Generous and specific financial incentives can help drive and sustain a rapid performance improvement. Seven principles can assist in delivering the maximum benefit during a transformation.
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 programs.
About the researchTo understand the economic benefit of transformation-incentives programs, we identified 60 publicly listed companies that undertook at-scale transformations over a 24-month period and whose total shareholder returns (TSR) could be compared with relevant off-the-shelf sector and geographic stock indexes. This analysis calculated each company’s excess TSR against these indexes for the 24-month period following the launch of its transformation. For each company, we surveyed participants to understand the type and extent of incentives used in the transformation program. To gain qualitative insight and pressure-test our ideas, we conducted multiple interviews with leaders from the most successful transformations around the world.
Despite these clear benefits, our research found only two-thirds of companies adopt a financial-incentives program when embarking upon a transformation (see sidebar “About the research”). 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 program 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 behavioral 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 programs 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 program was completely self-funded.” A tier 1 auto supplier CEO who undertook a transformation said that while he was initially skeptical after six months of implementation, he concluded it was the critical ingredient in overdelivering on the company’s transformation goals.
The benefits of such incentives programs 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 programs can also increase accountability and the perceived fairness of differences in compensation.
Design choices for nonfinancial incentivesEvery transformation should include nonfinancial incentives that complement financial ones. Nonfinancial incentives should appeal to the five sources of meaning: society, client, company, team, and self. Notably, recognition from the company, specific leaders, and direct supervisors is what truly makes the difference beyond the prizes and rewards that may go with it. For example, one company would invite the family of the “employee of the month” to join the town hall in which the individual was recognized, thereby greatly enhancing the impact of the recognition.
A nonfinancial-incentives program should be structured to provide frequent, repeated recognitions and tied to specific behaviors and mindsets that support both performance and health aspirations. These incentives can recognize progress on “macro” initiatives, such as leadership development or career moves, as well as “micro” initiatives. Rewards can vary, and companies have a good degree of flexibility to get creative and engage senior leaders. At one organization, each week the CEO gave up his parking spot, a widely sought prize, to the highest-performing employee. Another organization held an Oscars-type event every six months to hand out employee awards. Another gave frontline managers $500 each to spend on targeted gifts that were meaningful and relevant for individuals who demonstrated behavior that went above and beyond.
Moreover, financial incentives, along with a well-crafted program of nonfinancial incentives, can create a higher level of energy and excitement across the organization and boost the discretionary efforts of employees (see sidebar “Design choices for nonfinancial incentives”). 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.”
Companies can use the following seven principles to help ensure their transformation-incentives programs achieve the desired outcomes and behavior changes:
Too often, transformation-incentives programs are tied purely to general outcomes (for example, overall company earnings). For many employees, this metric is beyond their control, so tying incentives to this distant outcome can weaken their effectiveness. In some ways, a transformation can be compared to a pointillist painting. 1 A painting technique in which an artist uses small, distinct dots of color to form an image. Zoomed in, each dot in the painting represents a single initiative owned by a single employee. Initiatives are essentially projects that deliver value for the organization above and beyond business as usual. When you zoom out, the overall transformation consists of hundreds or thousands of discrete initiatives. Given the ability of performance-tracking tools to monitor progress on these initiatives, companies can get a clear picture of the new value being created by individual employees and teams. This visibility enables companies to calculate targeted financial incentives that directly influence the actions taken by specific employees.
One company decided to introduce targeted incentives to accelerate value delivery by challenging a team to execute initiatives worth $40 million. If the team achieved the goal within 40 days, it would receive $40,000 in financial incentives. This specific intervention with a clear, measurable, and memorable goal increased ownership and accountability while speeding decision making. The team overdelivered on the goal and did so several days early.
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 program 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 (Exhibit 1). 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 (Exhibit 2). This objective can be accomplished by mobilizing every employee to participate in the program—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.
At one company, the owners of the nonfinancial initiatives, such as a leadership-development program 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), 4 McKinsey’s Organizational Health Index benchmark provides leaders with a detailed picture of their organization’s health compared with peer companies. With more than one billion data points across geographies and industries, OHI offers a global standard to measure and manage organizational health. resulting in a strong focus on organizational health programs. 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 behaviors 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 program, our analysis shows that tracking nonfinancial impact to the program results in higher TSR than focusing on financial impact alone (Exhibit 3).
Creating a clear link between action and incentive reinforces behavior 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 behavior and building momentum can be substantial.
A transformation’s financial-incentives program should be designed to reflect a company’s strategy and culture. Tailoring the program to an organization’s context is critical to accelerate transformational change at scale. Contextual factors are numerous, such as geography, industry, strategy, culture, nature of unionization in the workforce, and current compensation structure. All of these factors can influence design decisions on how much to pay out to whom and when.
For these and other design decisions, executives should take time at the outset to ensure their financial-incentives program is fit for purpose. Furthermore, they can engage the board of directors early in the process. This step will help address any questions or concerns, and the board’s input can be incorporated at the preliminary stages to better inform design decisions and also avoid any delays once the program is ready for approval.
Several examples illustrate the trade-offs companies can make to align their financial-incentives program with their strategy and culture. One family-owned company placed a high premium on relatively equal wages and decided to cap the maximum payout for individuals at 80 percent of their annual salaries. Another private equity–owned insurance company decided not to institute a cap, meaning that if an employee delivered an initiative that generated $20 million in value, the person could take home about 2.5 percent of that total, even though this payout could be many times the annual salary.
At one global organization, leaders decided 80 percent of the financial incentives would be tied to the company’s performance. Whether the company achieved its overall transformation aspiration early or on time determined most of the financial incentive. By contrast, one medium-size bank linked 100 percent of incentives to individual performance.
Another company tied 100 percent of incentives to individual performance for initiative owners. However, the incentives for workstream leaders and sponsors were split evenly between workstream performance and overall transformation performance. This structure provided incentives for cross-functional collaboration among transformation leaders.
At a high level, a transformation’s financial-incentives program should be simple to understand and communicate. These attributes will not only increase the perception of fairness but also enable better alignment on the program among employees. Transformations that are done well typically result in a spike in excitement and renewed levels of engagement. When a transformation is done poorly, executives will often hear employees refer to the “black box” of financial compensation that feels like a roll of the dice rather than something within their control.
Creating an incentives program that’s simple to understand and easy to communicate does not mean leaving the detailed design principles to chance. The best programs are crystal clear about the granular choices leadership has made and their implications for employees. Such an approach acknowledges the important nuances around eligibility, payout logic, and governance as well as around their specific context, including what such a financial incentive could mean for specific employees and their overall compensation.
One manufacturer, for example, had historically struggled to set performance targets that reflected the full value at stake. Based on a detailed look at the financial-incentives program, the organization took a number of actions to ensure the full potential would be pursued. In particular, the program was launched several months into implementation after the finance team had signed off on all the valuation targets for every initiative. The program worked well, with the company exceeding its original target of $500 million in recurring value (a goal many executives thought impossible) by $300 million.
During an enterprise-wide transformation, companies ignore the human element at their peril. While some employees may throw themselves into improvement programs for the challenge or love of the job, companies that use financial incentives can significantly improve the odds of their transformation’s success while unlocking substantial and sustainable value.
Hugh Bachmann is a senior vice president in McKinsey’s Miami office; Robin Ligon is an associate partner in the New York office, where Dominic Skerritt is a partner.