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Wednesday, January 26, 2011

Annual bonuses or base salary increases?

Is it better for a company to hand out annual bonuses or to simply go with annual raises on employees' base salaries?

What do you look for as an employee? Do you want a company that hands out bonuses to its employees?

The company I've been with for the last year now gives its employees an annual bonus. It's my first experience with that since my last company didn't hand out bonuses at all.

I'm always happy to take more money, whether it's in the form of an annual raise or a one-time bonus. You won't hear me complain!

Still, I was curious if one method benefits the employer more than the employee. Do bonuses provide a sort of short-term psychological boost to the employee while the long-term benefits go to the employer?

Some quick analysis gave me the answer. The data in the graph below represents 5 different pay scales. All trending lines begin with an annual salary of $50,000 in 2010. Four of the lines are calculated based on a strict 3%, 4%, 5%, or 8% annual pay raise. The red line is based on an annual 3% annual pay raise plus an additional 5% annual bonus (referred to from here on as "3+5").

10-year pay analysis

As you can see, the 3+5 starts out ahead of all of the others for the first two years. Of course, there's also a psychological boost of that first $2,500 bonus check!

But because the base salary is increasing by an even 3% every year the annual 5% bonus doesn't change much from year to year and because it's not part of base pay, it doesn't get factored in for future 3% raises. In fact, someone receiving an annual raise of 4% would be making more money than the 3+5 person after just 7 years. Someone with a 5% raise every year passes the 3+5 person after just 4 years.

Of course, that 3+5 person feels like they're getting an 8% raise, right? But if we actually compare the 3+5 salary with a salary that has an annual 8% raise, the person with the 8% annual raise is making more money in just 3 years.

The point of this isn't to say that companies giving bonuses are trying to pull the wool over their employees eyes. Again, I'm more than happy to take more money however my employer wants to give it to me!

This simply underscores the long-term effect of annual increases. If I were to extend the graph over the life of a typical 40-year career, each individual would end up with the following salaries in 2050:
  • 3% annual increase - $158,351.35
  • 3% annual increase + 5% annual bonus - $166,268.92
  • 4% annual increase - $230,818.30
  • 5% annual increase - $335,237.56
  • 8% annual increase - $1,005,764.88
Never underestimate the power of an annual percentage point.

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posted by Joey at 1/26/2011 06:45:00 AM

12 Comments:

Anonymous Kandi declared,

I get bonuses each year from my bosses, usually right before Christmas. Although it's a nice boost (like you, I won't complain), I would rather have the annual salary increase...especially when one of my bosses mandated that I include it on my 1099 for the year. :P

1/26/2011 8:05 AM  
Anonymous Anonymous declared,

It entirely depends on the bonus structure. I generally craft compensation plans on a risk/reward basis. For example, I might offer you $50k flat salary or $40k salary with a $15k bonus potential based on company performance or specific MBOs. The more an employee is willing to tie their personal financial success to that of the company, the more I'm willing to reward them. But there's also a potential downside to the employee if the company doesn't do well.

In the end, it also depends on the employees standard of living. In the example above, if I know I need to ear at least $45k to maintain my standard of living, then I'd probably go to the flat salary. If I can have an acceptable standard of living at $35k, then why not go for the bonus potential?

Personally, I abhor blanket compensation scales. I negotiate my compensation every year and I expect my employees to do the same. My goal is to get as much money for my labor as possible and to give my employees as much as the company can afford to reward their talents. Every employee has different circumstances and the more flexible an employer can be, the better.

My 2 cents...

- Owen @ B&S

1/26/2011 9:05 AM  
Anonymous Anonymous declared,

Also bear in mind that many company benefits (disability coverage, 401k contribution, life insurance, etc.) are based on a percentage of the base salary. Always calculate overall compensation - not just salary/bonus/commission/draw.

- Owen @ B&S (again)

1/26/2011 9:20 AM  
Anonymous Anonymous declared,

Joey great topic!

I say why not both a raise and bonus!! :) That would be nice!

Is there a way to quickly adjust your graph to see what % bonus you would need each year to match the 8% yearly raise? I would be interested to see what that % bonus would be.

Dstew

1/26/2011 7:36 PM  
Blogger kristi noser declared,

I say if someone wants to pay me 50 big ones, I won't be asking for a raise or bonus!

1/26/2011 8:32 PM  
Anonymous Chet declared,

Something doesn't line up for me in your report. How could the salary by only $8000 higher in 2050 for the 3+5 than the base + 3.

If the 3% is applied strictly from the base salary for the fiscal year, and the 5% bonus is considered a "gift", wouldn't the salaries be equal?

Or, on the flip side, if the 3% is taken from the base salary AND the 5% bonus, wouldn't the salaries in 2050 be much different than $8000?

Another option... Perhaps the $8000 difference is due to the fact that the salaries ARE equal, but the bonus for that year is approximately $8000.

If the third option is correct, (and I think it is,) then the report is skewed, not showing the tens - perhaps greater than one thousand - dollars made over the previous 40 years in bonus money.

If that is the case, then even over 40 years the 3% raise plus 5% bonus is a better option than the flat 4% raise, and maybe even the flat 5% raise as well.

Feel free to disagree with me and show me any errors with what I'm thinking.

1/27/2011 10:22 AM  
Anonymous Chet declared,

So I just crunched all the numbers...Figured I might as well try to back my point up.

When it comes down to it, I wasn't thinking when I said that 3% plus 5% bonus was possibly a better option than 4% or 5%, so that was pretty stupid.

But I did figure it out that in 40 years, you would make $188,503 in bonus money. Not too bad, but then again, that doesn't even compare to how much you would have made over that time if you had just taken a base 4% increase. In fact, by taking a base 4% increase over a base 3% plus 5% bonus, you would make $792,709 more over a 40 year period. However, if you are more near-sighted and are only looking to work until 2020, taking a 4% base increase would earn a grand total that is $1548 LESS than the 3% base plus 5% bonus. It all depends on what you want with your job.

1/27/2011 10:42 AM  
Blogger Joey declared,

Owen, great points, especially on the overall compensation package. Salary alone is hardly a reason to take any position.

I realize that the graph in this is an over-simplification. It assumes consistent raise and bonus percentages every year. It really doesn't take into consideration that for many people, salary remains relatively constant and for others, it may stay about the same for 3 years and then jump by 30% with a new position.

As Owen noted, anyone considering an employer's compensation package needs to consider the entire package. My goal here is to just note that bonuses aren't always all they're cracked up to be. I work in Operations, not Sales, and bonuses with many companies are given based more on overall company performance than on individual performance. That's part of why the base salary increase is more meaningful to me given my non-sales role.

Dustin, the bonus you would need every year to match an annual 8% base salary raise would go up significantly each year. Because the base salary would remain the same, the only way for a bonus to keep pace with an annual base salary increase is for the bonus percentage to increase. By the end of the 40-year period, assuming the base salary increased by 3% every year for all 40 years, it would require a 635% (yes, six hundred thirty-five percent) bonus to match what the person with an annual 8% raise was getting.

Now, lifetime 8% raises are pretty unrealistic, but a lifetime average raise of 4% or 5% isn't out of the question for people who end up as CEOs or in other executive roles.

As Kristi notes, some of the numbers used obviously look ridiculous. Of course, I have readers who make 6 digits and others who make nothing, and all of those people probably have their own unique take on this topic.

Chet, I think your follow up comment clarified your first one. The red line reflects the total amount including the bonus. You're right, I didn't include lifetime earnings, but if I were to include those over the span of a 40-year career, the bonus structure still loses out big time.

1/27/2011 11:05 AM  
Anonymous Anonymous declared,

I think I'm still with the bonus method. Bonus driven industries will often give bonuses of 50% of your annual salary, often times the bonus may even exceed the base salary. I'm not sure that I would consider a 5% bonus a company that is bonus driven. If a company gives an 5% bonus with no raise, time to find a new job fast. Even bonus driven business should still give raises.........often.

Dstew

1/27/2011 12:34 PM  
Anonymous Bill Roehl declared,

I prefer the annual raises myself.

1/27/2011 7:07 PM  
Blogger Joey declared,

Dstew, fair point that a bonus of 5% indicates that the company isn't really defined as "bonus-driven" in its compensation.

For what it's worth, I ran the numbers on a 50% bonus. If you got a 3% base raise every single year along with a 50% bonus every single year - both unlikely scenarios - you would still be making less after 40 years than someone with a 5% annual base salary increase. You would be making just $7,000 a year more than someone with a 4% base salary increase. You would have made more over the course of that 40 years than the person with the 4% annual base salary increase but would have made less than the person with the 5% base salary increase. And again, that's still assuming there's a 3% base salary increase on top of the annual 50% bonus.

I can understand why people like the bonus-driven system. I think it's especially useful in sales. However, if that bonus is based significantly on the company's performance - and if often is - you're running a pretty significant risk as well. It's not uncommon for a company to drastically reduce or eliminate bonuses due to a poor year and for people who rely on those huge bonuses, that's a pretty tough pill to swallow.

But as Owen noted, if people are able to live within the means of their base salary already and the bonus is just extra, there may be a different mindset.

And ultimately, there's a whole lot more to all of this than consistently earning more money over time.

1/27/2011 10:32 PM  
Blogger Joey declared,

By the way, here are the numbers. The first number is the annual salary (with bonus if applicable) after 40 years and the second number is the total lifetime earnings over that 40-year period, again, starting with a $50,000 salary in 2011.

Base 3% increase - $158,351.35, $3,770,062.99
Base 3% increase + 5% bonus - $166,268.92, $3,958,566.14
Base 4% increase - $230,818.30, $4,751,275.78
Base 3% increase + 50% bonus - $237,527.02, $5,655,094.48
Base 5% increase - $335,237.56, $6,039,988.71
Base 8% increase - $1,005,764.88, $12,952,825.94

1/27/2011 10:39 PM  

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