As financial advisors create their own team practices or go independent and set up independent RIA firms, one of the biggest challenges they face is designing a compensation plan for themselves and those who work with them and for them. The problem is that there seem to be unlimited ways to do this, and advisors have to figure out which one is right for them.

Doing so means understanding what their firm's strategic goals are and what sort of compensation incentives are important given the specific talents, skill levels and motivations of the individuals working with them.

There are essentially six steps to take when you're creating your compensation plan. These should be followed in order to gain the most benefit from the process:

Evaluation. First you must conduct a comprehensive evaluation of the compensation plans already out there and develop a feedback report of the findings.

Compensation philosophy. Next, you must define your company's compensation philosophy, which defines how and with whom the company intends to compete for its human resources and how and under what terms its advisors and/or employees will be rewarded. This might mean setting fixed compensation (based on salaries) or it might mean creating variable compensation models (mixing different sorts of pay such as a percentage of assets under management; a percentage of gross dealer compensation; or a percentage of commissions, trails, recurring fees, etc. In most cases, your compensation structure will be a unique blend of some or all of these elements to best match the firm's philosophy.

Job analysis. After that, you should conduct a comprehensive analysis of each person's job to determine his or her primary functions, duties and responsibilities. This analysis will allow you to create a framework to develop market pricing. You should compare the compensation for each position in your firm with the industry's standards. Such an analysis should allow you to understand every person's unique contribution to the success of the firm.

Administration guidelines. The fourth step is to create a salary/bonus/incentive structure and write administration guidelines that let you set pay for each member of a firm and adjust it for performance, future promotions, changes in job function, specialization and changes in market rates.

Incentives and bonus plans. When appropriate, develop incentive or bonus plans that reward participants for hitting specific performance measures and achieving certain goals. Also, develop a financial model of the incentive plan costs that takes into account the different amounts you might actually have to pay out.

Long-term stakeholder plan. When appropriate, you should develop long-term plans that reward the members of your team for creating long-term shareholder value. This means writing up guidelines for granting stock options, stock or other equity instruments or equity-like "phantom" plans, as appropriate for your employees or producers. This often means you must research stock option granting practices in the market (finding out how many shares you should offer, at what price grants are made and how options vest). If long-term plans entail paying cash awards, you should assess how much such awards would cost in different scenarios and develop measures for making sensible long-term cash payments that can be adjusted and changed in different economic circumstances.

Even after you have set down these six steps, however, the plan will not work if your firm can't afford it or if it runs counter to the best interests of your clients. For that reason, any compensation plan must be accompanied by a study of how it fits into the overall strategic initiatives of the firm. This should be done in concert with a cost/benefit analysis to ensure you can pay for the plan. And perhaps most important, you should also perform an impact study on how such a plan would affect your clients.

One of the common mistakes financial advisors make when designing a pay structure is failing to consider how an economic downturn might hurt the firm (and lose it revenue). If you have a static plan (offering fixed salaries plus bonuses), the costs can quickly spiral out of control when you suddenly have less income to handle the expenses. There may be strong reasons to use some fixed component in the payouts anyway. But it is also good to structure plans so that compensation dovetails with a firm's profitability in some meaningful way by adding a variable component as well. That offers you the ability to curtail some compensation in years when the firm confronts flat revenues or even sees them decline.

Another mistake advisors make is to promise too high a payout for an employee's productivity only to find that it never materializes. It is far more difficult to negotiate down on compensation than up. Yet another misstep is to focus on new business production, (where you weight new business payouts more heavily than existing AUM-related compensation). This leaves your employees with little motivation to service existing clients. The opposite can be a problem as well, though, when compensation is based solely on servicing existing clients, which might deter the search for new ones.

The solution is to create a plan that delicately balances the firm's need for new business with the mandate to properly handle your current clients. At the same time, it must be an affordable program that motivates employees to stay productive and stick close to the firm's goals. It's a mistake to create a compensation structure without tying it in some meaningful way to the firm's strategic plans.

The biggest mistake of all is to assume that a compensation plan can and should be developed in a vacuum, without considering other related aspects of your business. For example, a firm might develop an employee compensation plan now, but leave its business continuity plan until later-even though each greatly depends on the other. Developing both together in a comprehensive effort would avoid the costly reworking of either one by itself later.

Consider also how it might hurt the firm to build a compensation plan that covers only some of the firm's employees/advisors. Perhaps your firm has decided to implement a new compensation plan for producing advisors and reps while leaving intact the current compensation arrangements for other types of employees. If the bonus plans and incentive programs are limited to only part of the team, those left out could feel alienated by the process.

Which brings us to one final point about the development of compensation plans: They should be a collaborative effort that includes input from all affected members of the firm. You are much more likely to have employees buy in if they have at least some say in how the plan is developed.

You may choose to take this journey by yourself or with the help of a third-party consultant. But whomever you work with, ensure that he or she has considerable experience in developing such plans. The devil is in the details.

David L. Lawrence, RFC, ChFE, AIF, is a practice efficiency consultant and is president of EfficientPractice.com, a practice consulting firm based in San Diego, Calif. (www.efficientpractice.com). The Efficient Practice offers an advisor network and a monthly newsletter.