Home ›› 25 Feb 2022 ›› Opinion
In our experience supporting hundreds of transformation efforts, generous and specific financial incentives are one of the most effective tools available for executives to motivate employees. In fact, companies that implemented financial incentives tied directly to transformation outcomes achieved almost a fivefold increase in total shareholder returns (TSR) compared with companies without similar programmes.
Despite these clear benefits, our research found only two-thirds of companies adopts financial-incentives programmes when embarking upon a transformation. Reasons for resistance include an overemphasis on the total cost, concerns about the burden an incentives initiative might have on internal support functions, and a failure to grasp the advantages such a programmes can yield. Furthermore, the effectiveness of such efforts varies widely depending on the choices an organization makes when designing them. Organizations must carefully consider these choices to achieve their desired behavioural changes and outcomes.
Our research explores the impact of financial incentives in transformations and offers seven principles to help maximize their benefit for an organization.
While some executives might believe instituting financial incentives for performance on top of existing compensation is unnecessary, such programmes can be an excellent investment. For example, a one-off investment of $50 million in incentives can generate $1 billion in recurring value above business-as-usual performance. With common earnings before interest, taxes, depreciation, and amortization (EBITDA) multiples, the impact on market value can be eight to ten times the recurring value delivered. An executive who led her organization through a transformation described incentives as “one of the best investments we made as a company. We delivered one hundred times more than what we paid out. Because we distributed rewards only after the value was delivered, the programmes was completely self-funded.” A tier 1 auto supplier CEO who undertook a transformation said that while he was initially sceptical after six months of implementation, he concluded it was the critical ingredient in over- delivering on the company’s transformation goals.
The benefits of such incentives programmes are not just financial. As the war for talent intensifies and companies grapple with record numbers of resignations, the retention of high performers has increasingly become a top priority for executives. Compensation is a key reason why people switch jobs, and providing financial incentives can help organizations retain their top employees. These programmes can also increase accountability and the perceived fairness of differences in compensation.
Moreover, financial incentives, along with well-crafted programmes of nonfinancial incentives, can create a higher level of energy and excitement across the organization and boost the discretionary efforts of employees. One chief transformation officer summed up this dynamic well: “Winning is contagious. It becomes addictive, and people don’t just want to sit on the sidelines. When employees were seeing their friends get bonuses, you won’t believe the number of people who swung by my office and asked me how they could roll up their sleeves and play a role in the transformation.” Transformational impact requires transformational incentives. Therefore, payouts must be generous and focused on encouraging transformational performance rather than just good performance. One executive remarked to us, “Once the incentives programmes was launched, employees were finally getting recognized and rewarded for their direct contributions in improving the bottom line of the company. The bias to action, focus, and willingness to go after the full potential increased virtually overnight.”
Moreover, exceeding expectations should be encouraged. Transformation is about going after the full potential and not leaving value on the table. One structure that can support outperformance is an S-curve payout. To make this structure work, organizations need to carefully calibrate payouts and implement a rigorous review process for all initiatives.
Sustained transformational change requires the widespread involvement of employees across an organization. Recent McKinsey research found TSR increases as the share of employee involvement expands. This objective can be accomplished by mobilizing every employee to participate in the programmes—either by contributing to or owning an initiative. As an example, one company allocated a small part of the transformation-incentives pool to the employees supporting initiative owners as well as to the initiative owners themselves. This structure unleashed a groundswell of bottom-up idea generation as employees looked to challenge the status quo, understand best practices, and identify ways to improve performance.
Many transformation-incentives programmes focus solely on financial impact. This approach can make the programmes easier to implement, with employees receiving a percentage of the financial value they directly deliver. However, to transform an organization—to radically and fundamentally improve and sustain the overall level of performance—delivering financial impact is not enough. A holistic view on improved performance allows companies to open the aperture around the types of initiatives required to change the organization, including customer experience, organizational health,2 capabilities, and social and environmental impact.
At one company, the owners of the nonfinancial initiatives, such as a leadership-development programme for all employees and an effort to drastically reduce the organization’s carbon footprint, received the median amount of the payouts received by the owners of financial initiatives. At another company, these nonfinancial initiatives were divided into three buckets (high, medium, and low impact), and a fixed amount was assigned for the owners of these respective projects. And at a third company, a significant part of the incentives for the leaders of the transformation was linked to improvements in the Organizational Health Index (OHI), resulting in a strong focus on organizational health programmes. A fourth company tied the incentives to meeting certain environmental, social, and governance (ESG) standards and key performance indicators (KPIs). The common theme here is that the companies identified the specific behaviours and outcomes they wanted to see in their employees and tied incentives to those results.
While this more inclusive approach to initiatives might add more complexity to the financial-incentives programmes, our analysis shows that tracking nonfinancial impact to the programmes results in higher TSR than focusing on financial impact alone. Creating a clear link between action and incentive reinforces behaviour change. At one company, the executive in charge of the transformation said, “We paid out incentives every quarter. The speed of delivery and urgency was critical for us, with every day that initiatives could be delivered sooner directly resulting in better overall results for the business. Originally, we were going to pay these out at the end of each financial year. I’m happy we didn’t go with that option. If I could do it again, I would have made payments every month.” While the administrative burden might feel high, the size of the value at stake and the positive benefit from reinforcing the behaviour and building momentum can be substantial.
mckinsey.com
