WTW recently conducted a survey on incentive funding, allocation and design within the insurance industry. When it comes to allocating annual incentive funding, we often hear from our clients that the practice of individual differentiation is less than optimal, particularly for high performers. According to the survey, this issue tops the list of challenges related to annual incentive funding allocation (47% of participants).
A variety of factors contribute to why organizations struggle with delivering appropriate rewards for top performers:
While some annual incentive frameworks can avoid or limit the impact of the factors above (such as forced rating distributions or profit-sharing designs), they often come with their own set of issues and are minority practice among surveyed organizations. Most organizations in the survey (77%) allow some level of manager discretion in determining payouts for their direct reports.
In order to address these issues, we’ve seen organizations use a holdback feature — an annual incentive allocation approach that represents a portion of the funded pool. While the term is not consistently used at all organizations, 29% of survey respondents indicate that they use “a feature in the annual incentive design that reserves funds from the overall annual incentive pool, or is separately funded and may be used to address one or more organization priorities during allocation.”
For example, if the organization’s total bonus funding is 120% of target, the organization might hold back 5% of funding to distribute outside the “normal” allocation process. The organization would then manage to the 115% budget during the initial allocation.
The 5% holdback would be allocated separately or after — or both. Specific design characteristics vary between respondents, but the overarching intent of the holdback is to provide organizations the ability to reward top performers more appropriately.
When we asked organizations that use holdbacks about the efficacy of the feature, 83% responded that it is effective at addressing the lack of differentiation for high-performers, a tremendous success rate for any compensation tactic!
So, how do these features actually work in practice? Among organizations indicating they use a holdback feature:
If introducing a holdback feature to your annual incentive program, design choices will likely hinge on such factors as organizational structure, funding and allocation approach for the overall pool, culture and the level of transparency expected by employees.
It is hard to argue with the responses from organizations that have implemented holdbacks, which overwhelmingly indicated they provide a net benefit for performance differentiation. That said, the feature in and of itself is not a substitute for appropriate performance management and communication.
First, proper governance and controls are essential to ensure that pay outcomes are fair and aligned with intended objectives of the incentive program. Most organizations have developed robust processes to monitor and calibrate bonus payouts across their employee populations. While we understand that simplicity is part of the appeal to a holdback approach, it cannot come at the expense of unwarranted risk for the organization.
Another limitation of the holdback is that it does not solve the underlying problems associated with skewed ratings (including manager sophistication or poor calibration) and their correlation with salary and organizational level. Unless an organization is willing to incrementally fund outside the program (as a small minority of respondents to our survey are), they should not expect a math miracle!
Organizations should also be aware of the risk that, over time, leaders and managers start to rely on the holdback funds to reward their top performers, further reducing differentiation in the initial allocation.
Overall, the survey results indicate that many organizations using a holdback approach are doing so with a large degree of success. We do believe that for organizations struggling with differentiation, instituting a holdback could offer a reset for the allocation process. Organizations that use this reset to bolster their performance management process, manager training and communication may be able to address challenges around differentiation more permanently. Organizations that implement a holdback feature without making other necessary changes will likely find a temporary improvement at best.
Please reach out to us or your trusted WTW consultant if you are interested in further insights and perspectives.
