At Risk Reward — The Annual Incentive

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Key features of the annual incentive plan (STI) are being continuously refined as Boards and management wrestle with a diversity of stakeholder expectations and in some sectors regulatory requirements such as clawback.

Performance Period

The one almost universal construct is the performance period of twelve months, though we are observing with the introduction of deferral that the delivery of a number of annual incentive plan payments are being extended for up to four years from the beginning of the performance period.

Performance Criteria

Performance criteria will often vary by organisational level though generally consist of the following core elements:

  • Financial performance,
  • Operational performance,
  • Development and/or project specific performance,
  • Strategy and innovative initiatives,
  • Position tailored performance objectives.

Many organisations have adopted a form of balanced scorecard in developing a standardised though variably weighted performance management assessment process to determine payments under the annual incentive plan.

Basis of Award Determination

At the most senior executive level, awards are generally determined as a proportion of fixed remuneration.  Occasionally senior management will have an agreed share of a performance award pool which would be a derivative of earnings.

Performance Expectations

Shareholders would normally expect that the STI would reward management for improving performance on the prior year with key objectives being aligned to Board approved nominated areas of performance.

Performance Standards

Increasingly STI performance expectations are structured with performance levels defined as:

  • 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 level of stretch.
  • Maximum – reflecting a payment arising from highly superior performance outcomes.

Very few organisations have an open-ended STI where management share in an uncapped incentive pool.

Some incentive plans do not have a threshold or a maximum, make no payments below target and pay an agreed level of incentive where targets are met with the Board and/or the Chief Executive exercising discretion to reward management for above target performance.  Some Boards clearly hold the view that payment of an incentive below the business plan or target is not appropriate.

In this context, a key challenge for many organisations is addressing the question of paying incentives at a business unit or function level which have met or exceeded expectation whereas the entire company has failed to meet its target or threshold performance.

Axioms of Performance Measurement

  • “What you see is what you measure”
  • “What you measure is what you get”
  • “What gets measured, gets managed”
  • and it is converse — “What doesn’t get measured, gets forgotten”
  • “If you don’t measure results, you can’t tell success from failure”
  • “If you can’t see success, you’re probably rewarding failure”
  • “If you can’t see success, you can’t learn from it”
  • “If you can’t recognise failure, you can’t correct it”
  • “If you can demonstrate results, you can win stakeholder support”

Payment Levels

Under STIs the significant majority of plans incorporate a clear statement of a monetary benefit for participating employees at all levels in the event that threshold performance is achieved in respect of all performance hurdles established, a target payment and a maximum payment.

Payments either commence at threshold performance or reflect between 20% and 50% of the award at target performance.

The increment above target for maximum payments for the vast majority of companies slots within a range above target performance reflecting an uplift between 25% and 100%.  The most common uplift at the senior management level is a 50% uplift for performing significantly above the organisation’s business plan (target).

A key and often controversial aspect of above target payments is what constitutes stretch and how frequently is such a level of performance likely to be attained.

Gateways

An increasing number of companies are establishing gateways which influence either the payment of any bonus or limit the bonus payment if the gateway is not met.  Where gateways are applied the most common gateways are financial or relate to the organisation’s safety and/or environment performance.  The latter gateways are adopted where the organisation chooses not to incorporate safety or environmental criteria as a key position objective but rather form the view that it represents a fundamental and core accountability for an executive or employee group to ensure that the enterprise is managed in a way which protects the environment and the safety of the organisation’s employees.

A similar approach is increasingly embraced in respect of managing the environment with the gateway arising in the event of a serious breach by the company of its obligations in relation to environmental regulation.

The financial gateway arises where the plan design dictates that a minimum earnings hurdle must be met before any incentive is paid.  Increasingly, in respect of recent listings bonuses are predicated on achieving the prospectus earnings forecast, which in part have encouraged new investors.

Modifiers

Modifiers, as distinct from gateways, are increasingly being introduced where companies embrace a form of balanced scorecard or multiple KPIs which have attached to them a level of incentive.  The most common modifier is a derivative of profit, be it an earnings measure, a return measure.  Where threshold levels under these financial criteria are not met, the incentive opportunity for the balance of the KPIs is often modified and reduced such that where an organisation incurs a loss or falls short of the base performance expectation, the incentive available under the other performance criteria is modified and reduced and in this way reflects the criticality of the ‘threshold’ performance from the Board’s perspective.

We have observed companies which have improved their loss position significantly though not achieved a profit where the company have established performance expectations reflecting a loss for a particular financial year, and where the improvement in the company’s position has been achieved, no modification to the incentive opportunity has been imposed.

Performance Weighting

Under STIs broad areas of performance generally reflect differential importance in the determination of the incentive benefit.  Financial criteria is normally the most significant though the company’s financial performance as a proportion of the incentive opportunity increasingly diminishes at lower levels in the organisation where incentive plans operate.  At middle management, senior professional and administrative staff levels incentive plans are often more focused on the employee’s line of sight and have a significant weighting on the performance expectation of the individual occupying a particular position or as a member of a team.

Payment Deferral

An emerging feature of STI payment in the last five years has been the deferral of a proportion of the award so determined.  Deferral has increasingly been in the form of a share right or restricted share in the employing company.  In a limited number of cases deferral is provided in the form of cash, either adjusted or not adjusted by an agreed interest rate (for example, the bond rate or the weighted average cost of the company’s borrowings).  Where the incentive is deferred, policies have been established which set out the conditions under which the deferred incentive could be forfeited or where the deferred incentive could be clawed back in the event of a misstatement of the company’s performance in the year in which the award was determined and partly paid.

Where restricted shares represent the instrument of deferral, the participating executive will often receive dividends progressively during the deferral period or dividends will be re-invested and delivered to the executive in the form of a fully paid share at the end of the deferral period.

Where rights are awarded under the deferral, increasingly the number of shares delivered to the executive at the end of the deferral period will be adjusted for the dividends awarded during the deferral period and additional shares delivered to the executive under the deferral.

Where cash is the deferred instrument, deferral is either unadjusted, adjusted by an agreed interest rate or the weighted average cost of capital to the company and paid to the executive at the end of the deferral period.

A small minority of companies whose deferral program is equivalent to a right to a security or a share, cash settle the deferral at the end of the deferral period rather than deliver shares.

Discretion

Egan Associates are of the view that Directors should always be in a position to exercise discretion in relation to the payment or non-payment of incentives where in their collective judgement a modified payment is appropriate.  A key accountability of a Board is to exercise informed judgement to ensure that management are appropriately rewarded for their accomplishments in the context of all outcomes whether it be up or down in relation to a formulaic answer.

Boards are accountable to shareholders for exercising judgement which is in the shareholders’ interest.  Some of our clients, notwithstanding our view, have a strong preference for highly disciplined and formulaic processes which curtail any tendency for a Board to exercise discretion in determining payments to senior executives under annual incentive plans.

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