2. 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.

Other Practical Considerations

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?

Adjustments to Metrics

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?