As businesses navigate uncertain times, the design and adoption of balanced, resilient pay for performance enforcement compensation programs will help businesses move forward through storm waters. If they don't already have it, the Compensation Committee may consider incorporating certain features, such as non-financial metrics, into the annual incentive plan, ensuring that long-term incentive programs balance performance payments and retention needs. Thoughtful planning design can significantly increase the resilience of these programs, even during periods of uncertainty.
Annual Incentive Plan
Over the years, the Annual Incentive Plan (AIP) has primarily rewarded participants for achieving key company financial goals, such as revenue, profitability and cash flow targets. However, in recent years, some companies have focused partially on non-financial metrics within AIP, as Covid and other events have limited future-looking financial visibility. Financial metrics are important, but they focus solely on financial results for the planning year. In an era of AIP and economic uncertainty within a particular industry, we recognize the value of measuring non-financial outcomes as well as metrics related to customer satisfaction, safety, operational goals and strategic goals. This change reflects the understanding that an organization's long-term success is built on both a strong financial and non-financial performance foundation. By maintaining a healthy balance between financial metrics and non-financial indicators, businesses can measure financial success while also recognizing the importance of key non-financial drivers.
Using a “balanced scorecard” approach to AIP design can help you address volatility related to financial metrics. A balanced scorecard approach to AIP provides the opportunity to leave some of the program “holding in money” and reward participants to achieve key strategic and operational metrics, even when financial results are lower than expected. A diverse set of performance measures will continue to function as an effective tool for participants' motivation, rewards and retention, even if it becomes clear in the planning year that their financial goals are far below the target.
Another approach that can be useful to businesses during turbulent times is to set broad performance targets for your target. A wide spread between thresholds, targets, and maximum targets (or parallel slopes of the performance curve) increases the likelihood of getting some payment, reduces the probability of maximum payment, and if the economic situation rebounds faster than expected.
Long-term incentive planning
It is common for compensation committees to adopt the philosophy of performance, but there is a need to balance several objectives (motivation, retention, shareholder adjustment, equity ownership) when designing long-term incentive (LTI) programs. A program mix that overwhelms any kind of award (e.g. performance share, time-based limited stock or stock options) can lead to suboptimal results at uncertain times.
For example, performance shares related to shareholders' total returns or stock options alone may have been “out of money” due to unstable market conditions, resulting in little retention value. Therefore, time-based limited inventory appears to counter the philosophy of performance, which can be viewed negatively by external observers, allowing a meaningful portion of executives' annual LTI opportunities in time-based limited stocks (e.g. 25% to 40%). Maintaining a balanced and resilient LTI programme not only strengthens retention during uncertain times, but also reduces the need to grant special retention awards outside of normal program structures. This is usually at a disadvantage by proxy advisors and institutional investors.
When designing performance shares, further actions can be taken to increase the resilience of your LTI program. For example, winning an award using multiple metrics may increase your chances of getting the right payment. In particular, award-winning can help you increase your resilience by using both absolute and relative performance measures. During periods of uncertainty, relative performance measures may provide an opportunity to win payments if achievement of pre-established financial goals proves challenging. Like AIPS, setting a wide range of performance targets around your target also helps businesses navigate periods of uncertainty and increase the likelihood that payments will be earned.
Periods of high volatility may highlight executive compensation programs. However, the Compensation Committee can assess whether existing programs effectively balance performance-based pay with design factors that promote resilience. This exercise helps businesses achieve program designs that work well in a variety of economic situations and avoid the need for extraordinary actions that can trigger scrutiny of wage practices.
