Owners are the firm’s leaders and need to set the right example and tone for the rest of the people in the firm. If they do not set their compensation based on what they are each doing, resentment can occur between partners. Also, others in the firm will have a pretty good idea of which owners pull their weight, are respected and are good role models.
It is not always easy to know how to properly reward owners for their production and management roles. This is especially true if they perform different functions in the management arena. However, there are ways to do this and some methodology and logic to doing the plan correctly.
The relationship between the owners is often the difference between a well-run firm and just an average agency. When one owner feels that there is inequality among the owners, then cooperation is limited and the agency’s performance will suffer.
Owner compensation is a very sensitive subject and it can often be the unspoken thorn in the sides of many business partners. Disputes arise when the original compensation plan is never revised, despite changes in the effort given and the roles played by the partners. Agency owners should review their compensation plans annually.
Compensation Plan Options
There are several common ways that agency owners compensate themselves, each with pros and cons. For example, some business partners may choose to pay themselves the same salary, especially if they have the same amount of stock, such as 50/50 partners, or partners that have 25 percent or 33 percent each. This is a simple solution that may foster teamwork in the beginning. However, resentment may occur if any one partner slows down, yet still draws the same salary.
Some agencies may pay the owners strictly for production. This method becomes unfair if one person is spending more time on management than the other owners, and his or her production is impacted.
Consider performance-based compensation plans. The best plan has three components: a fee for management, a production component and a share in the profits (return on investment).
How Performance Based Comp Works
A strategic management fee should be created to pay owners for their strategic management functions and range from 4 percent to 8 percent of total revenues, capping at about $250,000. To determine the correct percentage, think about what it would cost to hire an agency manger who would perform all the management duties that the owners currently perform.
The larger the firm, the smaller the percentage of revenue for the fee. Larger firms tend to have middle management to assist the owners with the strategic management of the firm. In these firms, managers are often doing more of a strategic function for the owners, so the compensation should not be duplicated. Owners of smaller firms need to be more active, because they have fewer or no managers and fewer people to manage. This strategic management fee is then split to pay the owners for their contribution to management.
The following split of the strategic management fee pie is recommended based on the typical average amount of time spent managing these functions, relative to all of management:
- 25 percent for management of the service function (PL, CL & L&H),
- 25 percent for sales management, 15 percent for administration and operations,
- 15 percent for financial affairs, 15 percent for market relations and placement, and
- 5 percent for automation.
Because each agency is unique, the specific formula used should be tailored to match the amount of time spent, efforts needed and expended by management.
The fees are for strategic management, not the day-to-day management of affairs. For example, the owner in charge of financial affairs does not handle the day-to-day accounting for the firm. Strategic management for financial affairs would include reviewing monthly financial statements and initiating the firm’s budget. Any major financial decisions still should be approved by all owners.
Assigning Management Roles
Management roles can be assigned based on individual talent and preferences, or in some agencies are simply rotated annually among the owners. Some functions can be shared.
For example, there should be one lead person for the marketing/placement function. The relations for the individual companies, however, should be assigned to the owner or producer with the best relationship. The owner in charge of the markets coordinates the overall marketing plan using the individuals as their arms and legs.
Large agencies or firms with a large portion of revenues outside of P/C commissions can develop the management fee based on each profit center rather than a single fee based on total revenues. A profit center could be the employee benefits department, commercial lines department, programs, etc. This takes into consideration the wider variety of management roles that may exist in a larger firm or firms with diverse sources of revenue.
The Production Piece
Almost all agency owners are involved in production. The second component of the compensation plan ideally would be based on each owner’s production. The formula is recommended to be the same as that for the non-owner producers in the firm. In a typical astute independent agency, the commission paid for production often averages 40 percent for new business and 30 percent for renewal. This includes both commercial and employee benefit lines of business.
To encourage sales of larger, more profitable business, there should be no commission paid for personal lines or small commercial accounts, unless the producer/owner has an active involvement or service role for those accounts. An agency cannot afford to pay two people to do the work of one. In smaller or rural firms, however, the producer is often involved with the actual servicing of these accounts and should be compensated.
Splitting Up the Profits
When the first two components (management and production) are incorporated into an agency, and if the agency has average control over other expenses, the firm should post a profit. The true profitability of a typical agency today is usually between 10 percent to 35 percent. Additional perquisites that the owners receive (such as auto and T&E) will lower this profit.
First the firm should retain some of the profits for capital investments and perhaps pension plans, or bonuses to employees. The balance left over should then be allocated based on the contribution of each owner to the firm.
The recommended split would be 25 percent for new production, 25 percent for size of the book of business, 25 percent for management and 25 percent for equity. This formula allows those who generate the profit to gain from their efforts.
Owners that choose to slow down and not work on management will receive less compensation for that component. The owners that have to pick up the slack will be compensated for their additional effort. Owners who excel in production will be compensated accordingly. It is a simple and equitable methodology that rewards owners for the work they perform.
Owner compensation plans need to be flexible to allow for the natural change in owners’ contributions to the firm over time. The plan needs to be fair, yet rewarding to the major contributors.
While compensation is often a sensitive subject to discuss, establishing a well-thought out plan that can automatically adjust to the owner’s contribution will remove the potential for disputes or difficult feelings between owners. When the key owners are satisfied with their compensation, they tend to be cooperative, thereby improving the overall health of the firm.
Oak & Associates has worksheets that are modeled after this article, with an agency example with all the calculations. If you would like to obtain a copy of these two tools, email email@example.com and reference this article.
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