Annual Incentive Design

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:

Executive Level	Base Salary	Annual Incentive % of Base Salary	Annual Incentive
CEO	$1,000,000	100%	$1,000,000
COO	$600,000	80%	$480,000
EVP	$450,000	70%	$315,000
SVP	$300,000	60%	$180,000
VP	$200,000	40%	$80,000

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.

Threshold Payout as a % of Target			Maximum Payout as a % of Target
Range	% of Cos.		Range	% of Cos.
< 25%	24%		100% < 150%	4%
25% < 50%	30%		150% < 200%	14%
50%	41%		200%	78%
50 < 100%	5%		200% < 250%	4%

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?

Performance Metrics

Before diving into the role of performance metrics in the annual incentive plan, it is worthwhile to briefly discuss the different categories of performance measures used by companies. They are described below:

• Operational/Strategic/ESG Measures: These tend to be measures of the success of the company or individuals in achieving operational improvements (e.g., fewer product defects, higher levels of customer satisfaction, less manufacturing downtime, etc.), executing strategic initiatives (e.g., implementation of an enterprise resource management platform, completion of an acquisition/divestiture, new product launch, etc.), or achieving environmental, social or governance objectives (e.g., reducing CO2 emissions, improving employee safety outcomes, increasing the representation of minorities at executive levels).
• Financial Measures: These include measures of top-line (e.g., revenue growth) and bottom-line growth (e.g., earnings-per-share growth), profitability (e.g., operating margin), financial returns (e.g., return on equity or return on capital), cash flow, and economic profit.
• Stock Price Measures: These include stock price appreciation and total shareholder return (TSR).

If we think of these metrics along a spectrum, the achievement of operational/strategic measures is expected to lead to improved financial performance, which will, in turn, lead to improved stock performance. For annual incentive plans, most companies use financial measures as the basis for corporate and/or business unit performance measurement while operational/strategic measures are the basis for individual performance measurement.

* Return Metrics include Return on Invested Capital, Return on Equity and Return on Assets. Source: CAP 120

Why don’t companies use stock price measures in the annual incentive plan? While these measures are great for aligning executives with shareholder interests, they do not send a clear message to executives or other employees about what the company needs to achieve from an operational or a financial perspective in order to drive increases in the stock price. Also, an annual performance period is difficult for setting a stock price objective and assessing performance, as market volatility may have a larger impact on the company’s stock price performance over a single year than the results attributable to management.

While stock price and/or total shareholder return are seldom used in annual incentive plans, it should be noted that many external critics of executive compensation are frustrated when annual incentive payouts do not decrease significantly in periods where the company’s stock price falls or significantly lags the broader market. It is important to keep in mind that the annual incentive is only one part of the executive compensation program, and there are other long-term elements of the pay program that will be much more sensitive to the performance of the company’s stock.

Financial measures are used as the basis for assessing corporate and business unit performance because they are results-oriented metrics that, over the long term, should lead to increases in shareholder value. They are also measures that management can influence more directly than stock price over an annual period. Management knows that they can increase return on capital by increasing revenue, decreasing costs, or reducing the amount of capital in the organization. However, it is challenging to identify how specific decisions or actions they take will directly impact the stock price within the course of a year.

Operational and strategic measures are less likely to be used at the executive level for several reasons. Often, success or failure on these measures is not necessarily a shared responsibility across all executives but rather a responsibility of a smaller subset. In addition, corporate and business unit financial measures tend to be used as the basis for funding incentives, while operational and strategic measures may be used only for allocating incentives among different individuals in the plan. In a sense, financial metrics are self-funding in that the incremental dollars of profitability fund incremental incentive payments. With operational and strategic measures, there is no guarantee that they will result in an improvement in financial results, let alone an increase in stock price. As a result, most companies are reluctant to base substantial amounts of annual incentive funds on the achievement of operational or strategic measures without the anticipated return.

With that as background, it is expected that the compensation committee will select performance measures for the annual incentive plan that will translate into increased shareholder value over time. Typically, the committee wants to ensure that the performance measurement framework sends balanced messages to management about what performance is important. For example, if only a return measure is used, there may be an excessive focus on cost and capital reduction as the way to improve performance at the expense of top-line growth. As a result, many companies that employ a return measure in their annual incentive plans use a revenue growth or earnings growth measure as well to help reduce the risk that returns are improved at the expense of growth. Ultimately, the measures selected should be linked to the company’s business strategy and how value is created in the business.

Practical considerations also factor into the selection of performance measures for an annual incentive plan. In our experience, using more than three or four metrics in the annual incentive can dilute the message about what performance measures are most important. A performance plan with ten performance measures will have an average weighting for each measure of 10% of the overall annual incentive. While this approach may give an executive a clear checklist of performance requirements, it does not prioritize the key results that will be most important from an investor’s perspective. By concentrating on a few key measures, the executive has some leeway in determining how to achieve the result and can focus on the activities that they feel will be most critical for that result.

Another practical consideration that factors into annual incentive design is whether the measure fits the specific organization. A measure like economic profit has a strong theoretical basis and advocates for the measure will say that it is highly correlated with the creation of long-term shareholder value. For most mature businesses, economic profit is a theoretically sound measure of business economics. However, economic profit is a complex measure to communicate and understand. Furthermore, many aspects of achieving an economic profit result (e.g., capital allocation and capital structure) may be out of the control of most annual incentive plan participants. It may also be challenging to measure something like economic profit at the business unit level, particularly if some physical capital is shared by different parts of the business. Similar arguments frequently apply to return measures like return on assets or return on invested capital.

To use certain measures, an organization must be committed to training and be confident in the financial knowledge of their employees. If the typical manager only impacts invested capital through working capital, then using a working capital measure like working capital turnover in combination with operating profit may be better than explicitly measuring economic profit. Below are some key questions to keep in mind when considering alternative performance measures:

1. Accuracy: How well does the metric capture business economics and shareholders’ expectations?
2. Complexity: Is the metric complex? Can business systems capture the metric?
3. Fit: Does the metric fit the planning process?
4. Industry: Does the metric capture industry dynamics?
5. Company: Does the metric fit the company culture?
6. Strategy: Does the metric capture the business strategy?
7. Correlation: Does the metric correlate with shareholder interests?

It should also be noted that the financial performance measures used for purposes of annual incentive plan calculations may vary from GAAP measures disclosed in the company’s financial statements. The reason for these adjustments is that there may be items that impact the financial statements that were either not anticipated in the budgeted numbers used in the annual incentive plan or are viewed as one-time items outside of the usual operations of the company. Below is a list of common adjustments made to financial measures (e.g., EPS, free cash flow, and return on net assets) in annual incentive plans:

• Any changes in accounting standards or treatments that may be required or permitted by the Financial Accounting Standards Board and the Securities and Exchange Commission, or adopted by the company after the goal is established
• Effects of changes in laws, regulations, or tax rules and treatments
• The gain or loss from the sale or discontinuation of a business segment, division, or unit and its budgeted, unrealized operating income
• Restructuring and severance costs pursuant to a plan approved by the board of directors and/or CEO
• Gains or losses from litigation, natural disasters, terrorism, or fraud/fraud investigations
• Results from an acquired business and costs related to the acquisition including earn-out payments, interest expense, and the EPS impact from the issuance of stock related to the acquisition
• Extraordinary items as defined by GAAP or non-recurring items
• Effects of changes in foreign currency exchange rates from the rates assumed in the budget
• Write-downs or impairments of assets that exceed $ ___________
• Termination or loss of license, lease, or long-term contracts
• Stock-based compensation costs to the extent not included in the budget
• The EPS impact of unbudgeted share repurchases and other changes in the number of outstanding shares and their corresponding impact on interest expense
• Unplanned capital expenditures that exceed $_________in expense
• Unplanned or out-of-period charges or credits

Deciding what exclusions should be made for purposes of determining annual incentive performance is frequently a contentious topic. Companies are frequently criticized for excluding items that adversely impact performance while not setting aside positive impacts. In our experience, the best approach is to agree in principle upfront on the types of items that will be excluded from the calculation of the measure, with the intention of making similar adjustments for both negative impacts (e.g., restructuring costs, asset write-downs, etc.) and positive impacts (e.g., gains on sale, legal settlements, etc.). In any case, the committee should reserve the right to apply discretion in the event that they feel management should be held accountable for an item that might otherwise have been excluded from the calculation.

Key Questions for Committee Members to Ask:

• Are the performance measures appropriate for measurement over a one-year period, or are they better measured over the mid-term/long-term?
• Do the performance measures provide us with a basis for assessing how well we are doing in achieving our business strategy? Will they potentially distract executives from achieving this strategy?
• Do the performance measures emphasize certain aspects of the strategy at the expense of others (e.g., encourage inventory turnover at the expense of increased revenue)?
• Are these measures long-term drivers of improvement in the stock price or correlated with stock price movement over time?
• Are our financial measures calculated on a GAAP basis? If not, what are the adjustments from GAAP accounting and why do we make them?
• Do the metrics in the annual incentive plan complement the performance focus in the long-term incentive plan?

Performance Goals

Selecting the right performance measures sends a signal to executives about which aspects of performance are most critical. Most companies will establish a target level of performance that will correspond to a target annual incentive payout. As a result, for appropriate pay-for-performance calibration, it is critical that the target level of performance be set at the expected level of performance (i.e., about a 50% chance of achieving above that level and a 50% chance of achieving below that level).

The overwhelming majority of companies set their annual incentive performance objectives based on the company’s business plan. As a result, the degree of rigor in establishing the business objectives will have a strong impact on the company’s pay-for-performance relationship. If the company sets an aggressive plan that is difficult to achieve, it is likely that they will underpay relative to performance. If the company sets a relatively conservative plan with a high probability of achievement, it is likely that they will overpay relative to performance.

Since predicting the future is impossible, there is often a great deal of uncertainty around financial projections (e.g., macroeconomic factors, price fluctuation of production inputs, regulatory decisions, etc.). As such, it is challenging to assess the accuracy of plan goals at the time they are set. Companies that take setting goals seriously should assess them from multiple perspectives such as the company’s past performance on the measure, industry peers’ past performance on the measure, and analysts’ expectations for the company and its peers in order to test the difficulty of the plan. If the plan departs from historical performance and analysts’ expectations, there may be reason for concern that the goals are not well calibrated.

A minority of companies avoid the goal-setting question by assessing annual performance on a relative basis vs. peers. Few companies take this route because of three challenges:

Timing of Data Availability: Due to the timing of public disclosures of financial performance information, it is challenging to calculate relative performance within the timeframe required.

Performance Comparability: Comparing financial performance across companies is challenging. Growth measures (e.g., EPS growth) can be problematic due to scale issues (e.g., a $0.05 increase in EPS may represent a 5% increase for one company while it represents a 100% increase for a company coming off a poor base year). Even return measures like ROIC have challenges as companies may want to adjust for differences in capital structure, goodwill, or non-operating items.

Peer Relevance: It may be challenging to identify a group of companies that are comparable in terms of business model and relevant for financial performance comparisons.

Under today’s disclosure requirements, companies are expected to disclose their annual incentive performance goals and actual performance results in the proxy statement’s CD&A as part of their explanation of how the annual incentive payouts for the fiscal year were determined. Directors should anticipate criticism from shareholder advisory groups if the performance objectives do not appear robust (e.g., decline relative to goals or actual performance from the prior year, significantly lag competitor performance levels, etc.) or the performance goals are achieved, but the company’s TSR or financial performance was weak on a relative basis.

Key Questions for Committee Members to Ask:

• How do the performance goals compare to last year’s performance? If they are not an improvement over the prior year, why is performance expected to decline?
• How do the performance goals compare to analysts’ expectations? If there is significant variation from expectations, what is the reason?
• How confident is the company in achieving its business plan? Does the company have a history of meeting its business plan and lagging peer performance levels or missing its business plan but exceeding peer performance levels?
• If relative performance goals are used, are the financial comparisons being done on an “apples-to-apples” basis? Are all peers equally relevant for performance comparisons?

Performance Ranges

Most companies have a performance range around a target that is used as the basis for determining the actual incentive payout relative to the target annual incentive payout. In the typical structure, a threshold performance level and a maximum or superior performance level are established that correspond to the threshold incentive payout and the maximum incentive payout. The table and chart below describe the typical structure:

• Wide Performance Range: 80%–120% of planned performance level
• Narrow Performance Range: 90%–110% of planned performance level

For performance measures where a relatively low level of variability is anticipated (e.g., top-line revenue), the threshold performance level should likely be set relatively close to the target performance level (e.g., 97.5% of plan); the maximum should be set close to target as well (e.g., 102.5% of plan). For performance measures that are expected to be more variable from year to year or in more volatile businesses, a much wider performance range could be used (e.g., threshold at 70% of plan, maximum at 130% of plan).

An effective rule for establishing performance ranges is that the threshold level of performance should be set so that the company expects to achieve it 80%–90% of the time and the maximum performance level should be achieved 10%–20% of the time. It should be noted that these probabilities are in themselves just the company’s best guess at the range of outcomes. To the extent possible, analyses of the historical variability of the company’s own and peers’ performance on the measure can be used as an input in determining the performance range.

It is common to set a symmetric performance range above and below target. This makes sense if the variability in performance is similar above or below the planned level of performance. If the performance range is not symmetric, management should provide a sensitivity analysis to the committee explaining why the asymmetry makes sense. As a committee member, you should be skeptical if the performance range is wide between the threshold performance level and target performance level and is narrow between the target performance level and maximum/superior performance level, particularly if there is significant upside opportunity in the payout.

Key Questions for Committee Members to Ask:

• How variable has the company’s performance been over time? Out of the past ten years, how many times has performance been either above the maximum level or below the threshold level?
• If performance falls below the threshold level, will the company still need to pay annual incentives at some level to retain key employees? If so, would it be better to have a wider payout range?
• Is there anything about the current environment that indicates the future performance may be more or less variable than historical performance?