The what, how, and why of short-term incentive plans

Short-term incentives, also known as STI, are one of the crucial parts of the total rewards package delivered to an employee. For HR professionals who design total rewards packages, finding the right balance between STI, long-term incentives (LTI), and salary is important when attracting and retaining the best talent.

STI plans were once typically reserved for only a small portion of the employee population, but in recent years have been applicable for more jobs and levels. Because of this, HR personnel need to be familiar with the value they offer, the options available for incentive pay, and their benefits and drawbacks. Keep reading for an overview of the basics of STI.

Role in the total rewards package

Perhaps your company has had solid retention rates in the past, but in recent years, you have struggled to keep the strong talent you need. If this is happening, this can be a good indication that you need to reevaluate your total rewards package.

Making more thoughtful decisions about the design of your total rewards package can be an excellent way to improve retention rates and attract new talent. By taking this step, you will better understand why each element is important, including annual or STI and the connection to performance.

For many roles, base pay and annual pay increases have shifted to a contractual element — they are expected each year regardless of performance. Unfortunately, these pay increases are often not significant enough for top-performing employees to feel they are valued and stay long term. While these pay raises still need to be competitive, you must consider total rewards beyond base pay to differentiate yourself as an employer.

A thoughtful addition of STI can have a more significant impact on those top performers and offer businesses more flexibility in the design of their total rewards package.

Annual incentives vs. Short-term incentives

Annual incentives are another name for short-term incentives. They are flexible and beneficial ways to reward your most valuable and best-performing employees.

Defining of Short-term incentives

STI have a performance term of 1 year or less, thus the term “annual incentive.” These could be paid out annually, quarterly, or even monthly, based on a schedule laid out in a formal incentive plan. Employees can earn an STI bonus when they achieve specific short-term goals.

One of the primary benefits of an STI plan is that it helps align an employee’s short-term goals with the company’s goals.

According to Mercer’s 2021–2022 US Short-Term Incentive Plan Design survey, 94% of companies have an STI plan in place. Most annual incentive bonuses are paid in the form of cash; however, some companies choose stocks or other compensation options.

Who’s typically eligible for short-term incentives?

In decades past, STI were typically considered part of executive compensation or reserved for higher level employees. They were used to reward those employees for meeting or exceeding their goals. Today, however, many employers are pushing eligibility further down in the organization, even offering short-term incentives at the hourly level. In Mercer’s 2021–2022 Short-Term Incentive Plan Design survey, 60% of employers indicated that their paraprofessionals were eligible for STI. These are professionals who work alongside executives, such as sales and support staff.

Comparing incentive types

Businesses can choose to reward their employees with a wide range of compensation vehicles. How do STI or annual bonus plans compare to other types of incentives, including commissions, spot bonuses, and long-term incentives?

What is a commission?

A commission is a type of incentive pay. It’s typically part of sales rep compensation. The payout is based on performance in the form of sales of particular services or products. For example, employees might receive a commission based on a percentage of sales they make above a goal or for selling a particular combination of products. Commissions are usually paid out shortly after an employee reaches the goal. They’re almost always paid in cash in addition to an employee’s base pay. Some sales rep compensation plans are exclusively commission based.

What is a spot bonus?

As the name implies, a spot bonus is paid out to an employee “on the spot” as a reward for a specific achievement or action. Organizations can use spot bonuses to recognize employee anniversaries, reaching goals, achieving an increase in productivity, or any other action that deserves recognition. Spot bonuses are much more flexible than an annual incentive or STI, which are typically governed with an incentive plan and tied to specific annual objectives.

What is a long-term incentive?

Long-term incentives (LTI) are typically earned by achieving longer term, sometimes cumulative, objectives. They can be granted annually, but due to the long-term nature, they typically have a vesting period to ensure long-term goal achievement prior to payout. While LTI bonuses can be cash, they’re typically paid out in some form of equity, like stock or stock options. LTIs have the benefit of giving employees a sense of ownership in their company, which is why they’re typically used as part of the compensation package for executive positions.

Examples of STI plans

There are many ways a business can use short-term incentive plans to reward its employees. Here are 3 examples to consider:

1. Team/group incentives
2. Profit sharing
3. Bonus plan

Team/group incentives

In a team/group incentive plan, the team or group would need to work together to achieve their performance goals. The reward might vary based on how much their performance changes, whether an overall goal or project is completed, or some type of a positive financial gain.

The benefits of this type of plan include:

• Focuses the team on particular performance and behaviors
• Gives the group a “rallying point,” or reason to collaborate and work together
• Discourages individual behavior or performance that would detract from the group goal

There are also some drawbacks to group incentives:

• Takes time to develop appropriate goals
• May include goals that might not be perceived as equitable across the company
• Requires group management to be committed to the program
• May cause 1 group to excel at the expense of another

Profit sharing

With a profit-sharing incentive plan, associates share a pool of profits that are generally created by exceeding historic or budgeted levels.

Profit sharing has numerous benefits:

• Helps pull large groups together
• Easily measured and understood
• Stimulates interest in the company’s financial results
• May lead to better associate focus

Profit sharing also comes with some difficulties:

• Possibly involves some factors outside the control of the associate and/or company
• Uses a measurement factor (profit) that’s too broad
• Commonly becomes an entitlement
• May stimulate excessive short-term actions and decisions
• Possibly lacks individual accountability

Bonus plan

This type of incentive plan applies to individual employees, each with their own set of objectives in addition to some application of corporate or business unit performance.

The benefits of a bonus plan include:

• Considers both individual and company performance
• Aligns individual goals with desired business outcomes
• Highly impacts performance and behaviors

The downsides to bonus plans include:

• Requires a high amount of supervisory effort (including goal setting and calibrating)
• Increases the amount of training required

How short-term incentives fit into the total rewards package

When considering what type of annual incentives and how much you want to offer, you need to evaluate your total rewards package. You want to offer competitive compensation in all forms to attract and retain the employees you need.

The incentives you offer plus the base pay are your total compensation or target total cash. In your short-term incentives plan, you need to specify the target total cash available to earn if an employee achieves all goals. Potential employees must understand the difference between their base pay and the nonguaranteed incentive opportunities available.

If you’re unsure what amount to offer, you can use our benchmark salary surveys to find a competitive rate. Consider data for both the split amount (60% base pay, 40% target incentive) and the total compensation amount. For example, if you set a total compensation amount for a role at $110,000, but the market average for that job is $145,000, your job won’t be competitive.

Successful design and implementation of incentive plans make sure these things are covered both in the plan design document and in clear communication to employees.

Consider what’s most important to your employees when you decide what and how much to include in your Total Rewards STI “pie.”

If you’re interested in learning more about short-term incentives, Mercer offers an STI Report for the United States and Canada. This report can help you compare your STI bonus options to those of similar organizations.