I'm convinced that the only way to create smart, sustainable incentive compensation plans is to tie them directly to value creation.
This means that the money to pay earned incentive awards comes from performance improvements, improvements which generate financial results and are driven by the plan design itself. Recent research from Aon Hewitt shows that most (86% of) organizations - at least most of the large organizations covered by this kind of research - "self-fund" their variable pay efforts in this manner.
A value creation and sharing approach like this helps lay the groundwork for a true talent partnership, where employees have the opportunity to directly contribute to - and directly share in - the success of the organization.
That doesn't mean, however, that incentive plans should necessarily be built entirely on financial performance metrics. Au contraire, it is important that not only the design but also the implementation and communication of incentives reflect a careful balance. A balance of the financial versus the non-financial, the short versus the longer term, the direct line-of-sight versus the greater organizational goals, etc. And, of course, all this along with a thoughtful consideration of potential impact and consequences. Therein lies the rub, and the reason why incentive design is no place for backside-of-the-cocktail-napkin amateurship.
Nonetheless, self-funding should top the list of incentive design objectives. Otherwise, as the Aon Hewitt research confirms, you are left with alternatives like funding awards through reduced salary increases (5% of participating organizations), reductions in headcount (5%), reduced benefit spending (2%) or pay freezes (1%). This kind of "robbing Peter to pay Paul" is neither a sustainable approach nor a winning talent strategy over the longer haul.
Creative Commons image: "Money" by Aaron Patterson