One of the toughest financial decisions agency owners face is how much to pay themselves. It's especially tricky for agencies with multiple principals, because it's rare that all owners make identical contributions to the organization. Deciding what's equitable compensation for each individual may cause unnecessary conflict.
Historically, owners were paid based on the agency's profitability. But with declining profit margins, this traditional model doesn't provide adequate compensation in most agencies. Today, the only fair way to reward owners is to pay them based on performance, as is the case with producers and customer service representatives. One owner shouldn't subsidize another owner, just as owners shouldn't subsidize producers.
The way to create an effective pay-for-performance system is to devise a formula for valuing the work owners do. Generally, owners should be compensated for current performance, rather than for past achievements.
But what about rewarding agents for building the organization? Surely that must have some value in today's dollars. It does. And it should be part of the formula, although a comparatively small part. The formula needs to be weighted more on the side of 'what have you done today?' instead of 'what did you do yesterday?' An agency will stagnate if everyone doesn't contribute today.
Replacing an outdated, unfair owner-compensation model with a new plan isn't easy. Some owners might receive reduced pay in the short term. But resolving this issue now will increase their equity value in the long term. A transition plan can help to make sure no one has to take an immediate, large hit. In most agencies with inequitable owner compensation structures, it took time to sink into this situation, and it'll take time to dig out.
To begin to formulate a fair owner compensation plan, set a value for each area of performance: management, production, and ownership
Whether an agency has two or 10 owners, each individual's compensation must be measured against the value of these contributions.
VALUING MANAGEMENT
Let's face it, the management function shouldn't be compensated at the same level as production. Production is the primary basis for compensation, because production fuels revenue. All else is expense. So it's not unusual - and shouldn't be viewed as such- for agency owners to make different amounts of money.
Most agencies value the management function at around 5% of total revenue, though it ranges from 4% to 7%, depending on an agency's size and its stage of growth. Sometimes management is worth more to an agency than at other times.
An agency that's bringing in several new producers, merging with or acquiring another agency, or taking on a big automation project will need more management oversight to expand successfully. But this needs to be kept in perspective. Former SAFECO agency management expert Dan Connors used a 'brother-in-law' analogy to help agents view this issue clearly: If you hired your brother-in-law - a competent, reliable person, but a nonproducer -to manage the agency, what would you pay him?
Whether all the management duties are handled by one owner or they're spread out over several owners and non-owner managers, a value should be established for each function. So if the general management of the agency is worth approximately 5% of revenue, you need to determine how much of that 5% pie should be devoted to each of these following management functions:
- Service
- Sales
- Administration and operations
- Financial
- Market relations
- Technology
The consulting group Oak & Associates suggests paying 25% of the management fee for service management, 25% for sales management, 15% for administration and operations, 15% for financial, 15% for market relations, and 5% for technology.
This is only a guideline. Every agency has unique needs that change over time, so it's difficult to apply a one-size-fits-all formula. During normal times, for example, sales management may be worth only 25%, but at other times it might be valued at 30% or even 50% of the management fee.
Agencies need to take a look at what they're trying to accomplish and then decide what kind of management is needed to reach their goals. It's important that every agency have at least one owner thinking strategically about the agency's management, not just handling the routine, day-to-day management tasks.
It's interesting to note that the larger the agency, the lower the percentage of income that's devoted to management. Though the need for strategic management oversight is greater in multimillion-dollar agencies, it's understood that management's cost shouldn't get out of proportion to its relative value.
Smaller agencies tend to get into trouble when management distracts owners from production, because production fuels the profit engine. It becomes a double whammy when owners with slipping production take up the slack in their personal income by taking too much of the income pie for management, which is not a full-time job in most insurance agencies. The key is to avoid spending too little time on management and then compensating too highly for it.
THE POWER OF PRODUCTION
One of the beauties of the agency business is that it partly reseeds itself with renewals. But without new production, agencies eventually turn unprofitable.
It's easy to understand how owners drift away from production as their primary means of personal income. As an agency grows, it begins to generate reasonable renewal income while creating increasing management responsibilities. The challenge is to find ways to minimize management distractions and resist falling into the mindset of 'I've paid my dues and earned the right to rest on my laurels.' Owners can't rest on their laurels and maintain a healthy business.
Smart owners rely on production as their primary source of income and take the same commission split that applies to the agency's producers. In agencies that maintain this discipline, we see a higher percentage of income for owners and producers being generated by new business than by renewals.
Lackluster production by a solo owner is relatively easy to fix, especially if they're a motivated individual. But it gets more complicated when there are multiple owners, especially if one or more of them are unable or unwilling to produce new business. This frequently happens in larger agencies in which the owners have tried to maintain equal incomes for producing and nonproducing owners. At some point, the nonproducing owners become overpaid, and the longer the imbalance remains, the harder it is to change.
Agencies first need to recognize that there's a problem and then establish a transition strategy so the nonproducing owner can either take on more of the responsibilities currently being handled by producing owners or have their compensation modified in phases.
Shrinking profits is only part of the problem. It's also a matter of fairness. If one owner is working 9 to 5 while the others are in at the crack of dawn and making client calls nights and weekends, there's going to be dissatisfaction. This can cause serious rifts in the partnership and hurt morale.
Owners need to get together and figure out how to share the work and the money. It's easier if certain people have specific skills or interests, or if some of the tasks can be outsourced. But keep in mind that vital functions, such as strategic planning, take top-level leadership and hands-on direction.
OWNERSHIP AND PROFITS
The final piece of the owner compensation puzzle is the value of ownership. If the organization is managed well and everyone's producing, there'll be profits. Part of the profits will be kept in the agency as retained earnings, and part will be distributed to the principals according to ownership share and individual contributions to production and management.
The potential for controversy lies in how much profit is taken out in bonus pay and how much is retained. We encourage agencies that have retained earnings to fund growth enhancers, such as new producers, books of business, and technology. But it's the owners who'll determine how much profit to take in compensation and how much to invest back into the agency.
Of course, there are tax implications to consider, so agents should consult with a qualified tax advisor. But in general, agents who want to take profit out should do it as either a bonus or a dividend, depending on the organizational structure and tax situation. Owners who base their decisions about profits solely on minimizing taxes, though, might not have the retained earnings necessary to keep the agency vibrant in later years.
Agents should decide in advance on a formula for the amount of profit that will be compensation and the amount that will be retained earnings.
It all comes down to planning. Every piece fits together, and the more you know about where you want the agency to go, the better prepared you'll be for making decisions about compensation.