Profit sharing

Profit-sharing offers employees the opportunity to share in the success of their company by receiving a free bonus in the shape of cash or shares or taking part of their normal pay in a form related to business profits. Such schemes have a long history in the UK, although their use has been fairly limited. Early schemes were often confined to industries such as gas, engineering and chemicals.¹ Pre-World War II figures estimated that only around 250,000 employees were eligible to participate in a profit-sharing scheme.² In comparison, the latest Inland Revenue figures show that the number of employees covered by approved profit-sharing schemes in 1995-96 was 740,000, having peaked at 900,000 in 1989-90 (see figure 3.1 ).³ Schemes in which part of normal pay is linked to profits in accordance with Inland Revenue-approved rules - profit-related pay (PRP) - are discussed in chapter one. This chapter looks at profit-related payments that are in addition to standard pay and may serve as an alternative to PRP for employers who may want to discard their PRP schemes when the tax advantages are withdrawn.

Figure 3.1: IR-approved profit sharing schemes 1979-80 to 1995-96

Source: Inland Revenue

Many companies in the past adopted profit-sharing schemes for such practical reasons as to combat labour unrest and unionisation and to overcome resistance to new work processes, while at the other extreme some were motivated by philanthropy and a desire to encourage loyalty and commitment on the part of their staff.⁴ Perhaps the best-known profit-sharing arrangement in the UK is that at the John Lewis Partnership, which has its roots in this benevolent approach. Profit sharing was a cornerstone of partnership principles established by the company's founder in 1929. All profits after reinvestment in the business are shared among the company's 37,500 employees (figure 3.2 illustrates the value of these payments to staff over the past decade).

Figure 3.2: John Lewis Partnership: bonus as % of annual salary 1988-98

Source: Pay and Benefits Bulletin; The Gazette (JLP company magazine), 2 March 1996

SHARING SUCCESS

More recent converts to profit sharing often see it as an incentive useful in attracting and retaining staff and as a way of linking employee remuneration to company performance. In a highly competitive environment, in which cost reduction measures and quality improvements can be quickly replicated by business rivals, people themselves are seen as a potential source of competitive advantage. Profit sharing can act as an incentive, encouraging higher productivity and improved customer service and quality. A further benefit is that it can assist in another of today's key management practices - teamworking. Profit sharing helps staff to focus on their collective endeavours rather than on individual performance, as is often the case with more conventional incentive schemes.

Management Review's survey found that more than 42% of respondents had either an IR-approved profit-sharing scheme or an unapproved profit-related cash bonus system. Among the companies with an approved scheme, engineering business IMI Norgren's aim in introducing profit sharing was to increase employee motivation and employee stakeholding/commitment to the organisation, as with some of the earlier schemes. Both Bank of Scotland and General Accident also mentioned these reasons, as well as the goal of matching pay to performance. Drinks company Guinness GB cited all three reasons, along with the aims of improving productivity and achieving strategic objectives. Companies with unapproved profit-related schemes also reported that the aims of increasing employee stakeholding/commitment to the organisation or improving employee motivation were the most common reasons for introducing them (more than 47% of those with unapproved profit-sharing arrangements). These reasons were closely followed by recruitment/retention (42% of companies with unapproved schemes). Figure 3.3 sets out the full range of reasons for introducing non-approved schemes.

Figure 3.3: Reasons for introducing non-IR-approved/registered profit bonus

n = 19; respondents were able to give more than one reason.

An earnings boost

Profit sharing can also significantly boost earnings in an era of relatively low inflation - to which annual pay rises are invariably linked - without increasing the employer's fixed labour costs. This point is best illustrated by comparing median levels of pay increases with examples of profit-sharing payouts. In the three years from June 1995 to May 1998, the monthly median pay increase recorded by the IRS pay databank hovered between 3% and 3.6%.⁵ At the same time, the retail price index fluctuated between a low of 2.1% and a high of 4.2%.⁶ In contrast, Midland Bank staff who rated as "good performers and above" received on average profit-sharing payments worth 7% a year between April 1996 and April 1998, while Lloyds Bank (later Lloyds TSB) paid its employees on average more than 10% of salary each year between March 1996 and March 1998 (see figure 3.5 ).

Figure 3.5: Profit sharing in the financial services sector 1996-98

Source: Pay and Benefits Bulletin.

Figures from the Office for National Statistics (ONS) also underline the impact that profit-sharing payouts can have on earnings. The ONS found that bonus payments, including profit and performance-related awards, increased by 24.9% in March 1998 (March is the main month for such payments because it comes at the end of the financial year), compared with the same month in 1997, boosting the average earnings index by 1.4%.⁷ In the financial services and chemicals sectors, bonus payments were worth more than a sixth of total earnings (see figure 3.4).

Figure 3.4: Bonuses by industrial sector, March 1998

Text missing

Source: Office for National Statistics

No risk

Apart from being an incentive to staff in periods of low inflation, profit sharing also offers, in theory, a degree of wage flexibility in that a portion of employee remuneration varies in accordance with profitability. Certainly, this was the general thrust of the profit-related pay ideas put forward by Martin Weitzman and others to prevent western economies suffering from "stagflation" (rapidly increasing inflation coupled with declining output and growing unemployment).⁸ The attraction for employers would be that fixed paybill costs would be contained while higher remuneration would be earned through increased profits. This thinking provided the basis for the Inland Revenue-approved profit-related pay (PRP) scheme (see chapter one), in which part of normal pay is intended to be linked to company profits.

However, research suggests that profit-sharing payouts are in practice usually an addition to basic market pay rates rather than a "flexible element of market determined total remuneration".⁹ Indeed, profit sharing is rarely associated with lower market pay rates, so that in reality there is no risk to an employee's basic salary: he or she is guaranteed a basic wage comparable to that prevailing in the rest of the industry and profit-sharing payments are simply a bonus, and the employee does not have to shoulder any of the business risk.

Evidence that companies with profit-sharing schemes tend to pay market rates is provided by a number of companies. In the retail sector, for example, one study found that JLP's basic pay rates compared favourably with those of Marks & Spencer, the acknowledged top payer, and were ahead of those at both Sainsbury's and Tesco.¹⁰ Moreover, when JLP's Partnership bonus is added, the company comes out on top, as its payouts are usually more generous than those of its competitors. In 1997, M&S, which usually pays a profit-sharing bonus worth 5% of salary, paid out a record profit-sharing allocation of 5.5% of salary to reflect the fact that its pre-tax profits had broken the £1 billion barrier for the first time.¹¹ But this compares with the JLP Partnership bonus in 1997 worth 20% of salary. The lowest Partnership bonus in the past 39 years was an 8% payout in 1993.¹²

A similar picture emerges in the financial services industry: market rates are matched and varying additional bonuses are linked to corporate performance. A comparison of the 1998 salary rates for cashiers at three high street banks shows that although NatWest's parameters are slightly wider than the salary ranges for cashiers at either the Midland Bank or the Co-operative Bank they are all broadly similar: Midland's rates range from £9,893 per year to £12,686; the Co-op pays an annual salary of between £9,957 and £12,796; and NatWest's cashiers receive a minimum of £8,000 and a maximum of £14,000 a year.¹³ Profit-related payments at the three banks in 1998 ranged from a cash bonus worth 9% for Midland staff rated as "good performers"; a bonus amounting to 5.05% of salary for eligible employees at Co-operative Bank, plus a further 2.5% group payment to satisfactory performers; and a cash bonus worth 9% of salary at NatWest to reflect group performance, plus an additional 3.9% cash payment linked to the performance of NatWest UK (see figure 3.5).

CASH OR SHARES?

There are two main varieties of profit sharing (apart from PRP) - share-based Inland Revenue-approved schemes and cash-based unapproved schemes (see figure 3.6 for a full explanation of both arrangements). The former pays the profit bonus in the form of shares rather than cash. Eligible staff receive free shares in the business, calculated as a percentage of salary, and which, if they want to benefit from the full tax breaks available on such schemes, must be left in a specially established trust fund for at least three years. Our survey included four companies that have approved profit-sharing schemes - Bank of Scotland, General Accident, Guinness GB and IMI Norgren.

Companies with unapproved schemes can make cash payments - calculated as a percentage of salary or as fixed sum, or as a variable amount based on individual performance - to staff from a profit-sharing pool which attracts no tax concessions. More than a third of respondents to Management Review's survey had a non-approved profit-related bonus scheme. These included: utility Scottish Power, engineering business Hosiden Besson, financial services companies Norwich Union, Provident Personal Credit and Visa International, general manufacturer T&D Industries, retailer Dixons, rail business Eurotunnel and mobile phone company Nokia.

Shares only, please

Share-only profit-sharing schemes aim to maximise the perceived longer-term benefits of financial participation rather than simply provide a short-term incentive. As was discussed in chapter two, share ownership gives the individual a "stake in the business" and helps to establish a common interest between staff and shareholders and to encourage loyalty. Marks & Spencer, which first announced its intention to introduce a share-only profit-sharing scheme in 1977, saw it as a way of creating a "community of interest" among employees and shareholders, both of whom "share the risks of the business" and who should also "share in the success".¹⁴ The goal of British Aerospace's share-only profit-sharing scheme, first introduced in 1997, is to turn employees into shareholders.¹⁵ All BAe staff in the UK receive an equal share of the amount set aside by the board for the scheme. This "egalitarian approach" aims to foster the notion that staff are "equal stakeholders" in the business.

Only one company in our survey, Guinness GB, stipulated that staff must take their payment in shares only. But some companies are actively trying to encourage staff to opt for shares rather than cash. For example, British Airways' 1995-96 annual report states that:

"The company is committed to increasing its employees' participation in it and would like to see the number of staff holding shares and their shareholding increased from the current levels of 66% and 4% respectively. To that end the company has introduced, from this year, an additional bonus of 20%, as an incentive for employees [to] use their profit-share payment to acquire shares in the company instead of taking this in cash."¹⁶

Organisations offering share-only schemes include: Cornhill Insurance, whose eligible employees each received shares to the value of 3.3% of salary in June 1997; BT, which used an equivalent of 2% of pre-tax profits to provide each employee with 134 free shares, with an initial market value of £524.27 (391.15p per share), in September 1997; Bass, which distributed shares worth around 5% of salary from a profit pool of £14 million to 19,250 participating employees in February 1997; and Railtrack, whose eligible staff each received shares worth £1,000 in March 1997.¹⁷

Many other companies offering staff the opportunity to take the profit-sharing payment in cash as well as shares adopt the same approach as BA and make shares the more attractive option. NatWest's profit-sharing scheme allocates shares in proportion to salary, and as an alternative, employees can elect to take their profit share in cash, but outside the Revenue-approved arrangement. Staff taking the cash option receive 20% less and the cash is subject to tax and National Insurance deductions in the normal way (see case study 2, Case studies). Before its merger with Lloyds, TSB paid two different amounts to staff depending whether the profit share was paid in cash or shares. In 1996, the last year the bank was independent, TSB staff received a payment worth 6% in cash and 6.3% in shares (see figure 3.5, The National Grid Company offers a cash alternative, but staff must ask for this option and it is at the company's discretion whether it grants the request.¹⁸

Others promote share ownership by buying a matching share from company profits for every share bought by the employee through a savings plan - the so-called "buy-one-get-one-free" (BOGOF) scheme. Vodafone has such a scheme. The company permits staff to contribute up to 5% of their basic salary each month to buy shares in the business and then matches each share purchased with one bought by the company, as long as participants agree to leave all the shares in a trust fund or in a personal equity plan (PEP) for at least two years.¹⁹

Take the money

Cash-based profit-sharing schemes are similar to traditional incentive schemes, which tend to focus on short-term gain. Boots actually refers to its scheme in the company's annual report as the "short-term profit-related bonus".²⁰ Different employee groups at Boots, including executive directors, can benefit from various bonus schemes based on a measure of performance against target. In 1997, individual payments had a maximum ceiling of £6,000. Elsewhere, Rover Group, the German-owned car manufacturer, replaced its IR-registered profit-related pay scheme in 1997 with a taxable cash bonus arrangement, described as a "holiday bonus", which paid £200 to each of the company's 33,000 "associates" in its first year and guaranteed additional payouts of £215, £230 and £250 over the following three years.²¹

Some unapproved cash bonus schemes link the level of an employee's profit share to his or her individual performance. Around 16% of companies surveyed by Management Review have such an arrangement. Midland Bank pays a "business cash bonus" annually to eligible staff, with the amount received depending on their performance rating. In 1998, staff rated as "good performers" received a bonus worth 9% of salary, while their colleagues with an "improvement required" rating got a third of that (3%).²² Also in the financial services sector, Allied Dunbar operates a corporate bonus scheme based on a mixture of company and individual performance. In May 1997, these taxable bonus payments ranged from 0% to 4% of salary, with more than half of eligible employees receiving a payment worth 1.5%.²³

Many organisations have tied their cash-based profit-sharing payments to Inland Revenue-registered profit-related pay (PRP) schemes. Almost 58% of respondents to our survey who made an unapproved cash-based payout also had an IR-registered PRP scheme. This was the case at Norwich Union, for example, where the 1998 bonus, worth 3.32% of salary, consisted of a 2.46% tax-free PRP payment and a 0.86% taxable sum. Other survey organisations combining profit sharing and PRP include Britannia Airways, London-based HSBC Asset Management, Oracle Corporation and Scottish Power.

Apart from our survey companies, others that tie in bonus payments with PRP schemes include: the John Lewis Partnership, whose Partnership bonus first attracted tax relief under an approved PRP scheme in 1991 and where usually around 70% of the total payment is tax-free;²⁴ Nationwide Building Society, which in July 1997 paid out a bonus to staff worth 8% of salary, consisting of a 4.5% tax-free PRP payment and a 3.5% taxable sum;²⁵ and Halifax Bank, whose staff received a bonus worth 8% of salary in 1997, of which 3.5% was tax-free, with the remainder liable to tax in the normal way.²⁶

Cash or shares? The choice is yours

As indicated above, it is not uncommon for companies to have both types of profit-sharing arrangement - IR-approved and unapproved schemes - so that staff have the opportunity to take the bonus in cash or shares. An IRS survey found that more than 47% of respondents with approved profit-sharing schemes also offered an unapproved cash alternative.²⁷ Some of the major banks offer staff this choice. Lloyds TSB and the Royal Bank of Scotland, for example, allow staff the option of taking the profit-share in cash.²⁸ Elsewhere, Thames Water's approved profit-sharing scheme gives staff the opportunity to earn an additional 5% of the basic paybill against the achievement of operational and financial goals and this can be taken in cash or shares. In 1997, employees received a payment worth £316 or 40 shares.²⁹

Among our surveyed organisations, three of the four companies with approved schemes - Bank of Scotland, General Accident and IMI Norgren - offered employees this option. Bank of Scotland's scheme allows eligible employees to take a cash alternative, or a combination of both cash and shares in 10% multiples. Although companies may also offer employees the option of taking the bonus in a form other than shares or cash (for example, additional voluntary contributions (AVCs) to pension funds), Management Review did not find any examples of this among the small sample of survey respondents who had approved schemes. However, the National Grid Company's profit-sharing arrangement is an example of a scheme that gives staff the choice of taking the bonus as an AVC linked to a personal pension.³⁰

At NatWest, which also gives staff the choice of taking the profit share in either shares or cash, the proportion of eligible employees taking the cash option in 1997 was 64%, the remaining 36% choosing shares. The proportion of staff taking shares has doubled since 1995, when it was only 18%, and increased to 29% in 1996. As is common in other companies, however, it is the more highly paid who tend to choose shares, the lower paid opting for cash. Some 70% of senior executives take shares, compared with only 12% of the lowest employment grade, with managers and executives evenly divided - around half opt for shares and half take cash (see case study 2, Case studies).

WHO USES PROFIT SHARING?

Although there are Inland Revenue figures showing the number of approved profit-sharing schemes, there is no official estimate of unapproved arrangements, because there is no requirement for such schemes to be registered. However, the 1990 Workplace Industrial Relations Survey (WIRS) found that "direct profit-related payments or bonuses were . . . the most widespread type of financial participation arrangement".³¹ An earlier study conducted by Baddon et al also found that cash-based profit-sharing was the most common form of financial participation, as is reflected in our own research.³² The 1998 Proshare survey meanwhile found that 34% of plcs and 19% of limited companies had either an approved or an unapproved profit-sharing scheme.³³

Distribution by sector

WIRS reported that 40% of businesses in the trading sector, a third of manufacturing companies and almost 50% of service sector organisations had some form of profit-related bonus scheme.³⁴ The Proshare survey considered both types of profit sharing and found that 77% of companies in the utilities sector used one scheme or the other, compared with 37% of financial services businesses and 33% of consumer goods companies.³⁵ The IR/ED/HMT survey referred to in chapter two examined the use of Inland Revenue-approved profit-sharing schemes by industrial sector and concluded that they were "still disproportionately common in the finance, banking, insurance and business services sectors of the economy".³⁶ Earlier Department of Employment (now Department for Education and Employment) research also reported that approved profit-sharing schemes were more common in the finance sector than in any other part of the UK economy.³⁷

As was noted earlier, ONS estimates of the impact of bonus payments on average earnings figures found that in the financial services sector they were worth more than a sixth of total earnings (see figure 3.4). Of the 40 organisations featured in an IRS survey of profit-sharing and share option schemes, 40% were from the finance sector and all had some form of profit-related bonus arrangement.³⁸

Proshare also found that companies with an annual turnover of between £501 million and £2,000 million were more likely to have a profit-sharing scheme than enterprises with lower business volumes.³⁹

Workplace size

Workplace size was identified by WIRS as one of four characteristics distinguishing companies offering profit-related payments and bonuses. The other types of company were those with a high proportion of non-manual staff; those performing far better than their industry norm; and non-union organisations.⁴⁰ WIRS found that larger enterprises (50,000 to 100,000 employees) were much more likely to pay profit-related bonuses than their smaller counterparts (fewer than 200 staff). The Proshare survey also found that companies with larger workforces were more inclined to have either an approved or unapproved profit-sharing scheme, although the research showed some discrepancies, which probably reflected the sample.⁴¹ For example, although 38% of companies with a workforce of between 1,001 and 1,500 had a scheme, only 15% of organisations employing between 3,001 and 4,000 staff did so, yet 39% of respondents with more than 4,000 staff had one.

The employees covered by profit sharing among our survey respondents account for almost 37% of the total represented in the research. All but three of the biggest survey respondents by workforce size - IT provider EDS (12,000 employees), business services company Mitle Group (18,000) and retailer Safeway (75,000) - had profit-sharing schemes. Surveyed companies with profit-sharing arrangements ranged in size from Newark-based Amcare, the supplier of medical products, which employs just 70 staff, to Scottish Power with 16,000 employees and retailer Dixons with a workforce of 19,000.

Early pioneers

It was noted earlier that profit sharing has a long history in the UK, but it was the advent of state support in the form of tax concessions - first through the 1978 Finance Act and later through modifications to the tax legislation in 1980 and 1985 - that helped to boost its popularity, even though non-approved schemes do not benefit from tax relief.⁴² Besides the John Lewis Partnership, such high-profile companies as Barclays Bank (1974) and M&S (1977) introduced profit sharing ahead of state involvement.

Inland Revenue figures for approved profit-sharing schemes show that after an initial burst, which in 1979-80 saw a record 117 schemes registered - a figure probably inflated as companies converted existing schemes to take advantage of the new tax benefits, the next significant upturn took place towards the end of the 1980s (see figure 3.1). The 1996 Bacon & Woodrow study also found a large growth in new schemes between 1985 and 1990.⁴³ One explanation for this latter surge in registered profit-sharing schemes is that the booming UK economy in the late-1980s fuelled labour shortages, provoking employers into investigating tax-efficient ways to boost incomes.

PROFIT SHARING IN PRACTICE

Participation

In order to qualify for approval, profit-sharing schemes must follow certain rules laid down by the Inland Revenue. One of these is that all employees must be able to take part in the scheme on similar terms and the arrangement cannot exclude or favour particular individuals or groups. Companies must make the scheme available to all UK employees with more than five years' service, but companies may admit those with less than five years' service, if they wish (see figure 3.6).

In practice, all four examples of approved profit-sharing in our survey set service requirements for eligibility at lower levels than the IR requirements. At Guinness GB, there is no service requirement for participation in the company's scheme, and service-related eligibility is six months at Bank of Scotland and IMI Norgren and one year at General Accident. The Bacon & Woodrow study reported that the most popular service qualification for approved schemes was one year, 38% of organisations citing this as the qualification.⁴⁴ Similarly, GlaxoWellcome's profit sharing applies to all employees with at least one year's service.⁴⁵

The following examples illustrate the range of service-related qualifications imposed by companies. Royal Bank of Scotland's approved profit-sharing scheme is open to all staff in post in September of the profit year, with those with less than one year's service receiving a pro rata payment.⁴⁶ At Sainsbury's, employees with at least one year's service receive 50% of entitlement, staff in post for two years get 75% and those with at least three years service receive the full amount.⁴⁷

Unapproved schemes allow employers far more flexibility in deciding who is eligible to participate. Nonetheless, it seems that, as with IR-approved schemes, employers prefer to keep service requirements to a minimum. Among our survey respondents, most commonly those who were employees during the relevant profit year were eligible - this was the case in almost 60% of companies with non-approved schemes. However, there were differences in eligibility when the proportion of the workforce covered is examined in terms of other criteria, particularly grade. Overall, around a third of our sample with non-approved schemes said that the bonuses were available to all employees; a third reported that they were applicable to the majority of the workforce; and a third included only a minority of employees. In this last grouping, most commonly only managers, and sometimes only some senior managers or directors, received profit-sharing payments. For example, the profit-sharing arrangements at Newark-based Amcare, Provident Personal Credit and T&D Industries covered only senior management. Some companies exclude specific groups of employees, perhaps because they have separate forms of performance pay. For example, the Oracle Corporation UK said that all its employees bar "salesmen" were included in its profit-related bonus scheme.

Profit pool

Employers use various methods to determine the size of the bonus pool that is to be distributed among employees. The most straightforward ways are to base the pool size on a pre-determined percentage of profits, which was the case at Bank of Scotland, or at the board's discretion each year following announcement of the company's profits, as was the case at IMI Norgren and General Accident. Other formulae are those at Guinness GB, which bases its pool size on real profit growth year on year, and at British Aerospace, where the amount of profit available for distribution to the company's 44,000 staff is dependent on the company achieving certain profit targets.⁴⁸ The Co-operative Bank distributes 5% of pre-tax profits, provided these, too, reach a specific level.⁴⁹ At NatWest, the formula for calculating the profit-share pool in any one year is that group profit should amount to least £600 million. The scheme provides a sum equal to 3% of the profit up to £1,200 million, plus 5% of the profit in excess of £1,200 million, adjusted to disregard the profit contribution made by units that do not participate in the scheme (see case study 2, Case studies).

A pre-determined formula was used by almost half of the companies surveyed by Management Review, whether they were approved or non-approved schemes. Board discretion accounted for most of the rest. It determined the pool size in nearly a third of enterprises with unapproved schemes.

At JLP, the size of the profit pool is based on three main criteria: the level of company profit; the level of profit that needs to be retained for reinvestment; and the cost of each 1% of bonus (for example, in 1996, 1% of bonus required funding of £3.8 million).⁵⁰ At Peugeot, the Coventry-based subsidiary of the French Peugeot-Citroen group, which awarded its staff a profit-related cash bonus worth almost 1.5% of salary in May 1998 - the first payout since 1991 - the bonus is triggered by profits in excess of £30 million.⁵¹

Allocation

As noted above, Inland Revenue regulations specify that all employees must be treated equally in terms of eligibility for an approved scheme. However, this does not mean that all employees receive shares of identical value, and companies have the freedom to vary the amount according to a sliding scale depending, for example, on employees' length of service or level of pay. In all four examples of IR-approved profit-sharing schemes in our survey, the shares were worth a percentage of individual salary/earnings, rather than being, say, a flat-rate allocation of shares, as in the Thames Water example above.

The design of unapproved schemes is left entirely to the employer, so there is a lot of variety in the way profit is distributed. In our survey, by far the most common method was to distribute the bonus pool by way of percentage of salary, with almost 74% using this method to allocate payments. Fewer than 3% of employers linked the size of payout to individual performance, as in the Allied Dunbar and Midland Bank examples noted earlier.

More than one scheme?

Companies with a profit-sharing scheme of one sort or another usually also offer other forms of financial participation. Around 40% of organisations surveyed in an earlier IRS study used another mode of financial participation, usually a Save-As-You-Earn scheme, in addition to profit sharing.⁵² The Proshare survey found that 32% of companies in the study with a SAYE share scheme also had a profit-sharing arrangement.⁵³ Management Review's own research found that almost 65% of surveyed companies employed more than one form of financial participation. Of those with either an approved or unapproved profit-sharing scheme, almost 74% also had other arrangements (see figure 2.2 in Financial participation).

PROBLEMS

Some of the benefits for employers of profit-sharing schemes, including enhanced employee motivation and commitment, and their use as a tool to help generate stakeholder attitudes among staff, were discussed earlier. However, several significant drawbacks with profit sharing have been identified, notably the lack of a real direct link between individual performance and profitability. Among the companies with approved schemes surveyed by Management Review this was a major disadvantage. General Accident, for example, believed that profit sharing was too remote from the actual performance of business units, and Guinness GB pointed out that it was sometimes forgotten that it was part of the whole remuneration package, and there was a delayed link to company performance. Some organisations with unapproved schemes also found difficulty in linking individual performance to overall profit levels in a meaningful way. For example, Eurotunnel pointed out that the "target is remote for shop floor and doesn't distinguish high/low performance". Norwich Union, too, said that a drawback was that profit sharing could be "too remote" from individual performance. In the same vein, Oracle Corporation UK declared that a profit-related bonus was "not a true performance bonus".

For this reason, some organisations have introduced financial participation schemes that are similar in operation to profit-sharing arrangements but focus on other financial indicators, such as total revenue, and additional measures of performance, especially customer service. This is the approach adopted by the National Provident Institution (see case study 1, Case studies).

Another difficulty is that, although, as was noted earlier, few profit-sharing schemes involve a real risk to the employee's basic salary, they are nevertheless in danger of raising expectations only for them to be dashed by circumstances outside of the control of both staff and company. Profitability can be adversely affected by numerous external factors which can prevent a payout even when, on alternative measures, corporate performance has significantly improved. For example, ICI, which has operated a profit-sharing system since the 1950s, reported in July 1998 that the high level of the pound had cost the group £40 million in lost earnings in the first half of the year and that the economic turmoil in south-east Asia had resulted in the loss of a further £20 million.⁵⁴ Pilkington, the glass manufacturer, faced a different problem, reporting that the General Motors strike in the US throughout most of June and July 1998 had cost the company £6 million in lost profits.⁵⁵ BAT's pre-tax profits in the three months to June 1998 were down 25% due to a £152 million legal settlement in the US over the adverse effects of tobacco and an increase in weather-related claims at its Eagle Star insurance subsidiary.⁵⁶

A reduction in profit-related payouts because of such experiences can have an adverse effect on employee involvement. Among our survey respondents, manufacturer Robert McBride acknowledged this potential difficulty, suggesting that the "'feast and famine' effect creates imbalance in employee perception".

A question mark also hangs over the ability of profit-sharing schemes significantly to change employee attitudes and to motivate them to work harder, given that in most cases the distribution of profits is skewed towards higher earners. A profit-sharing payment worth 9% of salary is of greater financial benefit to someone on £30,000 a year than to someone on £8,000, although its relative value might be worth more to those on lower salaries. Among our survey respondents, Liverpool Daily Post & Echo said that profit sharing was "considered unfair by some groups of employees".

Schemes that are not linked in any way to individual performance also run the risk of creating tension in the workplace. Where staff are equally rewarded without reference to their contribution, there is the potential for animosity on the part of those who have worked hard towards colleagues whose efforts have been less obvious.

Profit-related bonuses can clearly also be an expensive form of remuneration. Among our survey respondents, Scottish Provident UK pointed to the "cost to organisation" as a drawback, and HSBC Asset Management mentioned the "limited pool of funds allocation profits". However, in the case of approved profit-sharing schemes, although the costs are borne out of pre-tax profits, payments to the trust set up by the company to distribute shares to staff are tax-deductible. As a result, if a new issue of shares is used for the profit-sharing payout, the employer can realise a cash flow benefit.

Another obvious drawback of non-approved schemes is the lack of tax breaks, but some organisations believed this was compensated for by the ability to match remuneration to company objectives rather than Inland Revenue regulations. Hewitt Associates commented: "There are no tax benefits, but the opportunity to be flexible in application makes it better than PRP".

The reported advantages and disadvantages of profit sharing are summarised in figure 3.7.

Figure 3.7: Pros and cons of profit-sharing

An alternative to PRP?

On the above evidence, profit sharing is a form of financial participation that enjoys wide support. Where it is an IR-approved scheme, it is also a tax-efficient mechanism for both employer and employee. Clearly, therefore it is an option for employers contemplating their PRP exit strategies. Respondents to the Management Review survey with IR-registered profit-related pay schemes were asked to identify their definite or possible exit strategies, and around one in five (22%) said they would definitely or possibly introduce an IR-approved profit-sharing scheme. This was the most popular option in the category of alternative tax-efficient remuneration arrangements. The same number also said that they would definitely or possibly introduce a non-IR-approved profit bonus system.

(text missing)

NON-APPROVED PROFIT SHARING

A scheme which links cash bonuses to company performance. Participation in a profit-sharing scheme is at the company's discretion, but generally all employees are included subject to qualifying criteria, such as length of service. Payments are made from a profit-sharing pool and are fully liable to income tax and National Insurance. Employers are free to decide the size of the profit pool available for distribution to staff, although the bonus budget in some companies is based on a set formula. For example, payments may be triggered when a predetermined profit level is reached, with the size of the bonus or the pool increased on a sliding scale once the profit target is exceeded. Typically, individual payments are a fixed percentage of salary, although under some schemes eligibility is dependent on individual performance.

APPROVED PROFIT SHARING

A scheme which links cash bonuses to company performance. Participation in a profit-sharing scheme is at the company's discretion, but generally all employees are included subject to qualifying criteria, such as length of service. Payments are made from a profit-sharing pool and are fully liable to income tax and National Insurance. Employers are free to decide the size of the profit pool available for distribution to staff, although the bonus budget in some companies is based on a set formula. For example, payments may be triggered when a predetermined profit level is reached, with the size of the bonus or the pool increased on a sliding scale once the profit target is exceeded. Typically, individual payments are a fixed percentage of salary, although under some schemes eligibility is dependent on individual performance.

Inland Revenue approval, on which tax benefits depend, is likely to be forthcoming where a profit-sharing scheme meets the following conditions:

Participation

The scheme must be open to all UK staff, including part-timers, who have been employed for at least five years by the company which has established the scheme. A company may, at its discretion, also include staff with less than five years' service. Participation therefore is based on eligibility rather than board selection and no employee can be forced to participate. Shares can also be set aside for former employees up to 18 months after they leave.

Shares

All employees and directors are covered by similar terms, although the actual allocation of shares may be determined, for example, on a sliding scale by length of service or level of pay. The value of the shares set aside for each participating employee must not exceed £3,000 or 10% of annual earnings, whichever is the greater, subject to a ceiling of £8,000. Shares must be part of ordinary share capital (eg, attracting a dividend and, where applicable, bonuses) in companies quoted on a recognised stock exchange or in an unquoted company, which is not controlled by another unquoted business. Shares allocated under a profit-sharing scheme bestow on the holder the same rights, in terms of voting rights and the payment of dividends and other income, as on other shareholders.

Trustees

The trustees act as a vehicle to acquire the shares and they are generally appointed by the company establishing the scheme. Trustees cannot sell shares without the permission of the employee shareholder (or beneficiary) and they must notify each participant of the number, type and initial market value of their share allocation as soon as is practicable after the shares have been appropriated.

The trust acquires shares by purchasing them from existing shareholders (including scheme participants); by subscribing to a new issue of shares; by way of a gift; or from a rights or bonus issue of shares which have yet to be appropriated to scheme participants.

Staff - Eligible staff pay no income tax on the value of the shares when they are allocated to them by the trustees as long as they agree to leave the shares with the trustees for at least two years. Income tax on 100% of the share value is payable if the shares are sold in the third year after allocation. No income tax is payable if the shares are sold in the fourth year (or later) after allocation, although the employee may be liable for capital gains tax. The capital gains tax allowance, currently £6,500, can reduce all or most of any tax payable as a result of a rise in share value since the shares were appropriated to staff. Dividends are taxed in the normal way. At the release date (eg, the third anniversary of the date when the shares were appropriated), participants can opt to directly transfer their shares, worth up to £3,000 at the date of transfer, into a single company personal equity plan (PEP)*, which offers further tax advantages.

Business - Payments into the trust fund by the business are allowable as deductions in calculating the company's liability to corporation tax.

Matching offer or contributory schemes, also know as "buy-one-get-one-free" (BOGOF) schemes, operate on the same principles as profit-sharing schemes. Participants acquire shares out of their own funds and deposit some or all of them with trustees. This entitles the participant to receive additional shares free of charge under a profit-sharing arrangement. The shares deposited with the trustees by an employee do not count towards the statutory limit on the value of shares permitted under a profit-sharing scheme.

Inland Revenue rules state that the minimum amount a participant can invest in shares must be not more than £100 or 1% of salary. This is to ensure that as many employees as possible can participate in the scheme and it does not favour high earners.

BOGOF schemes are commonly used in the flotations of large companies and in privatisations.

Companies cannot award employees a cash bonus and invite them to take it in the form of shares under a profit-sharing arrangement. Under such circumstances, the Inland Revenue would assess income tax on the full amount. However, because participation in a profit-sharing scheme is voluntary, it is possible for participants to receive a share allocation under a scheme and for non-participants to receive an unrelated discretionary cash bonus which would be taxed in the normal manner - the individual has no right to receive a cash bonus in lieu of shares because he or she has declined to participate in a profit-sharing scheme. The cash bonus would be paid by the company not by the trustees.

The Association of British Insurers (ABI) publishes share incentive scheme guidelines to provide a "framework which will enable companies to operate the full range of employee share schemes within prudent limits which avoid undue dilution of the interests of existing ordinary shareholders". The ABI recommends that in order to prevent equity dilution due to share option and profit-sharing schemes, "no more than 10% of the issued ordinary share capital from time to time should be set aside for all the company's schemes in any rolling 10-year period". ABI guidelines also say that profit-sharing schemes should only come into effect once the company has announced its final results.

More information:

Inland Revenue: Approved profit sharing schemes - an outline for employees (Personal Taxpayer series IR95)

Inland Revenue: Approved profit sharing schemes - explanatory notes (Practitioners series IR96)

Association of British Insurers (1995), Share option and profit sharing (ABI guidance notes). Contact: ABI, 51 Gresham Street, London EC2V 7HQ. Tel: 0171 600 3333

* Personal equity plans will be replaced by Individual Savings Accounts from April 1999 but PEPs transferred into them by 5 October 1999 will continue to have special tax status.

¹     Report on profit-sharing and labour co-partnership in the UK, Cmnd 544 (1920), pp.13-15, quoted in Baddon L, Hunter L, Hyman J, Leopold J and Ramsey H (1989), People's capitalism: a critical analysis of profit-sharing and employee ownership (Routledge, London), pp.5-6.

²     Ministry of Labour Gazette, July 1930.

³     Inland Revenue Statistics.

⁴     Church R A (1971), "Profit-sharing and labour relations in England in the nineteenth century", International Review of Social History, XVI, part 1; Bristow E (1974), "Profit-sharing, socialism and labour unrest", in Brown K (ed), Essays in anti-labour history (Macmillan, London).

⁵     IRS (1995-1998), Pay and Benefits Bulletin 401, 417, 441 and 451.

⁶     Office of National Statistics (1998).

⁷     Ibid.

⁸     Weitzman M L (1984), The share economy: conquering stagflation (Harvard University Business Press, Cambridge).

⁹     Bradley K and Estrin S (1986),

The success of the John Lewis Partnership: a study of comparative performance (Partnership Research Ltd, London), p.23.

¹⁰    Ibid.

¹¹    St Michael News (Marks & Spencer staff newspaper), May 1997.

¹²    IRS (1993), "Lowest percentage parnership bonus for 34 years at John Lewis", Pay and Benefits Bulletin 325, April, p.8.

¹³    IRS (1998), "Finance deals dip to 4%", Pay and Benefits Bulletin 449, June, pp.7-12.

¹⁴    Marks & Spencer letter to shareholders, 9 June 1977.

¹⁵    IRS (1998), "We're in this together: profit-sharing schemes", Pay and Benefits Bulletin 444, March, pp.2-8.

¹⁶    British Airways plc annual report & accounts 1995-96.

¹⁷    IRS, see note 15, above.

¹⁸    National Grid Company: staff information pack (1997).

¹⁹    Vodafone Group plc annual report 1996.

²⁰    The Boots Company plc annual report 1997, p.41.

²¹    IRS (1997), "Rover Group: three-year inflation-plus deal agreed early", Pay and Benefits Bulletin 430, August, p.12.

²²    IRS (1998), "Midland Bank: merit awards worth up to 6% for clericals", Pay and Benefits Bulletin 449, June, p.11.

²³    IRS, see note 15, above.

²⁴    The Gazette, John Lewis Partnership newspaper, 2 March 1996.

²⁵    IRS (1998), "Nationwide Building Society: 5.5% pay pot", Pay and Benefits Bulletin 441, February, p.10.

²⁶    IRS (1997), "Halifax Bank: 3% benchmark award", Pay and Benefits Bulletin 432, September, p.10.

²⁷    IRS, see note 15, above.

²⁸    Ibid.

²⁹    IRS (1997), "Thames Water: performance pay rises of 1.6% to 5%", Pay and Benefits Bulletin 436, November, p.10.

³⁰    National Grid Company: staff information pack (1997).

³¹    Millward N, Stevens M, Smart D and Hawes W R (1992), Workplace industrial relations in transition: the ED/ESRC/PSI/ACAS surveys (Dartmouth, Aldershot), p.262.

³²    Baddon L, Hunter L, Hyman J, Leopold J and Ramsey H (1989), People's capitalism: a critical analysis of profit-sharing and employee ownership (Routledge, London).

³³    Employee share ownership research: stage 1 - status of employee shareholding in UK companies (Proshare, London).

³⁴    Millward et al, see note 31, above, p.262.

³⁵    Proshare, see note 33, above.

³⁶    Smith G (1993), "Employee share schemes in Britain", Employment Gazette, April, pp.149-154.

³⁷    Smith G (1986), "Profit-sharing and employee ownership in Britain", Employment Gazette, September, pp.380-385.

³⁸    IRS, see note 15, above.

³⁹    Proshare, see note 33, above.

⁴⁰    Millward et al, see note 31, above, p.262.

⁴¹    Proshare, see note 33, above.

⁴²    Baddon et al, see note 32, above.

⁴³    Sloan R and Jackson N (1996), Sharing in success? Employee and executive financial participation in FTSE 100 companies (Bacon & Woodrow, London).

⁴⁴    Ibid.

⁴⁵    IRS, see note 15, above.

⁴⁶    Ibid.

⁴⁷    Ibid.

⁴⁸    The new British Aerospace profit-sharing scheme: an equal share in our success (BAe, 1997).

⁴⁹    The partnership report: seven partners - a balanced view (Cooperative Bank, 1998).

⁵⁰    The Gazette, John Lewis Partnership newspaper, 2 March 1996.

⁵¹    IDS (1998), "Peugeot pays PRP bonus of 1.5% after rise in profits and productivity", IDS Report 761, May, p.7.

⁵²    IRS, see note 15, above.

⁵³    Proshare, see note 33, above.

⁵⁴    The Guardian, 24 July 1998.

⁵⁵    Ibid.

⁵⁶    Evening Standard, 29 July 1998.