability and effectiveness for their specific situation.
It is important to critically assess whether a governance practice is a passing trend or an enduring, effective strategy.
Building an effective incentive scheme requires a balanced approach that incorporates behavioural science principles, clear communication, realistic goal setting, regular feedback, meaningful rewards, and safeguards against negative outcomes. By continually evaluating and adjusting the scheme, organisations can ensure it remains effective and aligned with their strategic goals. Furthermore, while best practices can offer valuable insights, they should be applied judiciously, tailored to the organisation’s specific needs and context, and supported by empirical evidence. This thoughtful and strategic approach to incentive design can drive performance, enhance motivation, and contribute to the organisation’s success.