3. Performance Goals & Ranges

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.

Example : 

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?