A “Back to Basics” article by Blair Jones in the November/December issue recommended that a company consider three factors when creating a compensation philosophy: business priorities, management style and organizational culture. This article shares insights about how to determine the right incentive metrics to align compensation with business priorities. Since a significant portion of total compensation at the senior level is provided through long-term incentives, this article focuses on them, but the same approach could be applied to metric selection under short-term incentives. I think selecting the right metrics is one of the easiest things to do from an executive compensation point of view. At the same time, assigning appropriate quantitative goals against these metrics is probably the most difficult step.
Let’s start with the easier step: selecting metrics. HR professionals are responsible for leading these efforts, but Finance and the CEO also play significant roles. I suggest HR and its partners review the following materials to narrow down potential metrics:
- The company’s business plan, including its short- and long-term plan. A number of companies share their strategies at annual investor days and conferences organized by institutional investors/industry analysts. The materials for these discussions provide valuable insights into management’s priorities and focus areas. Similarly, a company’s quarterly earnings documents (press release, 10-Q, call transcript, call deck) are likely to provide additional insights into focus areas for management. Since most of these materials are reviewed by the company’s board and scrutinized by external parties, these materials are an excellent source from which to create a short list of potential incentive metrics.
- Analysts’ reports on the company, including industry reports. These materials, if available, are a valuable source to review value drivers from an industry expert’s point of view. These analysts know the company and its industry very well, including the company’s strengths and opportunities.
- Incentive metrics used by industry peers. This data should guide the decision-making process and could be used to validate metrics suggested by the first two sources. Peer data, however, should not be the main reason for selecting or rejecting a metric.
A few other thoughts to supplement the above process: Generally, two to three metrics should be used under the long-term plan to avoid placing too much emphasis on one measure. Use of multiple metrics also allows companies to balance profitable growth (e.g., revenue, earnings per share) and return measures (e.g., return on invested capital). Management also should consider practical issues (for example, how easy or difficult it is to track the desired metric). Market share could be a preferred metric, but is not always easily quantifiable. Another potential issue is goal setting. For example, is management comfortable setting a three-year goal for the preferred metrics?
Finally, we can’t complete metric discussions without referring to use of total shareholder return (TSR). Generally, management, the board, and shareholders do not like TSR as a primary metric. Shareholders seem to prefer a relative metric under these plans and since it is very difficult to have a relative financial metric (e.g., relative EPS), use of TSR as a modifier is an attractive alternative. TSR, however, comes with its own pros and cons and could be a topic for our next discussion.
Anil Agarwal is senior vice president of global compensation at American Express