3 Indispensible Definitions for Annual Incentive Plan Disclosure

Two years ago Egan Associates noted confusion among leading companies about the difference between “target” and “maximum” for annual incentive performance disclosure.

Target or maximum?

Conducting analysis recently, it became clear that the problem has not been resolved. There are still companies that are confusing the two terms.

There are three definitions that should be a reference for any company facing confusion on this matter:

  • Threshold – minimum performance level to earn an incentive payment.  Shareholders would anticipate that threshold reflects an improvement on the prior year.
  • Target – Performance aligned to the business plan embracing a certain level of stretch, but not “shoot the lights out” performance.
  • Maximum – Reflecting a payment arising from highly superior performance outcomes. Performance of this calibre would be the exception rather than the rule.

If these definitions are adhered to, payments made at target performance levels should not be the same as the maximum payment an executive can receive. Yet there appear to be companies where the target payment does equal the maximum payment (often called “target maximum” or similar).

In such cases, a shareholder should be asking:

  • If the “target maximum” performance is in line with business plan expectations, why is it the highest performance the company is aiming for under the incentive scheme? Surely there must be some provision to encourage executives to achieve performance that exceeds annual business plan expectations?
  • If the “target maximum” is a true stretch, and it is unlikely the executive will achieve such performance levels, what is the performance the company expects to achieve and therefore the incentive the executive will likely receive if they operate successfully but not above all expectations?

To avoid this confusion, all an organisation needs to do is adhere to the definitions and disclose both payment levels at target and maximum.

The issue has spilled over into the fulfilment of Corporations Regulations, where “for each grant of a cash bonus, performance related bonus or share based payment compensation benefit” an organisation should disclose the percentage of the bonus or grant for the financial year that was paid to the person or was vested in the financial year and the percentage that was forfeited. Some organisations calculate this as a percentage of the maximum incentive possible and others calculate this as a percentage of the target incentive. As a key shareholder trying to judge a company’s pay for performance in relation to its peers, such differences complicate comparisons.

It also leads to cases where an organisation discloses that an executive achieved 121% of the target incentive with 0% forfeited, but no indication of the maximum incentive the executive could have earned, as all payments made at over 100% of target will carry the same disclosure of 0% forfeited.

In some cases under profit share plans there is no maximum incentive level, with better performance delivering a higher incentive payment (although decelerating factors may be applied over certain performance levels). In all other cases there is no reason why a shareholder should not know what the maximum incentive entitlement of an executive is.

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