1. Target Annual Incentive Opportunity & Annual Incentive Payout Range

Annual incentive or bonus design is a complicated topic that could easily serve as the basis for an entire book on its own. For our purposes, we will focus on the information necessary to ask informative questions about the annual incentive design and to help ensure it does not raise any major concerns. Our discussion focuses on the incentive plan primarily as it relates to the most senior executives in the company.

Target Annual Incentive Opportunity

Most annual incentive plans will have a target annual incentive opportunity assigned to each executive participating in the plan. The target amount is expected to be earned if the company achieves its objectives at the planned level of performance and/or the individual meets their objectives at the expected level of performance. The target annual incentive opportunity is most often defined relative to base salary (e.g., 50% of base salary), though in some circumstances it is a set dollar amount (e.g., $50,000).

As discussed under the compensation philosophy section, annual incentive target opportunities are often established with reference to the market median (e.g., the market-median annual incentive opportunity for a comparable role or the amount of annual incentive required to result in market-median target total cash compensation). It is typical that the target annual incentive opportunity as a percent of base salary will be highest for the most senior executives with the greatest ability to impact the overall financial results of the company. The table below provides an illustrative scale for annual incentive opportunities:

It is critical to understand that the annual incentive target represents an opportunity to be earned. Given that it is performance based, the actual payout may vary.

A minority of companies (approximately 10% of the CAP 120) have adopted purely discretionary annual incentive designs without the concept of an annual incentive target. This structure is most common in financial services firms. In this context, companies and employees tend to look back at historical average incentive payouts as the basis for establishing expectations about the bonus opportunity.

Key Questions for Committee Members to Ask:

• How do our annual incentive opportunities compare to market benchmarks?
• If our annual incentive opportunities are significantly above/below market, are our performance goals demonstrably more difficult/less difficult than those of other companies?
• In the absence of target annual incentive opportunities, how do our employees gauge how their performance will translate into compensation outcomes?

Annual Incentive Payout Range

The annual incentive payout range is the range of potential payouts that an executive can receive based on performance. The most common structure is as follows:

• Threshold Payout: 25%–50% of target annual incentive opportunity
• Maximum Payout: 150%–200% of target annual incentive opportunity

The threshold payout level is established to indicate that below a certain level of performance, no incentive payout is warranted. While a minority of companies initiate bonus payouts at 0% of target, many companies have a threshold payout of 25%–50% of target to ensure that the incentive paid is a meaningful amount of money. The following table shows the prevalence of bonus thresholds and maxima among the CAP 120; a threshold of 50% of target is most common, while a maximum of 200% of target is most common.

Companies have annual incentive maximum amounts to help manage the overall cost of the incentive program, limit the risk of a windfall due to unanticipated events, and reduce the likelihood that executives will take inappropriate risks in order to earn out-sized payments in any given year.

Key Questions for Committee Members to Ask:

• How do our threshold and maximum payout levels compare to market benchmarks? If they are substantively different, what is the rationale?
• Are our performance objectives at the threshold and maximum levels appropriately calibrated to the incremental decrease or increase from the target annual incentive?