Which one of the following has been the most common payment option for bonus compensation in recent years?

August 30, 2022

In recent years, the battle to retain talent has been a growing challenge faced by many employers across varying industries. As a result, we have seen an increase in employee incentives and compensation in an attempt to improve employee happiness and wellbeing and encourage loyalty. One of the most common forms of incentive-based compensation is the bonus, with some employers implementing generous schemes in an attempt to beat out the competition. 

What are bonuses and how do they work?

Bonuses are often performance-based (either company, individual or both), with higher awards being granted to those achieving greater targets. In some instances, employers may choose to offer bonuses at a flat rate to all employees. Bonuses are not generally guaranteed. Employers will communicate whether their employees are able to participate in a bonus scheme and provide employees with information on how the particular scheme works. Despite the benefits that bonus schemes can have on employee retention, the legal implications of each scheme need to be understood. Bonus schemes tend to either operate outside the express terms of the contract of employment or be referred to in a manner involving discretion, in either case bringing about a level of uncertainty. 

Some bonuses are contractual, that is employees are told they have an entitlement to participate in the bonus scheme and/or an entitlement to a certain amount, usually calculated in accordance with a specific formula. For example, such bonuses are often calculated by reference to specific performance criteria. Where the employee meets those criteria, the employer will effectively be obliged to pay out the appropriate level of bonus. Alternatively, a contract may include a guaranteed right to a certain level of bonus during a particular timeframe. A contractual bonus is therefore a binding promise to pay, subject to certain conditions being met. 

Other schemes may be entirely discretionary in that they do not give any right to a particular level of bonus or indeed to even be considered for a bonus. 

In the middle are a large number of schemes which, while not entitling the employee to a specific amount for achieving a particular result, do give some rights. The extent of these rights varies considerably – for example, employees may be entitled to have the opportunity to earn a bonus but the level and frequency are wholly discretionary. 

Contractual bonuses provide more certainty and are therefore more attractive to employees, but they pose a greater risk to employers. Care has to be taken to ensure that clauses are drafted clearly and that there is no confusion as to how the scheme is to operate. This is because, in any dispute, the key question asked by employment tribunals is likely to be one of construction of the documents and any ambiguity will usually be interpreted in the employee's favour. In drafting their schemes, employers should try to take account of potential future events that may affect bonus entitlements and perhaps consider including payment caps. For example, in the recent case of Mast Group Ltd v. Chalmers, unforeseen increases in sales of medical testing kits following the COVID-19 pandemic led to an employee receiving a bonus payment of more than £245,000. The employee's bonus entitlement was to be calculated as 5% of any additional sales over and above her year-end targets. Increased demand for testing kits attributable to the pandemic had a colossal impact on sales, resulting in the employee's bonus entitlement being far greater than anticipated. Despite arguing that the scheme was not intended to be construed in this way, the employer was ultimately ordered to pay the full amount to the employee.

Are bonuses truly discretionary?

In the vast majority of cases, employers will reserve the right to exercise discretion when awarding bonuses. However, many have questioned whether bonuses are truly discretionary. It is often the case that past practice is taken into account and any previous bonuses awarded to the employee are considered. For example, where an employee has consistently been awarded a bonus, a tribunal may consider that the custom of paying bonuses has become contractual and that a refusal is a breach of that contract. 

Employers should be mindful of the implied term of mutual trust and confidence which requires employees to be treated reasonably and "even-handedly". This does not mean that employees cannot be treated differently but rather that employees must not be singled out unfairly. Prudent employers should therefore have well-thought-out and justified reasons for declining to award any bonus, even in discretionary schemes – and these reasons must not, of course, be discriminatory! 

Conclusion

Despite the potential legal risks of bonuses, they remain one of the best ways to increase motivation, business performance and business loyalty, and assist in making employees feel valued by their employers. A well-drafted bonus scheme should include information in respect of the date it is to be paid as well as for how long it is to be in operation (e.g. whether it is only for the current year or subject to an annual review). Providing as much clarity as possible in the rules of the scheme will ultimately have the effect of reducing claims being brought in a tribunal. 

Despite the perennial question of whether a discretion is real, discretionary bonuses remain the most popular with employers. Contractual bonuses are, by their nature, difficult to change in line with business needs and can lead to unanticipated liabilities, as in the Mast Group case above. Fully discretionary bonuses give the employer the ultimate power to decide when and how much to pay and, subject to avoiding discrimination and acting in good faith, who to pay. To minimise risk, prudent employers should consider implementing a cap on the bonus payable and should clearly communicate any changes to the bonus scheme to their employees well in advance of these being implemented. For advice on the drafting or implementation of your bonus schemes, or for any other matter related to your employment contracts, please reach out to a member of our team for support.