Setting incentive goals always has been one of the biggest challenges in incentive plan design. It’s also the most important. While the target level of performance often receives most of the attention, it’s the performance range around the target that actually drives incentive payouts. Setting the right performance goals is where the rubber meets the road, and it is key to ensuring alignment between pay and performance.
Compensation committees face a challenging balancing act when approving incentive goals. The committee must balance goal setting that is fair and properly motivates management with payouts that are appropriate for the results delivered to shareholders. Additionally, committees make these decisions when information is asymmetrical: Management has a more in-depth understanding of the business and a better sense of the difficulty of the goals. This adds to the complexity the committee faces in carrying out its fiduciary role of assessing and improving incentive plan goals.
Goal setting can go off track in even the most well-intentioned and rigorous pay-for-performance cultures.
Investor scrutiny also is higher than it’s ever been. Institutional investors and proxy advisers are assessing incentive goals more rigorously and diving deeper in those assessments by looking at things like year-over-year growth or comparisons to company earnings guidance. In some cases, incentive goal setting even becomes ammunition for activist investors: In 2017, Trian Fund Management criticized the incentive plan goals in its proxy campaign with Procter & Gamble Co.
Goal setting can go off track in even the most well-intentioned and rigorous pay-for-performance cultures, with the most common breakdown occurring in the performance ranges. For instance, consider a company with a strong pay-for-performance orientation that starts with the board and CEO, and cascades down the organization. This company sets aggressive stretch budgets and narrow performance ranges around the budget for threshold and maximum incentive payouts. The goal is to pay well for exceptional performance and avoid paying for underperformance. The plan covers the top several layers of management, so the goal-setting philosophy carries down to the division level. Yet, while the intent of this plan is commendable, this goal-setting philosophy has led to unintended consequences: More than two thirds of the payouts were at the extremes of the range, either below threshold or above maximum. In addition, many payouts were driven by influences outside of management’s direct control. In the end, the incentive plan was more of a lottery rather than a truly aligned program that measured management’s contributions.
Fortunately, a few simple guidelines and analyses can give the compensation committee a framework to get more comfortable with goal setting.
Determine a Philosophy
The goal-setting philosophy provides an overall framework to guide the process and can help address the diffi culty of goals (e.g., how frequently goals and performance ranges need to change to recognize changing business circumstances; how often the incentive plan should pay at threshold, target and maximum).
One approach some companies use is to set a fixed ratio for threshold and maximum performance levels that is consistent year to year. Under this philosophy, a company might set threshold performance at -10% from budget while maximum performance might be set at +10% from budget. The rationale for this approach is, on average and over time, payouts will be appropriate even if that year’s payouts are not perfectly aligned because ranges are too broad or narrow for that year’s business circumstances. This approach is simple to administer and transparent to all stakeholders, but the challenge is that it does not adjust for unique situations in any given year.
Another approach is to change the threshold and maximum performance levels each year based on the business environment and stretch in the budget. Figure 1 demonstrates a simple framework in which threshold performance is set to be exceeded 90% of the time and maximum performance is set to be achieved 10% of the time. The performance required for threshold (10% below budget) and maximum performance (15% above budget) would change each year to keep the likelihood of achieving those goals at 90% and 10%, respectively. The challenge with this approach is truly knowing what level of performance is 90% likely or 10% likely to occur in any given year. Seasoned executives and board members may be able to accurately estimate the levels, but supplementing an intuitive estimate with data and analysis also is helpful. That’s where the next two approaches come into play.
Review Probability of Achievement
Analyzing historical financial results helps provide a baseline for what may (or may not) be achievable. Figure 2 demonstrates how probability of achievement for a set of comparator companies can be used to provide additional context to a company’s incentive plan goals. In this analysis, financial results are analyzed over a period of time (10 years, in this case) for a group of similar companies (e.g., 10 to 20 companies in the same industry and with similar economics). This analysis can be used to understand what levels of financial performance are realistic to expect.
Probability of achievement analysis needs to be used carefully. It clearly works best when there is a clear set of companies that all are subject to the same industry and business dynamics. It also is critical to understand the time period analyzed and the effect of any anomalous periods. In some cases, anomalies can be informative to understand the effect outliers can have, while in other cases they can distort results and make them less applicable for go-forward periods. For example, reviewing the performance of financial institutions from before the financial crisis may not be applicable in today’s environment. However, historical analysis often provides helpful context, despite some imperfections.
Test Sensitivity of Goals
In addition to historical analysis, understanding the current drivers of performance and the sensitivity of the various drivers on performance provides forward-looking perspective on an expected range of outcomes based on the current business situation. For instance, another company prepares a set of analyses each year for the committee to help illustrate how the maximum earnings per share (EPS) goals could be achieved based on key drivers (e.g., same-store sales, operating margin). (See Figure 3.)
Strict adherence to reported metrics may not always be appropriate for incentive purposes.
This approach helps evaluate the goals in the current economic environment and operating model as well as supplements historical probability of achievement to help understand realistic performance outcomes.
Understand External Expectations
Proxy advisers and institutional investors increasingly are looking at incentive plan goals relative to both company earnings guidance and analyst expectations. A well-informed compensation committee should understand how the incentive goals stack up against other Wall Street inputs. For example, would achieving target payout mean that consensus earnings were achieved? How far above consensus is the maximum performance level? Based on inputs, the committee can understand how investors may perceive payouts at the end of the year. (See Figure 4.)
Some more technically oriented companies take analysis of external expectations one step further: They analyze the potential effect that achieving incentive goals may have on the stock price. They accomplish this by applying financial models (either discounted cash flow or forward earnings multiples) to the goals. The comparison to Wall Street expectations also can become part of the discussion in the Compensation Discussion and Analysis (CD&A) relative to the goal-setting process, which helps with shareholder communication for the say-on-pay vote.
Test Sharing Ratios
Another helpful guidepost is to understand the sharing ratio in the incentive plan. That is, how much of the company’s incremental earnings are being paid out in incremental bonus? Figure 5 illustrates how a sharing ratio often is defined.
Several factors can affect sharing ratios, including weighting and type of metrics; number of plan participants; and presence of other incentive plans throughout the company that may be tied to different metrics. While these factors can create challenges when making comparisons across companies, general guidelines are still a useful reference. Typically, sharing rates are between 20% and 30% for an incentive plan that covers a broad population. Competitive practices in some industries support a higher sharing rate (e.g., highly paid financial services professionals). But, for the most part, a sharing rate that is too high or too low would suggest the need to re-evaluate the level of performance required to achieve maximum payout and then adjusting the payout curve. Figure 5 demonstrates how the performance range could be adjusted based on the sharing rate.
Adjustments to Financial Results
A second, related goal-setting challenge is determining if (and when) to adjust financial results for incentive purposes. Of course, the simplest and most straightforward approach is to adhere to Generally Accepted Accounting Principles (GAAP) or standard GAAP-adjusted metrics, which are consistently reported as part of investor communications.
However, strict adherence to reported metrics may not always be appropriate for incentive purposes. Adjusting goals for events not contemplated in the budgeting process or outside of management’s control sometimes can be the fairest outcome for both management and shareholders. Following a few guidelines can help committees navigate a path through an area that often is fraught with challenges:
- Establish guidelines for adjustments at the beginning of the year. Securing agreement early on the types of items that will be considered for adjustment helps avoid scrambling at year-end. It also helps avoid situations in which the performance outcome may be known when adjustments are being considered or the dynamic between management and the committee becomes uncomfortable.
- Ensure adjustments are fair. One way to test the appropriateness of adjustments over time is to consider the effect on incentive payouts over a multi-year period. If payouts always are adjusted up (or down), there may be some bias in the adjustment methodology that needs to be addressed.
- Disclose rationale for adjustments. Investors are scrutinizing incentive plan adjustments more closely. It helps mitigate investor concern, and the effect on the say-on-pay vote, if the rationale for adjustments is clearly disclosed in the proxy. The company should be willing to stand behind the adjustments and clearly disclose why they are appropriate in the context of incentive payments.
The challenge of setting incentive plan goals always will exist, but getting it right is important.
After all, the performance goals — particularly threshold and maximum performance levels — are where the rubber meets the road in the incentive plan.
Companies can help ensure the incentive plan is hitting on all cylinders by defining the goal-setting philosophy upfront and informing the goal-setting process with historical and prospective data and analysis. Certainly, all of these approaches may not be appropriate for all companies or in all circumstances. However, in today’s environment, with a heightened focus on incentive plan goals from institutional investors and proxy advisers as well as activist investors, these analyses and frameworks help compensation committees apply a consistent, rigorous approach and have confidence that incentive goals are based on an informed and thorough process.