How should I go about switching from an annual payout to a quarterly payout?

While it is generally better to pay as close to the selling event as possible, it is not always the case that more frequent payouts are better. All one needs to do is consider the most extreme circumstance (daily incentive payments ?!) to see how you can have too much of a good thing. When companies are considering switching to a more frequent pay cycle, there are several factors to consider:

1) Is the pay mix changing at all? Often more frequent payments can be a way to alleviate some of the sting of a change to a more variable pay mix (if you have had to make reductions in base salary, increasing the frequency of incentive payments can help your reps meet their regular financial obligations).

2) If the pay mix is not changing, what impact will smaller more frequent payments have on your reps' perception of the incentive program? Will the amount paid still be meaningful or will it get sucked into their regular expense budget and not be as noticeable as a larger lump payment would be?

3) Can your company handle the increased administrative burden of more frequent payments, and what are the limits? Most companies would not find it cost-effective to make daily incentive payments, although I have known some to make weekly payments (against my advice).

4) How will more frequent payments change the reps' behavior - are there any unintended consequences and can these be alleviated through selection of the appropriate design option?

On point 4, there are typically two choices for performance period when switching to payments that are anything other than annual in frequency: discrete and year-to-date (YTD). In all our examples below we will assume the change is from annual payments to quarterly payments, as per the initial question. However, the same logic could work for monthly payments that are on an annual, semi-annual, or quarterly performance period.

We'll start with discrete periods first. In this method each incentive payment corresponds with the end of a performance period, and the next payment starts fresh with the next period. There is no carry-over of performance from one period to the next. This type of plan is common in highly transactional, high frequency selling environments where sales are made regularly and there is little ability for the rep to game the timing of sales crediting. If the rep can control when sales are credited, you will likely see peaks and valleys in performance from one period to the next, where reps are pulling or pushing sales to maximize earnings. If your plan has thresholds (that require a minimum performance before payment is earned) and escalators (where payment increases for increased performance) and you are using discrete periods, you are very likely to experience some of this "porpoising" as reps figure out how to get the most bang for each sale. The end result of this behavior is an overall annual performance that may be below target, while the rep has been able to earn above target pay by using the escalators to his/her advantage in high volume periods. If there is little possibility of this behavior, using discrete periods is the most straightforward mathematically and often the most motivating in the short term for the reps.

The most common solution for this problem is to use a YTD mechanic instead. This requires that performance be tracked against a longer performance period and that each payment is calculated against an annual YTD target incentive amount as well. While the mathematics on this can be a bit daunting at first, once reps and managers understand that pay is not "lost" in a bad period, but may be earned back, they quickly see the advantages. In a typical YTD approach, an annual quota is divided into four even amounts as is the annual target incentive. We'll use $1,000,000 as the annual quota and $10,000 as the annual incentive. A quarterly YTD approach would work as follows:

Q1 Quota: $250,000
Q1 Target Incentive: $2,500

Q2 Quota: $500,000 (Q1 + Q2)
Q2 Target Incentive: $5,000 (Q1 + Q2)

Q3 Quota: $750,000 (Q1, Q2 + Q3)
Q3 Target Incentive: $7,500 (Q1, Q2 + Q3)

Q4 Quota: $1,000,000 (full year)
Q4 Target Incentive: $10,000 (full year incentive)

While there are many ways to arrive at the amount earned as a percentage of target, the common mathematical element critical to the success of a YTD plan is to calculate the percentage of the YTD target incentive earned and then subtract any prior payments already made. This creates the "true-up" which ensures that sales which may fall later in the year still "count" toward the reps overall annual payment. Those who are mathematically astute will quickly see there is a potential for ending the year in arrears using this method. Therefore we recommend capping Q1-Q3 payments at 100% of target, and saving any payments for performance above 100% until the full-year results are in. That way a strong start to the year and weak finish will be less likely to create the need for a rep to "pay back" money already paid.

There are some variations on this approach, which combine different aspects of a discrete plan and a YTD plan. Here are two:

1) Use discrete quarterly periods for payments up to 100% with a year-end bonus that rewards for any full-year performance above 100%. This avoids the need to do the true-up calculation which causes some organizations communication difficulty. It does not, however, eliminate the potential for reps to play with the timing of sales to increasing their earnings, but it reduces it by keeping all the "upside" until the end of the year. As with the traditional YTD approach this also acts as a retention tool for anyone running above 100%. Should they leave prior to year-end they will be walking away from any upside the plan may provide.

2) Software companies sometimes use YTD quotas while paying using a discrete quarterly target incentive. This encourages more balanced performance throughout the year, but puts a pretty high premium on the accuracy of quarterly quotas. If business is steady and/or seasonality is highly predicable, this may be an effective way to get even performance throughout the year (as there is no true-up opportunity, it really does matter more WHEN the sale happens, not just that it happened sometime during the year). There is another advantage to this method in that it puts more emphasis on sales that happen earlier in the year. If a rep can "fill the bucket" as quickly as possible in the year, he/she will have the best chance of being in the "sweet spot" of the plan design (where the escalators are the steepest) for each quarterly payment period. As there is no true-up, there is also no chance of ending the year in arrears. There is, however, the possibility that a rep who starts out slow but ends strong will make less money than a rep who had a very strong start but ended weak. Consider which outcome is better for your business when selecting between the traditional YTD approach and this variation.

Words of caution:
It is common for incentive plans to include hurdles and modifiers. These can become especially challenging when dealing with the traditional YTD plan (using a true up calculation). You must be very cautious to do any modifier calculation AFTER the YTD calculation has been completed and you have the final quarterly payout calculated. Whether the modifier increases or decreases the quarterly payout, you must include the ORIGINAL quarterly amount (prior to modifier) when calculating your next quarter's YTD payout. If your plan has complex calculations including modifiers, hurdles, and any other type of linkage between elements (especially if they are using different performance periods), you should make the choice to use a YTD calculation very cautiously. If it is important to your business to go this direction, you may need to change some of the other elements of your plan design to ease the calculation complexity and ensure your reps have a clear understanding of how they will get paid.