Performance-Based Compensation

Publication Date :

17 May, 2025

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Table of Contents

What Is Performance-Based Compensation?

Performance-based compensation refers to a progressive pay model where the financial incentives of the employees are reliant upon their accomplishments rather than deciding a fixed remuneration for them. Such pay motivates the employees and teams to outperform their previous achievements, goals, and targets.

It is a common compensation structure for investment portfolio managers, especially hedge fund managers. It encourages working professionals to work harder and set higher benchmarks and promotes meritocracy in organizations. Moreover, attracting and retaining the industry's top performers is key, thus ensuring business success.

Key Takeaways

Performance-based compensation is a remuneration model in which the company evaluates the employees' pay based on their measurable contributions, achievements, and work. Hence, better performance means higher compensation.
It is a motivational trigger for the employees, who are encouraged to perform even better at their jobs. It also helps the company attain success and realize its goals within the expected time frame.
Some of the most common types of merit pay plans are commission, bonus, merit-based pay hike, profit-sharing, stock options, equity grants, and rewards and recognition.

Performance-Based Compensation Explained

Performance-based compensation is a merit-oriented variable pay structure where the employees are remunerated according to their work, achievements, and contributions. Thus, it is different from the fixed compensation model, where the employees receive regular and consistent periodic pay from the company. Such a pay system involves different financial and non-financial incentives like commissions, bonuses, merit-based pay hikes, profit-sharing, stock options, equity grants, and rewards and recognition. It motivates the employees to enhance their performance and helps the companies achieve their goals.

In investment firms, a performance-based pay system is applicable for remunerating hedge fund managers, investment bankers, and portfolio managers. The Investment Company Act of 1940 has prescribed various standards for determining the pay structure of portfolio managers. However, the company's board of directors approves the investment managers' compensation plans. Indeed, hedge fund managers are primarily motivated through a performance-driven financial incentives system, which they earn in the form of fees. Hence, they often go out of their way to undertake complex strategies to ensure impressive mutual fund returns to their clients. Their fee schedule ranges between 2% to 20%.

Types

The ways of paying employees based on their performance differ from industry to industry or on the basis of business goals and level of competition. However, some of the prominent kinds of performance-based compensation plans include:

Merit-Based Pay Increase: This is a pay model in which the company increases the employees' salaries after a systematic performance assessment to reward their efforts and contributions.
Bonus: It is a one-time compensation offered during a month, quarter, or year for superior performance of a person, team, or organization or when an employee or individual outperforms their targets.
Commission: It is the variable compensation offered to the employees (generally sales employees), usually above their fixed pay, as a certain percentage of the financial returns (sales revenue) they have generated for the company.
Reward and Recognition: These are non-monetary rewards like certificates and awards that the company provides to its employees as a token of acknowledgment for their efforts, achievements, and contributions to the business's success.
Stock Options: These are an opportunity provided to deserving employees whereby they can buy the company's shares at a given price during a specific tenure. They motivate them to perform better and contribute to the appraisal of stock prices for personal benefit.
Profit Sharing: It is another progressive idea in which the firm shares a certain portion of its profits with the employees in addition to their fixed pay. Such profits are distributed according to specific criteria for achieving a person, team, or company's profitability.
Equity Grants: Here, the employees are subjected to receive equity units or company stocks, making them eligible to have an ownership stake in the business.

Examples

Companies that value employee growth parallel to their business success often adopt a performance-based compensation system. Let us discuss the relevance of this pay model in the following examples:

Example #1

Suppose LMN Publishing House has a team of 91 sales personnel, including sales executives, sales managers, and a sales head. The company has a performance-based compensation plan that offers compensation to sales personnel based on their sales achievements. The sales executives received a commission of 5% on each book sold by them, while their managers received 2.5% on the sales revenue generated by their teams. Also, the sales head received a 2% commission on the overall sales during a given period. The company motivates its employees through a progressive pay structure where the employees are motivated to perform better with financial incentives offered to top performers.

Example #2

According to this Fortune report - https://fortune.com/2023/12/20/tesla-trims-merit-based-stock-awards-squeezing-compensation/, Tesla Inc. refused to offer some of its salaried employees the merit-based equity rewards in 2023. However, the company failed to provide any official explanation for this decision. Nevertheless, the employees still got a modest cost-of-living hike and base salary adjustments; there were no merit-based stock grants for even the top performers, which were earlier provided based on their annual performance reviews. Notably, some employees who were at the end of their four-year vesting period received stock refreshers to make their overall pay competitive.

Further, whether this decision is a temporary move or Tesla has changed its employee compensation plan is not evident. CEO Elon Musk has often emphasized the need to offer company stocks to the employees to increase their pay without spending cash and avoid turnover or unionization. However, Musk has warned of global economic concerns, including rising interest rates, high credit card debt, and commercial real estate challenges; Tesla's CFO Vaibhav Taneja has discussed the company's troubled economic period and its plan to cut costs for dealing with the situation. Thus, it could be a potential reason for Tesla to eliminate merit-based equity awards.

Advantages And Disadvantages

Advantages

This type of compensation structure is considered to be fair since it financially rewards hardworking individuals.
It further helps the organization value, attract, and retain the company's top performers.
It is a cost-effective model in which the company refrains from making a fixed payment to employees while compensating them according to their work and achievements.
It helps the business entity achieve its goals and objectives within the desired timeframe and ensure overall success.
It builds a progressive culture where everyone strives to become better and perform higher for mutual growth.
It is a flexible structure that can easily accommodate dynamic business needs and conditions.
It boosts employees' morale, making them more competitive in a challenging work environment.
Further, it aids the company to clearly state its performance expectations and compensation system to the new joiners.

Disadvantages

The employees would start subsiding the tasks that don't add to their compensation while emphasizing only the measurable activities, affecting the overall work quality.
They would focus more on short-term objectives that would derive personal financial benefits while overlooking the long-term goals of the company.
Some managers can make biased decisions while rewarding the undeserving employees based on favoritism, hence demotivating the deserving employees.
However, it may negatively affect team dynamics, as the employees may be more concerned about their personal goals rather than performing as a team.
Some miscreants may unrealistically uplift their performance by manipulating the metrics.
However, employees may feel overburdened with high targets and performance expectations, resulting in a higher degree of work stress.
However, it also increases the workload of managers and human resource teams since implementing such a compensation plan involves resources, time, and cost.