With increased scrutiny of executive compensation and greater transparency attributable to enhanced disclosure requirements, having a pay-for-performance compensation philosophy is practically a must for U.S. companies. Companies not only need to show a relationship between executive pay and company performance but they also must demonstrate that they pay the appropriate level for performance.
One of the main challenges in designing an incentive plan is being able to forecast company performance and setting goals at the right level, especially for periods longer than a year. Executives are motivated, and the likelihood of desired performance increases under incentive plans when the following conditions are met:
1. Clear performance metrics—executives understand the performance goals and view them as achievable.
2. Clear ties to pay—there is a clear link between performance and compensation.
3. Meaningful incentive levels—executives view the pay associated with the incentive plan as meaningful. For example, it is large enough to justify the effort required to achieve the performance goals.
If performance goals are not set appropriately, there can be negative consequences. If performance goals are set too high, executives will not be motivated, knowing that there is little likelihood of achieving the targets. At the other extreme, if executives are achieving the performance targets consistently and easily, executives are being sent the wrong message that superior performance is not necessary to receive an incentive payout.
Typically, short-term incentive plans have established performance levels:
• Threshold—a floor represents the minimum level of performance that must be achieved before an incentive can be earned. The most prevalent threshold is 50 percent of target.
• Target—the expected and/or planned level of achievement or a realistic goal that is achievable and meaningful.
• Maximum—the total incentive opportunity that may be earned for superior performance, sometimes referred to as a cap. The most common maximum payout levels are 150 percent and 200 percent of target.
The level of performance relative to target that should correlate with threshold and maximum payout levels can be difficult to calibrate. A simplified approach is to set the threshold performance level at 80 percent or 90 percent of target performance and to set the maximum performance level at 110 percent or 120 percent of target performance.
For example, if revenues are the performance metric and the target is $1 billion in revenues, then a maximum performance level based on 120 percent of target, or $1.2 billion, might be reasonable. However, if total shareholder return (TSR) is the metric and 10 percent TSR is target, then 120 percent of target, or 12 percent TSR, would likely set the maximum goal too low.
Calibrating threshold and maximum goals appropriately can depend greatly on the performance metric. One way to test the reasonableness of the goal-setting process is to estimate the probabilities of achieving the performance levels and compare them to standard achievement frequencies.
• Threshold goalswould be achieved 80 to 90 percent of the time.
• Target performance goalswould be achieved 50 to 60 percent of the time.
• Maximum goalswould be achieved 10 to 20 percent of the time.
Goal Setting Approaches
There are two basic approaches companies can use in setting the right goals.
• Absolute—goals are set based on the company’s year-over-year performance, and budgets are developed assuming the projected growth of the company. An internal approach requires a strong planning process and is difficult in industries where external events can have a dramatic impact on results. Performance goals are usually effective when there is rigor around the goal-setting process and the goals are based on the company’s strategic and operating objectives. This approach can be enhanced if shareholder expectations are incorporated in the process.
• Relative—goals are focused on how a company performs relative to its competitors or peers. A relative or external approach measures the company against direct competitors that are impacted by similar macroeconomic factors and that compete in the same market or with the same products. This approach eliminates the need to set internal company performance goals because it focuses on how the company performs against its peers. In addition, it mitigates the risk of setting the goals too high or too low.
A potential drawback to a relative approach is selecting a peer group, which might be difficult for some companies. It might be particularly challenging for companies with a unique business model or in a consolidating industry. The relative approach can sometimes result in unintended payouts. If a company outperforms the majority of its peers, it’s nevertheless possible that it created negative value to shareholders, such as negative profitability or negative total shareholder return. This situation can be addressed in the following ways:
1. The compensation committee may apply discretion in determining the incentive payouts.The committee would have the ability to pay no incentives if the company did not create any shareholder value.
2. An absolute threshold can be established where no incentives are paid if the threshold performance level is not achieved, in addition to the relative goals based on performance compared to the peer group.
In selecting a goal-setting approach, companies should consider several factors:
• Management process—how much rigor and structure is in the process? How much information is available to management regarding shareholder and analyst expectations and peer company metrics?
• Strategic priorities—what are the company’s business objectives, and what is its ability to forecast performance based on the company’s life cycle and maturity?
• Company performance—how volatile is the company’s performance on an absolute basis and relative to peers historically?
Setting goals for incentive plans is a subjective process that requires much discussion and consideration. The board and management should be able to provide sound rationale for the goals and approach selected.
David Wang is a consultant in Hay Group's executive compensation practice.
Originally published in Hay Group’s newsletter, The Executive Edition, 2008, No. 4.