Caterpillar plan illustrates risk of variable pay plans
Caterpillar has put workers on notice that its short-term incentive plan, the centerpiece of a performance-based, profit-sharing program, will make its smallest payout since the recession when the payments go out next March.
Like a lot of companies, the world's largest maker of mining and construction equipment has adopted what is known as a "pay-at-risk" compensation system, which ties a percentage of nearly every non-union employee's income to Caterpillar's financial performance.
(Read more: Caterpillar cuts year outlook, CEO counters Chanos)
In updates to the plan's roughly 60,000 participants, and in quarterly disclosures to investors, Caterpillar said it expects outlays related to the program to be down as much as 40 percent from last year, reflecting sharply reduced payments to employees.
As U.S. workers pause this weekend to mark Labor Day, more of them than ever before are being required to participate in these alternative pay systems. The plans enable companies to have their labor costs more closely track the ups and downs of business cycles—but they also expose employees to those fluctuations.
"Where I think we stand on Labor Day in 2013 is that workers are bearing more risks in their employment relationship than they have at any time in the last quarter century," said Donald Lewin, a compensation and reward expert at the UCLA Anderson School of Management.
Ninety percent of companies now require employees to participate in variable pay plans, up from about 50 percent two decades ago, according to a survey of 1,100 U.S. companies by human resources consulting firm Aon Hewitt.
The dollars tied up in the plans, meanwhile, have quadrupled, from about 4 percent of payrolls in the early 1990s to about 12 percent of payrolls today, according to Aon Hewitt.
(Read more: Jim Chanos slamsCaterpillar)
Advocates of the plans say they allow employees to participate in the prosperity of their employers. Caterpillar, for instance, has issued checks worth nearly $2.8 billion over the last three years.
But critics say the plans are also part of a broader transfer of risk from employer to employee that has in recent decades led to the demise of company-paid traditional pension plans and the rise of self-funded, self-directed 401(k)s.
"Variable pay is not just for executives anymore," said Ken Abosch, a compensation expert at Aon Hewitt. "There's been a very strong but consistent trend to push variable pay programs deeper into organizations, and it's become a mainstream pay-for-performance practice."
It is not clear whether ordinary workers have prospered as the plans have proliferated.
In the early 1990s, when only half of U.S. companies had variable pay programs in place, workers could count on annual pay increases of 5 percent on average, according to Aon Hewitt.
Two decades later, with variable compensation plans in place at 90 percent of all U.S. companies, workers are seeing their pay grow an average of 3 percent each year, Aon Hewitt said.
Executive pay, meanwhile, has jumped by double-digits year after year, rising faster than average salaries, managerial pay or corporate earnings, according to Standard & Poor's annual compensation survey. The key driver? Performance-based compensation.
"Cynics say that variable pay is just a thinly disguised way to get executives more money," said Kerry Chou, a senior practice leader with WorldatWork, a non-profit trade association for compensation professionals.
The "pay-at-risk" plan at Caterpillar, like similar incentive programs at thousands of other U.S. companies, accounts for between 8 percent and 64 percent of an employee's annual compensation, depending upon pay grade.
Yet the payouts can roller coaster in ways that seem unrelated to the company's actual performance, and create uncertainty around what employees actually get paid for the work they do.
In March 2012, shortly after Caterpillar closed out what was at the time the most profitable year since its founding, it distributed a record $1.2 billion to the roughly 50 percent of its 120,000 global workers who participate in the plan.
The next year, the Peoria, Ill., company did even better, with sales up 10 percent and earnings-per-share up 15 percent. But the payout to employees plunged 31 percent. The reason: The results, while impressive and an all-time record, fell short of internal targets set by management.
Doug Oberhelman, Caterpillar's chairman and chief executive, was not exempted. His short-term incentive pay dropped 34 percent last year, according to securities filings. But unlike many rank-and-file employees, Oberhelman also participates in a medium-term incentive plan, which pays out cash each year based on three-year performance measures, providing a cushion from annual fluctuations.
As a result, Oberhelman's total cash incentive pay rose 2 percent last year, and his overall compensation jumped 32 percent, according to SEC filings.
Caterpillar spokesman Jim Dugan said in a statement that the anticipated reduction in short-term incentive pay for 2013 would "impact Doug Oberhelman's compensation significantly in total cash terms." Dugan added that "the value of other compensation components will also significantly impact his total compensation" but declined to be more specific.
Lewin at the UCLA Anderson School of Management said top executives often have added features in their "pay-at-risk" program that rank-and-file employees do not enjoy. That sometimes leaves ordinary workers more exposed to the ups and downs of corporate performance than executives.
Lewin said he believed that disconnect was contributing to the growing income gap that President Barack Obama—in a speech this summer just down the road in Galesburg, Illinois—said was threatening to strain the country's social fabric.
"It's a huge issue and feeds into the problem of income inequality in the United States," said Lewin.
Ripple effects in Peoria
Caterpillar will not break any profit records in 2013. Cancellations from mining customers have weighed on sales and profits, and the company has been forced to cut its forecast for full-year earnings twice, and to plan major cost cuts.
Still, Caterpillar is on track to report its third-highest profit in history. If the company's current projections hold up, when this year ends, Caterpillar's earnings per share will have fallen 12 percent over a two-year period. But payouts under its short-term incentive plan will have plunged 60 percent.
In Peoria, home to 6,000 of the workers covered by the plan, City Treasurer Patrick Nichting said that in good years, it is easy to see ripple effects of the Caterpillar payouts on the local economy.
"If we just look at home rule sales tax, from 2009 to 2012, comparing it year over year and month over month, there always seems to be a spike in March," Nichting said.
This year, though, retailers noticed a dip after Caterpillar began to warn employees that payments for 2013 could drop. Some local business people say they noticed an almost immediate drop in sales activity.
"We had a really strong first quarter," said Mike Wiesehan, one of the owners of Lippmann's Furniture, a family-owned business that has been a fixture in Peoria since 1949.
"And then April 1 (came) and it was like someone put a padlock on the front door," he said.