Why you should separate goals and compensation

Or why you should abandon your bonus formula

By Felipe Castro, Partner at Lean Performance

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Let's say you have two employees on your team: Paul and Mary.

• Paul is smart, focused and delivers results. But he is driven by monetary rewards and is always trying to figure out how to make more money.
• Mary is also smart and focused but she is driven by her achievements. She believes that if she delivers, money will follow.

Now let's say that your organization uses a classic bonus formula, connecting goals with bonuses (simplified for this exercise):

Bonus paid = ƒ(% of goals achieved * salary grade)

This means that the size of your bonus is a function of your salary grade and the percentage of goals that you have achieved.

We say that in this case the compensation and goals are tightly coupled (or at least the engineer in me would say that).

Now let's imagine the following scenario:

• Paul achieved 110% of an easy goal, that he successfully reduced after several rounds of negotiation with his managers.
• Mary achieved 80% of an extremely hard goal, going way beyond anyone in the company thought was possible. A true stretch goal.

Who should receive the higher bonus? Mary, of course. But who gets the bigger bonus in this model? Paul.

This is a classic example of a perverse incentive. Our incentive system is, for all practical purposes, rewarding the inappropriate behavior.

We are all Paul and Mary

Everyone has a bit of Paul and Mary inside. Your incentive system should work for real people in real life. And even if you have team full of Marys, why would you have a system that incentivizes something you do not want to happen?

If you want to create a culture in which setting stretch goals is the norm, you should really think about dropping the tightly coupled (or formula-based) model for both bonuses and promotions.

What's the alternative?

The alternative is to adopt a system in which the achievement of goals is an input to the performance evaluation process, in which bonuses and promotions are defined.

In this model compensation and goals are loosely coupled.

Basically, the performance evaluation considers not only the percentage of the goals achieved but also the goals themselves: the difficulty and the impact on the business.

Think about it as the Difficulty Score in gymnastics: you get more points for performing routines that are more difficult.

OKRs and compensation

A cornerstone of the OKR framework is to separate compensation and goals.

As Andy Grove, Intel's former CEO, wrote about OKRs (then called MBOs) in his seminal book High Output Management:

It is not a legal document upon which to base a performance review, but should be just one input used to determine how well an individual is doing.

Rick Klau, from Google Ventures, wrote:

OKRs are not synonymous with employee evaluations. OKRs are about the company’s goals and how each employee contributes to those goals. Performance evaluations — which are entirely about evaluating how an employee performed in a given period — should be independent from their OKRs.

"But this is too subjective"

One of the common complains about this model is that it is "subjective" while the formula-based model is "objective".

The problem is that simply using a formula at the end of a process does not make it objective. People simply think it is objective because all they can see is a bit of math:

• Even the best companies in the world use, as least sometimes, spot bonuses or discretionary bonuses to compensate or complement the bonus policy. Both are 100% subjective.
• Calculating the bonus based on who has the best negotiating skills to reduce the goals is subjective.
• Project/resource allocation is subjective. Sometimes the organization needs somebody to turnaround a trouble project, which may hurt his/her bonus in the short run —which is usually compensated by spot bonuses.

And how about sales quotas?

Sales teams are different, since the result is easier to measure. You can attach compensation to a sales quota but you should avoid any model that rewards employees that negotiate a reduction in the quota.

(Did you enjoy reading? Please recommend ❤ or share this article, follow me on Twitter @meetfelipe, and check out more of my work. You can also visit my website: felipecastro.com)