When are companies most likely to find lump sum increases useful?

A recent client question reminded me that not every HR professional is familiar with the use of lump sum merit increases as an approach for rewarding employees who have "topped out" by reaching (or passing) their salary range maximums.  With this in mind, here is a quick post on the basics.

(I suspect that a number of readers may already be well versed in this topic.  For those who are, please feel free to weigh in with your thoughts, experiences and any tips.)

Ahem.  To start with, let's define what we are talking about when we use the term lump sum merit increase. 

A lump sum merit increase is not really an increase at all, but rather something provided in lieu of a salary increase.  Rather than being added to the fixed base salary, the lump sum is delivered in the form of a single cash payment, separate from base salary.  For this reason, it is also (and probably more accurately) referred to as a lump sum bonus.

While there are other applications, the most common use for the lump sum merit increase - to the best of my knowledge - is as a substitute for a salary increase for those employees whose salaries have already reached - or surpassed - the maximum of their assigned salary range. The rationale is typically and simply this:  the employer wishes to recognize and reward employees who are performing well in their job, but whose salaries have reached a point where no further increases are allowed.  So the employer does so with a lump sum award, which does not exacerbate the "at or above max" problem by increasing the fixed base wage, but does provide the employee with a cash reward for their performance.

In most of the situations that I have encountered, the amount of the lump sum merit award is identical (as a % of base salary) to what the employee would have earned via the guidelines if they were still within the confines of their salary range.  In other words, if the merit increase guidelines suggest a 3% increase, the employee receives a lump sum award equal to 3% of their current salary.  I have seen a couple of situations where the lump sum award is reduced from that level suggested by increase guidelines (i.e. 50% of the amount suggested by guidelines).

(Note also that, in the interest of compliance with the Fair Labor Standards Act (FLSA), in situations where a non-exempt employee is involved, the organization must include this lump sum payment when determining the employee's regular rate of pay for the purposes of calculating overtime.)

That's my take.  Other perspectives and experiences?

A lump-sum payment is an often large sum that is paid in one single payment instead of broken up into installments. It is also known as "bullet repayment" when dealing with a loan. They are sometimes associated with pension plans and other retirement vehicles, such as 401(k) accounts, where retirees accept a smaller upfront lump-sum payment rather than a larger sum paid out over time. These are often paid out in the event of debentures.

• A lump-sum payment is an amount paid all at once, as opposed to an amount that is divvied up and paid in installments.
• A lump-sum payment is not the best choice for every beneficiary; for some, it may make more sense for the funds to be annuitized as periodic payments.
• Based on interest rates, tax situation, and penalties, an annuity may end up having a higher net present value (NPV) than the lump sum.

Lump-sum payments are also used to describe a bulk payment to acquire a group of items, such as a company paying one sum for the inventory of another business. Lottery winners will also typically have the option to take a lump-sum payout versus yearly payments.

There are pros and cons to accepting lump-sum payments rather than an annuity. The right choice depends on the value of the lump sum versus the payments and one’s financial goals. Annuities provide a degree of financial security, but a retiree in poor health might derive greater benefit from a lump sum payment if they think they will not live long enough to receive the entire benefit. And by receiving an upfront payment, you can pass on the funds to your heirs.

Also, depending on the amount, an upfront payment might enable you to buy a house, a yacht, or another large purchase that you would otherwise not be able to afford with annuities. Similarly, you can invest the money and potentially earn a higher rate of return than the effective rate of return associated with the annual payments. Or, of course, you could lose money on your initial investment.

It is not always best to take the lump-sum payment in lieu of periodic annual payments; if offered the choice, consider taxes, investments, and the net present value (NPV), which accounts for the time value of money.

To illustrate how lump-sum and annuity payments work, imagine you won $10 million in the lottery. If you took the entire winnings as a lump-sum payment, the entire winnings would be subject to income tax in that year, and you would be in the highest tax bracket.

However, if you choose the annuity option, the payments could come to you over several decades. For example, instead of $10 million of income in one year, your annuity payment might be $300,000 a year. Although the $300,000 would be subject to income tax, it would likely keep you out of the highest state tax brackets. You would also avoid the highest federal income tax bracket of 37% for single people with incomes greater than $523,600 in 2021 and $539,900 in 2022 or $628,300 for married couples filing jointly in 2021 and $647,850 in 2022.

Such tax questions depend on the size of the lottery win, current income tax rates, projected income tax rates, state of residency when you win, in which state you will live after the win, and investment returns. But if you can earn an annual return of more than 3% to 4%, the lump sum option usually makes more sense with a 30-year annuity.

Another big advantage of taking the money over time is that it provides winners with a "do-over" card. By receiving a check every year, winners have a better chance of managing their money properly, even if things go badly the first year.

Hiring and retaining top-tier talent is a key objective for business owners, and paying employees is an important part of the recipe for success. Employees are the backbone of every small business. They are the face of the enterprise and directly influence its success or failure.

Evaluating the pros and cons of raises versus bonuses—and striking the right balance between the two—can help a business owner achieve staffing goals while also maintaining a healthy bottom line or profits.

• Raises and bonuses boost morale, incentivize employees, and ensure that staff feel rewarded and appreciated.
• Raises are a permanent increase in payroll expenses; bonuses are a variable cost and therefore give business owners greater financial flexibility when business is down.
• Bonuses can be tied to sales or production volumes to incentivize employees and help companies boost their profits during peak times.
• Other forms of compensation include partnerships, stock, profit-sharing, and even tickets to cultural or sports events and gift certificates.
• Business owners need to gauge the effect of raises and/or bonuses on their company's profit margin.

Most people go to work to make money. From an employee’s perspective, more is better. However, employers may not always be able to pay their employees more. As a result, many small business owners offer employee compensation packages that are made up of a mix of salary raises and periodic bonuses. This type of compensation package gives an owner the flexibility to reward employees when business conditions are good and adjust variable costs to reduce expenses when business conditions are tough.

Some companies give out across-the-board raises each year, with every employee receiving the same amount. The raise could be a set percentage based on the employee's pay. An annual raise helps employees plan and budget for their monthly expenses by helping them keep up with the cost of living. Although there are many ways to motivate and retain a company's best employees, raises help boost employee morale and ensure that long-time employees are rewarded more than their new hires.

A small percentage raise each year can be less costly than paying bonuses that may fluctuate with sales or production numbers. However, annual raises are a permanent increase in the cost of doing business. Oftentimes, payroll is the largest expense for a company. As a result, it's important that business owners determine whether the company generates enough revenue and monthly cash flow to meet the increased payroll expenses.

Cash flow is the net amount of inflow and outflow of cash from a company and is reported on a cash flow statement. Business owners must include the increased salary expenses in their monthly budgets using their cash flow and revenue estimates. A cash-flow shortage could disrupt a business' day-to-day operations.

Companies with predictable and steadily rising profits might find it easier to issue raises than companies with periodic or seasonal earnings. Also, companies with variable costs and less-predictable revenues are typically more reluctant to impose a permanent increase in payroll expenses.

Bonuses can be more financially feasible for business owners to manage since they're a variable cost, with payment tied to sales or production volumes, for example. Bonuses incentivize employees to exhibit the behavior that a business needs to be successful, whether it's generating new clients, client retention, or improving cost controls. While pay raises typically reward longevity, bonuses are paid based on performance.

Since the compensation is variable, a bonus can be reduced or eliminated if business conditions make it difficult or impossible to fund them. The variable cost structure of a bonus package helps business owners during times of low sales or production volumes. Pay raises are permanent, but bonuses keep payroll costs lower when the revenue isn't there to pay them.

While the ability to minimize or avoid the expense of bonuses is attractive for business owners, it can be detrimental to staff morale. Employees rely on their income to pay bills and put food on the table. Large, unpredictable fluctuations can be disruptive and cause workers to seek employment elsewhere.

Because of this, employers need to communicate to staff members that the ability to reduce expenses when necessary not only helps the company save money but also avoids the need to make staff reductions when business temporarily slows. In a well-run business, cutting bonuses can save jobs.

A typical payout structure is 3% to 5% of annual salary for clerical and support staff. Managers might receive payments in the low double-digit percentage range, with executives in the mid-double-digit range. Senior executives at the highest levels may receive the majority of their compensation via bonus payments.

Bonuses can be structured to recognize individual merit or to reward collective success. Individual merit-based bonuses reward top-producing employees for their efforts.

Sales-based bonuses, for example, could be paid to employees who generate the most new business. Production-based bonuses could be structured for those who answer the most customer phone calls or produce the most widgets.

Also, bonuses can be set up as a short-term incentive, say, for a new directive or sales campaign. A three-month sales initiative to bring in new business or a business with seasonal production increases, for example, could be tied to a bonus system.

By incentivizing employees during peak periods, a company can maximize its revenue and profits during a critical time of the year.

A bonus can also be based on the overall company's success. If the company hits its sales goals, profitability goals, or other defined metrics, all employees are rewarded. Under a company-based system, employees often receive a predetermined payment amount that is based on the collective achievements of the corporation rather than individual performance.

In short, bonuses can be part of an employee's ongoing compensation package or offered as one-time events to recognize significant milestones such as growth, profitability, or longevity.

While cash bonuses are likely the most familiar form of a bonus, there are other forms that may be worth considering. Companies can offer an ownership stake in the company, which can come in the form of a partnership offer in the firm, or through shares of stock. Smaller companies that cannot extend such offers could consider the creation of a profit-sharing plan that makes a discretionary payment toward employees’ retirement savings.

There are various unique employee offerings that can provide an incentive for team members. Possibilities include granting extra vacation days, awarding tickets to sporting or cultural events, or giving movie passes or gift certificates. These small tokens of appreciation are available to even the smallest businesses at a reasonable cost.

It's also important to consider the impact of bonuses and raises on a company's profit margins. A company's margin is the amount of profit generated as a percentage of sales. If, for example, a company has a margin of 35%, it means the company generates 35 cents for each dollar of sales. Business owners must analyze how a bonus versus a raise would impact their company's profit margin.

It can be helpful to backtest a raise or bonus incentive plan with a prior year's financial performance to gauge how much expenses would rise and impact profit margins. Of course, it's difficult to estimate the increased amount of sales that would have been generated had a bonus structure existed in prior years. However, applying a potential raise and bonus payout structure to prior years' sales and revenue figures should provide owners with a sense of the potential cash flow scenarios.

Since employees are at the heart of every business, rewarding them properly is critical to success—and for holding on to your best performers. Any compensation model should involve incentivizing employees and providing ongoing communication to ensure team members know their efforts are appreciated.

Many employers will give a cost-of-living adjustment (COLA) once a year to reflect inflation and changes in salaries and living costs. Some employees may be happy with this minor adjustment. In order to retain high performers, however, you may have to incentivize them with yearly, bi-yearly, or even quarterly raises.

A standard raise after one year is somewhere around 3%. However, this could be either substantially higher to combat inflationary pressures. Or, if the business itself is being hit hard by inflation, they may choose not to give a raise at all.

You can give an employee a bonus as a one-off payment that is a separate check from their payroll check. You can give an employee cash if you plan on giving them a small amount, or you could give the employee a bonus in the form of stock options or equity.

Giving a bonus can keep an employee, but offering a permanent raise really shows them you care. If done at the right time, this can be the difference between and employee staying or leaving. Oftentimes, a small bonus can cost less than the investment required to hire and train a new employee, so keeping the solid performers is paramount.