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Law at work - Drafting Bonuses and Incentives

Care needed when drafting bonuses or incentive payments clauses

Additional remuneration in the form of performance bonuses or incentive payments are likely to become more common given the need to retain good staff in our tight labour market. Therefore, it is a timely reminder that care should be taken when drafting such clauses so that employers are not unnecessarily trapped by poorly drafted employment documentation. A well drafted bonus clause will protect an employer and provide flexibility to allow an employer to choose whether the bonus or incentive should be paid.

There are various types of bonus arrangements. One of the most common types of bonus is a merit-based scheme where an individual is entitled to a bonus based on their own performance. Alternatively, many bonus schemes are based on the company’s performance, or a combination of both individual and company performance.

Generally, a bonus scheme depends on certain criteria being met. Any bonus should be very specific as to the criteria which must be met for the bonus to be payable. If the bonus scheme relies on an employee having “satisfactory performance” or “significantly exceeding their performance,” thenwhether the employee has satisfied these pre-requisites must be assessed objectively by the employer, which can be difficult to do. In addition, the employer must have put the employee on notice that his or her performance is not satisfactory prior to the period when the employee is to be awarded the bonus.

One of the major determinants of whether an employer will have flexibility in bonus arrangements will depend on whether the bonus is a contractual entitlement of the employee or whether its existence, amendment and operation (including any decision to pay) are at the sole and absolute discretion of the employer. A contractual bonus is a bonus where, if the criteria are fulfilled, the employer is obliged to pay it in accordance with the terms of the bonus. The employer has no ability to revoke the bonus, or not pay any bonus. Alternatively, a discretionary bonus is paid at the employer’s discretion and there is no guarantee that it will be paid. However, employers are under an obligation to exercise their discretion reasonably and fairly, when deciding whether to pay any bonus. Employers should also note that, even where the bonus is discretionary, a legitimate expectation may be created where it has always been paid to employees. Further, if all employees have met the criteria for the bonus, the employer cannot only pay the bonus to some employees and not to others.

A well drafted bonus clause should provide that any bonus is discretionary, and should be worded so that it appears as a one-off bonus, and so it is at the absolute discretion of the employer. Any bonus clause should also provide that the employer reserves the right to vary the terms of the bonus, or revoke it. Having discretionary bonuses assists employers manage bonus programmes, and also removes bonus payments from annual leave calculations, thereby reducing costs.

Some bonus schemes provide that the employee must be employed by the employer at the time the bonus payments are quantified and paid to employees. Such a clause is recommended and is beneficial to employers. However, employees who are working out their notice period are still employed by the company, and accordingly remain entitled to their bonus under this type of rule. Further, an employer cannot delay paying the bonuses to employees, to avoid having to pay it to a specific employee, where the bonuses are usually paid during a particular time of the year.

Performance bonuses or incentive schemes are in addition to an employee’s salary and constitute part of an employee’s total remuneration package. This should be made very clear in employment documentation. The employee’s salary should be referred to as ‘base salary’ to be clear that this entitlement does not include any other remuneration, such as the bonus.

If an employer does not pay an employee their bonus or incentive entitlement, when they are entitled to it, they may bring a claim in the Employment Relations Authority for a breach of contract and may seek arrears in wages. This is in addition to the annual leave costs that can accrue if bonuses are contractual and not discretionary. For these reasons, well-drafted bonus and incentive payment provisions are crucial, and getting them right can be critical to avoiding unnecessary cost and inconvenience.

This article was written by Jennifer Mills and Isobel Foote.

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Disclaimer: This information has been written for and submitted to HRINZ for publication and has been published in good faith for the general information of HRINZ Members of the Institute. HRINZ accepts no legal responsibility for the contents of the Knowledge Base and appropriate professional advice and assistance should be sought in particular cases.

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