Under the microscope Featured

8:00pm EDT August 26, 2009

It’s hard to hit a moving target. So when faced with the convergence of a volatile economy, new government legislation on executive pay and the growing momentum behind say-on-pay initiatives, many companies adopted a wait-and-see approach when constructing 2009 executive short-term incentive plans, opting for scaled-down or discretionary incentives until the dust settles.

Despite the complexities of developing realistic performance objectives and payout opportunities, as well as navigating a multitude of legislative changes under the watchful eye of investors, companies need to maintain the motivational and retentive qualities of their incentive plans. Compensation committees and executive management are being challenged to develop short-term incentive plans that are fundamentally sound, do not promote excessive risk-taking and can withstand increased scrutiny from the SEC and shareholders.

“Based on the fallout from the stock option backdating scandals, we learned that duck-and-cover is not a viable strategy for resolving executive compensation issues,” says Jason Taylor, senior compensation consultant for Watson Wyatt Worldwide. “Failure to act may result in the withholding of board member votes and negative press to financial settlements.”

Smart Business spoke with Taylor about the best ways to redesign and document executive short-term incentive plans in the current environment.

What’s influencing the trend in executive short-term incentive design?

Bonuses paid to executives in financial firms receiving government funds (TARP participants) exacerbated the already growing shareholder sentiment that executive pay is not appropriately calibrated to company results and needs greater oversight. So now the legislation originally created for TARP recipients may lead to broader intervention in all companies, including a stated review of the relationship between incentive pay and excessive risk taking and clawbacks of bonuses or incentives that were awarded to executives based upon materially inaccurate financial statements. This trend will likely influence pay actions in privately held companies as well, as stakeholders will want to ensure their short-term incentive plans meet corporate governance practices.

Additionally, as a result of enhanced disclosure requirements and the introduction of say-on-pay legislation, shareholders and investors have more access to compensation data, and are being more vocal with their opinions. Further, the SEC continues to review proxy statements to determine whether they contain sufficient rationale, background and information in describing the incentive plan design process, which requires the compensation committee’s validation and confirmation.

How can companies strengthen their incentive plan design process?

The overall theme is to apply more analytical rigor to the process. While citing the practices of industry peers is a good start, compensation committee members and executive management need to take their documentation and testing process to the next level by demonstrating why the plan mechanics and payout opportunities are appropriate for the company’s unique situation. We often find that, in many cases, there is historically little correlation between the metrics used to calculate executive short-term incentives and year-over-year shareholder return. Further, companies often fail to analyze the probability of performance achievement, which can result in sandbagging or windfall bonuses and no-confidence votes from shareholders.

The analytical process should include, at minimum, determining which metrics support the company’s short- and long-term strategic and financial objectives, analyzing the correlation between changes in shareholder value and various combinations of performance metrics, as well as reviewing incentive opportunities in relation to set performance levels. Additionally, incentive structure and mechanics should be analyzed to determine to what extent, if any, the plan promotes excessive risk taking. Last, document the process and findings in order to meet disclosure requirements and justify the appropriateness of the plan design.

What are the best incentive design work steps to follow?

  • Continue to benchmark against peer companies and credible compensation survey data with comparable jobs. Avoid small sample sizes in both peer company and survey data, as well as any statistical summaries that have low confidence levels.
  • Consider incentive opportunities within the context of executives’ total compensation package, not on an element-by-element basis.
  • Evaluate incentive plan components independently to assure they incent appropriate behaviors and outcomes that have strong relation to improved shareholder returns.
  • Use performance thresholds and bonus caps to avoid unintended consequences.
  • Most importantly, calibrate incentive levels to appropriate performance. For example, 75th percentile pay opportunity should require 75th percentile, or above, performance.

What is the best way to set realistic year-over-year performance goals in a turbulent environment?

If projecting next year’s goals is too challenging, consider linking incentives to operational or qualitative improvements that historically have a strong relation to financial performance. Consider shorter-term incentives (e.g., quarterly, semi-annually) for hitting interim benchmarks, with overall year-end adjustments based on annual performance. Although discretionary plans are always an alternative, these plans may have a hard time passing muster with investors and the SEC in the current climate. Additionally, they can lead to management ‘gaming’ and/or entitlement issues, which makes conversion back to a true pay-for-performance incentive plan extremely painful for everyone.

Jason Taylor is a senior compensation consultant for Watson Wyatt Worldwide. Reach him at Jason.Taylor@watsonwyatt.com or (415) 733-4125.