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Bonus, Incentive and Pay Schemes
This article was written by John Hannan, an employment law specialist and partner of the Trans-Tasman commercial law firm, Phillips Fox.
Like marriage, arrangements to top up base-level remuneration packages with bonus, incentive or profit share schemes are not to be undertaken lightly. This is true not just of the design of the schemes – whether they motivate the right behaviour – but also of their legal status. Employers who fail to appreciate and navigate the legal pitfalls can get into serious difficulties.
The main legal issues employers have to address are:
- Can the employer change – or even discontinue entirely – the bonus/incentive/profit share scheme?
- Is payment for holidays, redundancy compensation or other benefits calculated by reference to the bonus/incentive/profit share scheme payments or not?
These are important questions because:
- A scheme that is poorly drafted can end up being very inflexible if the employer's circumstances change. For example, an employer might be bound to pay much more than the job is really worth. Or if profitability in the business declines, an employer may not be able to adjust the scheme to encourage the sort of behaviour that is now needed.
- An employer may have to pay holiday pay on payments under the scheme. This can add significantly to its cost. Yet this can usually be avoided by appropriate design and wording.
- An employer may have to take payments under the scheme into account when calculating other benefits, such as redundancy compensation. Again this can be avoided with proper design and drafting.
Binding or discretionary?
It is very normal for employers to draft bonus, incentive and profit share schemes so that the employer is not 'bound to continue the scheme from year to year' or so that the continuation of the scheme and payment under the scheme are 'at the employer's sole discretion'.
The first advantage of this approach is flexibility.
For example, suppose the employer agrees a bonus scheme which pays a percentage of the amount by which the profit of the company exceeds a stated minimum, say the budgeted profit.
And suppose the organisation enjoys substantial growth in profit in absolute terms. This may or may not have been due to the contribution of the employee. As profit grows, the proportion of the employee's remuneration contributed by the bonus increases, relative to the amount that is base remuneration.
Total remuneration may grow to the point where the employee is regarded as over-remunerated. This may or may not reflect what the employer was trying to do when it originally started the bonus scheme.
If words like 'at the employer's discretion' are not used, and if the employer wants to change the scheme, the employee may object to any change on the grounds that it is legally part of the employment agreement which the employer has no right to change, unless the employee agrees.
It's all in the words
Employers should always:
- Deal with the bonus/incentive/profit share element of remuneration in a separate document from the employment agreement.
- Not refer to the bonus/incentive/profit share scheme in the employment agreement. If the scheme is referred to in the employment agreement it should only be to say that the employer may offer such schemes from time to time but that any such scheme does not form part of the employment agreement. The employment agreement might also say that the employee will be invited to participate in whatever bonus scheme the employer operates from time to time, but the employer is not bound to offer any such scheme or to continue it.
- Take care over when. That is how frequently payments are made under the scheme. 'Regular' payments are more likely to cause problems than payments made either at irregular intervals, or yearly. Payments made weekly or monthly are more likely to be regarded as part of the standard remuneration under the agreement which an employer is bound to continue.
Bonus payments for holidays?
Pay for annual leave is based on 'ordinary weekly pay' or on 'average weekly earnings' (average weekly earnings are 1/52 of 'gross earnings' for the year. The Holidays Act 2003 made significant changes in the way that 'ordinary weekly pay' and 'average weekly earnings' are defined. 'Ordinary weekly pay' includes 'incentive-based payments' if they are 'a regular part of the employee's pay'. However, such payments will not be part of ordinary weekly pay if they are 'discretionary' payments which the employer is not 'bound by the employment agreement' to make. 'Gross earnings' means all payments that the employer is required to pay under the employment agreement including incentive-based payments, but excluding payments the employer is not 'bound by the employment agreement' to pay, for example 'discretionary' payments.
For higher-paid staff the difference could be very significant. If a staff member is earning, say, $200,000pa, and 25 percent of that is made up by a bonus or profit share element, the amount paid for annual leave can be significantly greater if the bonus/profit share is an item the employer is 'bound' to pay by the employment agreement. Yet if the bonus is purely discretionary, or if (in particular) it is not paid 'regularly' it needn't be included in calculating holiday pay. Some employers with bonus/incentive/profit share schemes designed under the pre-2003 Holidays Act 1981 have found they are now being required to make significantly greater amounts by way of holiday pay/pay for annual leave than would otherwise be the case.
No case has yet clarified what 'not bound by the employment agreement to pay' means. If the bonus arrangements are not agreed in the employment agreement, and are expressly stated in a side letter or a memo to be discretionary, the employer can most likely safely say it is not 'bound' to make the payment. Then, it will not need to include these amounts when calculating holiday pay/payments for annual leave.
But we do seem to be bound…
If, for whatever reason whether historical, or by incautious reference to bonus/incentive/profit share schemes in employment agreements, an employer believes it may be locked into an inflexible and expensive bonus or incentive or profit share arrangement, all is not lost. First, it is rare for the annual review of remuneration to include an obligation to increase. So if an employer believes that when the bonus scheme is taken into account the employee is over-remunerated, this can be reflected in how base remuneration is dealt with when it comes to annual reviews. The mix between base remuneration and bonus/incentive elements is a matter of design and preference both for employers and employees.
Many employees will prefer to have a larger element of their remuneration fixed as base remuneration, rather than run the risk that in a bad period or year their remuneration can significantly decrease. So there is likely to be room for negotiation. The other option is to carefully explore just what wording has been used in the employment documentation. If the employer has any discretion about payments, and if the payments are not 'regular' but at long intervals, there will be room to argue that the employer is not 'bound' to pay. These matters all depend upon the fundamental relationship of goodwill and good faith between employers and their staff. The key to avoiding difficulty is careful design at the outset of the scheme, including careful drafting and consideration of where bonus/incentive/profit share arrangements are recorded.