Chapter Corner

Get Your Compensation Systems in Good Order for the Market Upswing

Posted in: Features, August 2014

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Is it easy in your market to recruit and retain top estimators, project managers, and superintendents? Have you been surprised by the recent turnover of a high-potential employee? Many of your peers have. Just a year or two ago, FMI was hearing from clients that there was plenty of available talent on the street because of downsizing during the recession.

Now those same clients are reporting difficulty finding qualified candidates for open jobs, multiple competing job offers when they do find them, salary compression (having to offer new hires salaries at or above tenured employees), and a large group of baby boomers ready to retire without obvious replacements. Now is the time to get your compensation and performance management systems in line with the new normal of higher competition for talent, worries about retention, and experienced managers aging out of the workforce.

The "New" Best Practice Approach

The process seems simple to describe in a few bullet points, but, in practice, it requires a hard look at how you do things on the “support side of the house.” The overhead-cutting approach that got you through the Great Recession is simply not an effective method to address the upswing that seems to have arrived in most markets. In many cases, companies have not looked seriously at their compensation or HR systems since the Great Recession. Now that things are turning around, they are surprised that they are having a hard time attracting talent, or they have lost one or more high-potential employees for which the company had big plans.

At the very least, a company should migrate to known best practices in the following systems:

  • Establish a compensation philosophy for your company and share it with your people.

  • Benchmark base compensation levels to objective, external market data.

  • Benchmark short-term incentives (annual bonuses) to the same objective, external market data.

  • Offer an incentive (bonus) system with clear structure, including measurable goals where the employee understands what the incentive opportunity is and how he or she can “move his or her number” based on predefined behaviors and outcomes.

  • Offer long-term incentives in senior positions that are vested over the course of a few years to create “golden handcuffs” that will retain key management talent when it would be disruptive to the business to lose them.

Establish a Compensation Philosophy

Let’s define a compensation philosophy first. For our purposes, it is the mix of base salary and bonus that a company offers versus what is available for a given title in the labor market. For example, consider a company that has a compensation philosophy that states, “We pay less than market base salaries, but pay more than market incentive compensation in order to deliver an overall compensation package that is market competitive or better.” Another common philosophy is, “We pay our employees more than market base salaries because we want to attract top talent, but in order to stay market competitive with our labor costs, this means fairly low bonuses.” Finally, a common, but often unstated, philosophy could be described as, “We play it safe. We try to pay as close to average as possible on both base and bonus; that way we rarely lose a person over compensation.”

Many companies in the construction industry have never formally articulated a compensation philosophy, but even if they have not stated one, there is a “phantom” compensation philosophy that exists based on their historic practices. The trouble comes when actual practices do not match up with the company’s self-image, or when the company leadership believes they are following one philosophy, while the rank and file believes something much different. This occurs often when managers have been with the company so long that they are disconnected from the realities of the external labor market and start to believe that everyone’s compensation is just as fair as they believe their own is. You can be sure that younger employees, who are closer to the experience of changing jobs, have a clear idea of their value and how (or if) the company is rewarding them appropriately. In this situation, employees begin to gripe that they work for a “cheap” company and talk about management being disconnected from the reality of being an employee, which can result in problems with morale.

The next logical question when discussing compensation philosophy is, “Which one is best?” Each approach has pros and cons. The answer really depends on the culture of your company and the kind of environment you are trying to build. FMI has worked with companies that effectively execute on any of the named philosophies. The low-base pay, high-incentives approach works best for companies that have (or want) a culture that strongly rewards top performers and is willing to pay for it by accepting low-incentive payments to role players. The high-base, low-incentive approach favors a culture focused on collaboration and making the most people happy, but role players may get a bit lazy and entitled, and top performers may feel like they are not getting the recognition they deserve. One longtime FMI client that uses this approach complained, “I have great morale, but during hunting season, I can fire a cannon in the office, and no one is there to hear it. My guys are just not motivated to do more than expected.”

One thing an astute reader will notice is that all of the compensation philosophies assume a company knows where it is relative to the market value of the jobs it has at the company. If you do not benchmark this and really know (rather than guess) what your compensation package looks like relative to your competitors’ packages, then your compensation philosophy will always be a guess and subject to drift. This brings us to the subject of benchmarking.

Benchmark Your Base Compensation Levels

In FMI’s recent survey of compensation practices in the industry, we discovered that the vast majority of companies do not use objective labor market data. Even though many managers know this data is available and know that they run a risk of over or underpaying employees by not using it, they still wing it. The excuses for this are numerous. We hear things like, “I know my markets” or “I polled three of my competitors over golf last weekend, and they say this pay package looks okay,” or “I call around and see what my contract recruiting firms are paying.” Yet these same companies complain they cannot recruit top talent, they lost an employee that they were optimistic about or that they cannot understand how competitors can bid work so cheap “when their labor costs must be about the same as mine.”

There are layers of risk to a construction business that result from paying base salaries that are too high or too low. The consequences of paying too high should be obvious in a competitive industry like construction. Letting fixed labor costs get even a little bit above market norms can have a devastating effect on the ability to win work. Think back on a few projects you lost when you were second-low on the bid list. If there were less than a few percentage points in labor cost between your company and the winner, and you had not benchmarked your pay in recent memory, then your potential over-market pay may have cost you that job.

On the other hand, underpaying your people has a less obvious, but more insidious, effect on your business. First off, if you do not pay market salaries, you will not be able to attract top talent. Many companies rationalize low base pay by observing, “We are able to fill open positions, even with a low pay scale.” Nevertheless, it is often those same companies that have problems with performance management and productivity. Their low base pay has resulted in attracting only the employees who are not good enough to be hired at a competitor that does pay market- level compensation. Therefore, they get the candidates that are left over. If the company is able to attract a few quality hires, despite the low base salary environment, then it runs the risk of becoming a training ground. A smart competitor that pays attention to compensation would let your company hire and train a few key professionals, and once they are ready for more demanding assignments, have a recruiting firm steal your people by offering them market- competitive pay. Note that they do not even need to overpay to do this, because you pay below market! This again leaves you with the less talented employees from the group you have hired. This just adds to an already difficult situation, the turnover cost of hiring, and training replacements for those who are poached away.

Some companies do make a smart, strategic decision to offset low base salaries with higher incentive pay as part of their compensation philosophy, but that only works if they know what market pay really is by benchmarking it to external data and adjusting their pay-mix from there. Otherwise, that is just an excuse a company uses to cover up a lack of knowledge about the competitiveness of its compensation and thus the lack of competitiveness in its labor cost structure.

Benchmarking Short-Term Incentives

A company should benchmark annual incentive pay externally for many of the same reasons it should benchmark base salary levels to external data. Notice we did not use the term “bonuses.” While many people use the term bonus and incentive interchangeably, FMI strongly believes that incentives connect the payment in the employees mind to desirable behaviors and outcomes. Bonuses are more of a thank-you in a good year (but more on that later).

When you look at the various available sources of data for base salaries, the information is usually in a format where a particular job description has a 25th percentile, a midpoint (or 50th percentile), and a 75th percentile. The market pay for that job description “lives” between the 25th and 75th percentile. The midpoint is the mathematical median, but if your pay falls between the 25th and 75th percentile, it can be said to fall within the market. If you pay below the 25th percentile, you risk turnover of existing employees and difficulty in filling open positions. If you pay above the 75th percentile, you risk having an uncompetitive cost structure and the opportunity cost of not having those dollars to invest elsewhere in the business.

How does this connect to benchmarking annual incentives? Most compensation datasets provide average annual incentives as a percentage of median base salary. This information guides a company to set the “right” level of annual incentive compensation to ensure that the company is market-competitive. For example, the market data may suggest a midcareer project manager should have a base pay of $100,000 and a bonus opportunity of 12 percent. That would mean an average bonus would be $12,000. You can structure a system where a truly excellent project manager could get more, and an average project manager could get less, but you are targeting an average that makes sense in the marketplace. Then it is up to the employee to perform at a level that warrants the big number. It is empowering to him or her and it ensures you get what you pay for with incentives — above-expectations performance.

Offer a Formal Short-Term Incentive System

Common practice in the construction industry is to approach incentive compensation in a way that most other industries in the U.S. abandoned in the 1980s and 1990s. Companies build a bonus pool by accruing a set percentage of each profit dollar and, at the end of the year, the CEO or senior managers run through a spreadsheet and assign bonuses on a discretionary basis to the employees that they think did a good job. This is the smoke-filled-room approach, which is often a legacy of when a company was smaller and less sophisticated. The pool approach appealed because it is easy. However, this approach is problematic on many levels.

The funding mechanism of a bonus pool is flawed. It ignores two vital drivers in a business:

  • Pay a return on the capital base that is a reasonable risk-adjusted return on equity

  • Be externally competitive to retain your best people

The pool approach typically does neither. It often pays out bonuses long before the return on equity (ROE) is reasonable, and it completely ignores what a competitive bonus level is from the point of view of the external labor market. When combined with a discretionary distribution of those funds, you get a bonus plan where the employee does not know how his or her individual efforts drive the bonus. FMI hears comments such as, “I wish I could understand how I can move my number” and “Bonus time is when everyone gets mad because it seems so arbitrary and unfair.”

What should replace the pool-funded discretionary plan? FMI advocates three things:

  1. Create a plan that clearly connects clear measurable goals for employees with:
      • Their individual performance 
      • The performance of the small team they belong to, which can be as small as a functional team like an estimating department or as large as a business unit 
      • The performance of the company as a whole 

  2. Benchmark the bonus opportunities (as a percentage of base salary) to objective external market data.

  3. Self-fund the plan by setting a goal for pre-incentive net profit that is equal to the sum of all of the individual bonus opportunities at target plus an appropriate ROE for ownership.

A detailed explanation of how to build one of these plans is beyond the scope of this article, but readers should notice a key concept. The three factors FMI typically uses in a bonus plan drive good behaviors, while offsetting the possible negative behaviors that could result from the other factors. For instance, the individual performance incentive ensures top performers are recognized and compensated. But it is important to have the corporate incentive in the plan to offset the possible selfish behaviors that could result if the individual incentive was used alone. Many corporate-only profit sharing plans effectively share the wealth of a successful company; but without the individual factor to drive accountability, a profit-sharing-only plan can suffer from free riders.

Consider a Long-Term Incentive Plan

Long-term incentive plans (LTIP) are incentives that are targeted at senior managers of a business and typically vest over the course of three to five years. These are designed with the retention of top talent in mind and often prompt participants to use the description “golden handcuffs.” Unlike short-term plans that focus on driving annual business and individual performance, long-term plans usually offer incentives for attainment of goals that are lengthier in nature.

The vesting of LTIP awards over time gives a current employer a strong position when a competitor attempts to hire away a plan participant. Even if the competitor offers a competitive salary and short-term bonus opportunity to make an attractive deal, the competitor also must buy out the unvested long-term incentives that are payable in the future. Therefore, the competitor has to pay up now to get the employee to defect, while the current employer gets to wait until the awards vest later. Thus, the competitor has no choice but to either overpay in the shorter term or look elsewhere for its new hire. Objective, external market data is available to help benchmark the amount of long- term incentives for a given position.

Once a company gets its base salaries, short-term, and long-term incentives in line with best practices and market norms, it will be in much better shape to address the tightening labor market for construction professionals. The winners during the next upswing in the business cycle will be those companies that can attract, retain, and develop the best people. Getting your compensation systems in shape is the first step along that road.

Reprinted with permission from FMI Corporation, (919) 787-8400. For more information, visit www.fminet.com or call Sarah Avallone at (919) 785-9221.

Grant Thayer is a senior consultant with FMI Corporation. He can be reached at (303) 398-7255 or via e-mail at gthayer@fminet.com.

FMI is the largest provider of management consulting, investment banking, and research to the engineering and construction industry. It works in all segments of the industry, providing clients with value-added business solutions, including: Mergers, Acquisitions, and Financial Consulting; Strategy Development; Market Research and Business Development Leadership and Talent Development; Project and Process Improvement; Compensation Data and Consulting; and Risk Management Consulting.