CIPD - Bonuses and cash incentives

Pay and reward

Revised May 2009

This factsheet gives introductory guidance. It:

defines and sets out the rationale for bonuses/cash incentives
describes different types of bonuses and incentives
examines the coverage, trends and levels of bonus payments among employers
looks at key issues in designing and managing schemes effectively
sets out a summary of legal aspects
includes the CIPD viewpoint.

It may be useful to read this factsheet in conjunction with our non-cash incentives factsheet.

Go to our factsheet on non-cash incentives

Definition

Bonuses and cash incentives are a form of variable pay based on the use of cash lump-sum payments – that is, they are not consolidated into basic pay – linked to individual, collective or organisational performance (or some combination of these factors). In the case of cash incentives, it is particularly likely that formal goals or targets may be set in advance. Bonuses and cash incentives differ from other forms of variable pay that are consolidated into basic pay, such as individual performance-related pay (also known as merit pay), in that they have to be re-earned. They may be used in place of, or in addition to, certain other aspects of remuneration.

Further information on alternative or complementary forms of variable pay can be found in our factsheets on relevant topics.

There are also a number of more specialised bonuses that are beyond the scope of this factsheet, such as the Christmas bonus, the attendance bonus and the retention bonus.

Distinguishing incentives from bonuses

Although the two terms are interlinked, and sometimes used interchangeably, it is important to draw a clear distinction between the concepts of incentives and bonuses.

Incentives aim to directly affect future employee behaviour or performance, usually via the setting of targets: if a specific target is met, the employee will receive a particular cash payment. They are therefore mandatory in the sense that there should be no question that they will pay out if the relevant targets are achieved.
Bonuses encompass a wider range of purposes and could be mandatory or discretionary (see also legal issues section below). Like incentives, they may be used in an attempt to directly influence employee performance or behaviour to meet pre-set objectives – but they could also be used on a more ad hoc or retrospective basis to reward past performance (for instance, if managers retrospectively decide to recognise an employee’s extra efforts on a particular task or project).

Background

Traditionally bonuses and cash based incentives were used to drive improved performance among manual workers – under such systems, employers would set production targets or piece rate measures and a bonus would be paid if these were achieved. In the case of ‘piecework’, incentive payments would be made according to time/productivity savings on each ‘piece’ of work completed. The use of these types of bonuses has diminished in line with widespread perceptions that such schemes are open to manipulation, tend to deteriorate over time and focus purely on the level of achievement (rather than quality).

Meanwhile, the increasing trend to incorporate bonus/incentive plans into wider managerial and non-manual packages during around the past decade has been driven in part by the influence of the ‘new pay’ philosophy – which advocates that ‘guaranteed’ basic pay should comprise only a relatively small element of the overall reward package – and shift towards strategic reward linking employee performance and pay to the wider business strategy.

In addition, there has been a move in certain sectors (such as financial services) towards market-based pay, whereby an employee might only receive a pay increase if the market rate for the role (for example, management accountant) had increased – in this scenario, individual contribution could be recognised via a bonus instead of a pay rise.

More information on market pay can be found in our factsheet on that topic.

Go to our factsheet on market pricing

Rationale

In common with many aspects of the pay and benefits package, the rationale for operating bonuses/cash incentives, when well-designed, includes:

increasing employee motivation
enhancing employee engagement
assisting recruitment and retention
improving business performance/profit levels.

But what can bonuses and incentives specifically set out to achieve compared with other forms of remuneration?

For the employer, the advantages of bonuses/cash incentives when compared to consolidated salary increases include:

ongoing motivation effect as bonuses have to be re-earned
lack of impact on employer pension contribution or other on-costs that are linked to basic salary levels
capacity for maintaining pay competitiveness without necessarily inflating the annual paybill
potential for greater alignment with the market
ability to differentiate – and hence deliver appropriate recognition – between employees who are performing highly and those who are performing less well
flexibility through, for example, the ability to set bonuses at higher levels during buoyant times but reduce or even halt payments during economic downturns
capacity for bonuses to be self-financing by say, helping to increase sales or boost productivity.

For the employee, the main benefits are:

greater control over own remuneration
higher payments are potentially possible.

But the downside for employees includes:

in effect, the flip side to certain advantages for the employer, for example, that non-consolidated payments must be re-earned and do not attract pensions or other contributions for the employee
payments may be unpredictable or lower than expected if targets cannot be met.

Problems can arise for both employer and employee when the use of bonuses fails to work as anticipated, particularly by encouraging inappropriate behaviours, as has occurred, for example, in certain cases involving the mis-selling of financial products. The prospect of achieving the incentive outcome may cause undue employee focus on manipulation of targets and recording mechanisms that becomes destructive.

Some schemes could also engender a sense of unfairness and cause employee disengagement. This could occur, for instance, if scheme designers make them overly complex to the extent that they lose the original objective of communicating to the employee what is important in the short-, medium- and long-term.

Hence there is a school of thought that considers monetary incentives detrimental to business by motivating adverse behaviours and creating unintended consequences, with certain quality initiatives and philosophies also militating against the use of incentives.

From the union perspective, finally, there may be a mixed bag of views, for example they might support the implementation of collective measures such as profit sharing or team bonuses but oppose the use of individual bonus plans.

Main types of bonuses and cash incentives

As a general rule, the payment of bonuses/cash incentives may be linked either to the quality and/or quantity of work, on an individual or collective basis, or to some measure of company performance such as profit levels (or both).

The main types of bonuses/cash incentives may be broadly divided into the following categories, although definitions vary and may overlap or be linked.

Individual-based. Under these schemes, payment of the bonus/incentive is determined by some measure of individual performance. An advantage of such schemes is that individuals should be able to directly influence their own bonus payments by attaining the desired performance levels, hence there should be a considerable incentivisation effect. Sales commission could be included within this category (although some definitions of bonuses would exclude this aspect, regarding it as a distinct form of remuneration in its own right). Individual bonuses might also be used in the situation where employees at the top of their pay scale would receive a non-consolidated bonus payment rather than a consolidated pay rise.
Schemes driven by business results. These schemes often use company profit levels as a measure to help determine bonuses, with other measures including company turnover, revenue, sales and cashflow. Under cash-based profit sharing, for example, the level of payout might be determined by means of a formula linking the levels of profit to individual payments across the workforce. While such payments may be too far removed from individual employees to have a direct incentivisation effect on employee behaviour, they are extremely useful to enable an ongoing communication about the business progress and requirements – hence engendering a sense of belonging and potentially assisting with recruitment and retention. Business results also tend to be a key indicator for executive schemes designed to incentivise or reward high-level executives.
Team-based. Such schemes link the bonus with some measure of team performance, often with the aim of fostering effective teamworking. More information on team-based pay can be found in our factsheet on that topic.
- Go to our factsheet on team reward
Ad hoc/project based. The bonus is associated with the completion of a particular project or ad hoc task. This arrangement might be used when a particular deadline is imperative, for example to reward construction workers for completing a building project on time – although some caution should be exercised with such schemes as they may be open to manipulation.
Department/site-based. A variation on the collective bonus theme, payments could be pitched to reward, for instance, production workers who attain productivity improvements in one particular plant in a manufacturing firm.
Gainsharing. An approach based on the idea that employees should be able to share in financial gains achieved through improved performance (particularly enhanced productivity).
Combination. Bonus or incentive payments can be based on a combination of two or more of the above programmes. One common combination is some measure of individual performance (possibly using the same performance appraisal ratings that determine consolidated merit pay rises) together with some measure of business performance (such as profit levels). Some schemes use revenue or profit to determine the bonus “pot” and individual performance to determine individual payment levels.

Coverage of bonuses

Cash-based bonus or incentive plans are operated by 70% of employers according to the CIPD reward management survey for 2009. However, the headline figure masks wide variations by sector, with the figures for employers operating bonus or incentive schemes standing at the following levels:

private sector services: 89%
manufacturing and production: 85%
public services sector: 33%
voluntary sector: 30%

Overall, the various types of bonus scheme are found in the following proportions among UK employers, according to the survey:

individual-based : 61%
schemes driven by business results: 56%
combination: 41%
team-based: 23%
ad hoc/project based: 14%
departmental/site-based: 14%
gainsharing: 3%

In general, as noted in our survey, the most popular arrangement is an individually based plan (such as commission or personal performance), followed by a plan driven by business results (such as revenue).

In the public sector, schemes linked to individual performance are the most common form of bonus plan. More detailed information on the issues surrounding the use of bonuses and other incentive pay in the public sector can be found in a 2007 study from the Office of Manpower Economics¹.

Employers often use more than one bonus scheme – covering different occupational groups for instance. The median number of cash-based bonus or incentive schemes overall stands at two per employer in our 2009 survey. Unsurprisingly, this varies by size, with the following figures recorded:

organisations with fewer than 50 employees: 1 scheme
workforce between 50-4,999 employees: 2 schemes
5,000 and more employees: 3 schemes.

See the full results of our 2009 reward management survey

Calculating bonus payments

Employers need to decide the means to be used for determining bonus payments, including whether to make use of a formula and how to express payments (for example as a percentage of salary or as a flat rate payment).

A formula is a commonly used method to link the achievement of targets to the size of the bonus. Under a combination scheme based on individual and company performance, for example, a formula might be used to set a level of payment associated with each of a range of performance appraisal ratings together with a separate element linked to profit levels.

According to a 2006 e-reward survey of bonus schemes in 86 organisations², the payment of bonuses as a percentage of salary is by far the most popular approach among employers, used in more than half (53%) of bonus plans. The other main methods, used in 19% of cases each, are differentiating payment by employees’ grade and paying an equal flat-rate payment.

Setting level of payments

If they are to impact on employee behaviour or performance, bonus or incentive payments need to be ‘worth having’ – that is, set at a sufficiently high level to have an effect. To put the percentage figures for levels of bonus payments (see below) in context, a week’s pay is around 2% of salary. The level of an incentive is important psychologically as, perversely, an inappropriate level of payment may draw attention to the limitations of the scheme and actually demotivate.

By contrast, caution needs to be taken in setting bonuses at very high levels to avoid driving undesired behaviours. Market practice may also need to be taken into account.

An important factor in the calculation of any bonus is that it is kept as simple as possible. Ideally participants should be able to measure progress against targets and carry out the calculation themselves so that they know how they are progressing and what payment level might be achieved.

Levels of bonus earnings

Our 2009 reward management survey includes a detailed examination of both target and maximum bonus/incentive potential broken down by sector and occupation.

Overall, the survey found target bonus/incentive payments standing at the following levels when expressed as a percentage of annual salary:

executives/board members: 35%
senior managers: 23%
middle/first-line management: 16%
technical/professional: 12%
clerical/manual: 8%

Meanwhile, respondents to the 2006 e-reward survey of bonuses were asked about the average levels of payments recorded during the most recent bonus award round, also expressed as a percentage of annual base pay, with the following findings:

senior managers: average payment worth 17.7% of annual base pay
managers and team leaders: 10.3%
professional, technical and administrative staff: 7.3%
manual workers: 5.6%

More detailed information tracking specific breakdowns of bonus payments over time (by gender, for instance) can be found in the government-sponsored Annual Survey of Hours and Earnings³.

Bonus payments represent a ‘major influence on earnings growth’ as measured by another government series, the Average Earnings Index, as highlighted in an article published by the Office for National Statistics⁴. The majority of large bonuses are generally paid in the period December to April each year, while an analysis by sector reveals that ‘nearly 60% of the total for that period is paid by the financial services sector’.

Designing and operating bonus schemes

When setting up or revising bonus plans, practitioners need to consider a number of key issues.

Selecting type of scheme

It is essential to consider specifically what the organisation is trying to achieve with its bonus scheme and select or design an appropriate scheme to meet those objectives. The greater the desired incentive impact on employee behaviour, the closer the link should be between the activities of the employee and the payment of the bonus – known as a close ‘line of sight’.

Tailoring bonus schemes

Whichever type of scheme is chosen, be it individual- or company-based or somewhere in between, it is essential to tailor the arrangements to the organisation’s own culture and requirements. A key message from Duncan Brown’s book examining the issue of bonus plans and incentives⁵ is that there is no ‘one-size-fits-all’ model.

Setting targets

Targets communicate the priorities of the organisation and as such should be regularly reviewed. While targets are often linked to financial measures, many organisations now design them additionally to reinforce behaviours and reflect company culture – although in all cases, bonuses should not be used as an alternative to good management. While some employers prefer to set multiple rather than single objectives to meet more complex organisational needs, there is an inherent danger in over-complicating plans to the extent that employees cannot understand how to achieve the desired end-result.

Determining frequency of payments

In respect of frequency, annual payments for management are typical and meet many practical needs (for example, the requirement to link with company profit reporting period), although in some circumstances they may be deemed too far-removed from targets to provide a clear and readily-achievable incentive to higher performance levels. For levels below management and especially in a sales environment the payments are likely to be more frequent, perhaps monthly or quarterly.

As detailed below, however, there is also a major debate about whether schemes should in some cases extend, rather than shorten, bonus periods, with the aim of encouraging a greater focus on long-term performance. Employers may also need to consider issues such as deferral periods, for example, employees on commission sometimes only attain the bonus when payment from a customer has been received rather than when the sale has been made.

Considering practical aspects of scheme

There is a need to consider the practical details of schemes such as the reliability and accuracy of performance measures and whether these are open to manipulation; the availability of information on progress against targets; the level of trust between the individual and the organisation that payments will be made; and the governance and administrative arrangements to measure results and make the payments.

‘Stress-testing’ the scheme

Scheme designers should aggressively test the design in an attempt to find weaknesses. This involves calculating many outcome scenarios and how a devious mind might exploit a scheme to personal advantage or, alternatively, how a scheme may have an unfortunate impact upon an employee leading to strife and discontent. The potential impact on each employee should be examined to ensure that the proverbial ‘own goal’ is not produced.

Relationship with annual consolidated pay rises

Employers need to decide where base pay should be set against market rates and whether or not any shortfall should be made up through non-consolidated cash incentives or bonus payments. More information on the links between bonus payments and basic salary increases can be found in our factsheet on the salary review process.

Go to our factsheet on the salary review process

Communicating with employees

The capacity for programmes to have an impact on behaviour demands clear communications about what employees have to do to achieve the bonus/incentive – as such arrangements will fail to achieve their objectives if employees do not understand how they work.

From employers’ point of view, the aim of an incentive scheme is to promote a ‘win-win’ situation and they should go out of their way to coach employees on how they can win. When the employee wins, a good scheme will ensure that the employer wins too.

For more on employee communication, see our factsheet on that topic.

Go to our factsheet on employee communication

CIPD members can find more detailed information on how to design and implement bonus plans in our guide.

Go to Bonuses and incentive plans: a development guide

Recent developments

In the wake of the global banking crisis and structural upheaval in the financial services sector, the use of bonuses has become a highly contentious issue with the whole nature and mode of operation of bonuses called into question – potentially leading to lasting changes in the use of bonuses in certain sectors at least.

‘Although it is hard to prove a direct causal link, there is widespread consensus that remuneration practices may have been a contributory factor to the market crisis’ acknowledges the Financial Services Authority in a consultation paper issued in March 2009⁶. Practices in investment banking in particular tended ‘to reward short term revenue and profit targets’ and, in so doing, ‘gave staff incentives to pursue unduly risky practices’.

Several analysts have predicted the emergence of a new culture surrounding the use of bonuses with lower bonus levels that are linked to longer-term, sustainable performance rather than short-term goals. Signs of early changes, particularly in respect of City bonuses, include instances of some firms choosing to defer bonus payments (or part of the payments) over, say, three years.
In essence, there continues to be a need for a clear link between high levels of performance and the payment of bonuses, but with a need to avoid the problems that may arise if a lack of rigour in the application of this principle means that bonuses are in practice rewarding less-than-robust performance.

Legal aspects

There are a number of legal aspects surrounding the use of bonuses and incentives, with employers needing to bear in mind the following issues in particular:

Whether bonuses take the form of a contractual entitlement or are purely discretionary. While plan rules and communications often state that the awarding of bonus payments are discretionary and non-contractual, care still needs to be taken as, if the plan is used for several years without substantial changes, it may be deemed part of ‘custom and practice’ and therefore effectively a contractual payment.
Application of the National Minimum Wage in respect of bonuses – more information can be found in our factsheet on the minimum wage
- Go to our factsheet on the National Minimum Wage
The need to avoid unlawful discrimination between groups who have and do not have access to bonuses (for example by ethnicity, gender or disability) as well as arrangements for people on maternity or other long-term leave and those who resign or are made redundant from the company.

Detailed information on the equality aspects of bonus payments can be found on the Equality and Human Rights Commission website (see Useful contacts below).

CIPD viewpoint

The use of bonuses and cash incentives, when carefully designed and tailored to align with an organisation’s own culture and needs, can help to create and sustain high performing workplaces. To be effective, bonus and incentive plans need to operate as part of an integrated reward strategy closely linked to business objectives including long-term goals and corporate governance standards. The success of such schemes will depend on how effectively performance is defined, managed and ascribed, requiring effective communication and engagement on the part of both employees and line managers.

Useful contacts

Equality and Human Rights Commission. Equal pay in practice - high risk grading and pay practices.

HM Revenue and Customs

References

PRENTICE, G., BURGESS, S. and PROPPER, C. (2007) Performance pay in the public sector: a review of the issues and evidence. London: Office of Manpower Economics. Available at: http://www.ome.uk.com
E-REWARD (2006) What is happening in bonus schemes today: part 2 – survey findings 2006. Available by subscription at http://www.e-reward.co.uk
OFFICE OF NATIONAL STATISTICS. Annual Survey of Hours and Earnings. Available at: http://www.statistics.gov.uk/statBase/product.asp?vlnk=13101
DUFF, H (2008) The effect of bonuses on earnings growth in 2008. Economic and Labour Market Review. Vol 2, No 10, October. pp30-32.
BROWN, D. (2002) Guide to bonus and incentive plans. Executive briefing. London: Chartered Institute of Personnel and Development.
FINANCIAL SERVICES AUTHORITY (2009) Reforming remuneration practices in financial services. London: FSA. Available at: http://www.fsa.gov.uk/pubs/cp/cp09_10.pdf

Bonuses and cash incentives