Annual Incentive Metrics: Hit the Target

Issues regarding the use of the performance metrics on which organizations base their annual incentive payouts to employees were raised in several sessions at the 2014 WorldatWork Total Rewards Conference, held in Dallas May 19-21.

“At more than 90 percent of U.S. companies, broad-based variable pay is a key component of companies’ total compensation programs,” said Ken Abosh, compensation practice leader at consultancy Aon Hewitt. Typically, variable pay for salaried employees is about 12 percent of payroll, he noted.

Incentive payouts are based primarily on meeting overall organization performance targets and individual performance targets. Some organizations also include team performance, although “it can be difficult to determine where a team starts and stops,” Abosh noted.

The right balance of metrics on which to base rewards is crucial. “If the targets are too easy, the rewards risk becoming an entitlement. If the targets are too difficult, people just give up,” he pointed out.

Typically, plans include a:

• Threshold or minimum level of performance achievement (i.e., paying 50 percent of the reward if 80 percent of the goal is met).
  
• Target business goal (i.e., paying 100 percent of the reward if the target is 100 percent met).
  
• Maximum level of performance achievement above target, setting the upper limits of the payout (i.e., a 150 percent payout if 120 percent of the target is achieved).

An Optimal Number

For organization targets, Abosh recommended that incentives be clearly understood “line-of-sight” measures, that no more than 3 to 5 metrics be used, and that they be clearly communicated both at the start of and throughout the year.

According to 2014 research reports produced jointly by Deloitte Consulting and WorldatWork and referenced during a conference session led by Deloitte, most U.S. companies whether private and publicly traded rely on one to three organizational performance measures for their annual incentive plans:

Peer Group Comparisons

"When using a relative metric, the right peer group makes all the difference," explained Dan Laddin, a founding partner of Compensation Advisory Partners, who co-presented with Takis Makridis of Equity Methods.

Their session highlighted commonly used company performance metrics, such as — predominantly — growth in total shareholder return (TSR) encompassing stock appreciation and dividends, as well as additional financial metrics including:

• Earnings
• Revenues
• Profits
• Cash flow

Other, industry-specific metrics, might focus on employee safety (manufacturing) or customer satisfaction (retail), for instance.

But these metrics only become meaningful in their performance is measured relative to that of true marketplace competitors, so as to distinguish the company's out- or under-performance.

While total shareholder return “embeds every other metric, participants may not understand how they impact value,” Laddin noted. “No one comes to work in the morning and says, ‘Today I’m going to manage TSR.’ ”

Makridis advised monthly reporting to employees on company performance, “or at least quarterly,” so participants in the incentive program understand how their performance impacts payout.

Stephen Miller, CEBS, is an online editor/manager for SHRM. Follow him on Twitter @SHRMsmiller.