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Article | Executive Pay Matters

Simple plan design tweaks to improve executive pay performance alignment

What the East can learn from the West

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By Trey Davis | July 11, 2019

It is easy to see that senior executive pay levels across Asia-Pacific continue their quick, recent increases.

In fact, a number of Asia-based CEOs are among the highest paid in the world, including the CEO of Hong Kong-listed WH Group, who received nearly U.S.$300 million in cash and stock grants. These increases in executive pay aren’t limited to a handful of the largest companies. For instance, from 2016 to 2018 increases in median total compensation for executives ranged from 15% in Singapore to over 44% in India (Figure 1).

What is not so easy to see, however, are the regulatory and environmental dynamics that are precipitating these changes and trends in Asia. Remuneration committee members and senior HR professionals should also understand how these drivers of change differ from those in the West, particularly in the U.S., and how they will continue to impact Asian pay practices, and particularly incentive plan design practices.

Current criticisms of Western and Asian governance

Consider an archetypal American company. The senior executive team’s annual and long-term incentive (LTI) plans focus on just two or three key performance metrics, all tied directly to shareholder returns. Each metric has several layers of performance goals, with a range of positive and negative outcomes for actual performance that falls above or below the expected level of performance. The company has a strong performance culture which is focused on a very narrow and short-term definition of performance.

Compare this simplified American company to the incentive plan of an archetypal Asian company. It consists of numerous performance goals, of sometimes indeterminate importance, and reflects the interests of a number of stakeholders including employees and customers. The metrics lack clear performance goals, and executives’ rewards are not clearly associated with under- or over-achievement. This company has a strong, long-term view of corporate health but lacks an emphasis on corporate and individual performance.

These exaggerated Western and Asian approaches result in very different outcomes, but neither incentive plan is healthy, and both will create serious issues if allowed to operate unchecked over extended periods of time.

Although exaggerated to make a point, both the Western and Asian companies are working to tackle their respective perceived weaknesses.

In Asia, the most obvious change is the rapid increase in target pay levels, largely through higher annual and LTI awards, as illustrated in Figure 1. Executives at all levels are seeing a higher proportion of their pay tied to incentives rather than base salary or benefits. However, as the cost of incentives increases, remuneration committees are realizing that they may not be optimizing these investments in their annual and long-term performance plans.

While many Asian companies are not ready to design and implement new plans or lose incentive plan features they like such as the focus on multiple stakeholders, they are taking some relatively simple steps to address investor criticisms and build a performance-oriented culture, including:

  • The creation of clear linkages between company performance and executive reward outcomes
  • Greater emphasis on shareholder outcomes
  • Probability-based target setting so that incentive plans are achievable and motivational, yet sufficiently stretched

Ensure appropriate weighting in the total compensation package

We often see companies that set target annual bonuses for professional and lower-level management employees at 5% or even less of base salary. In such cases, we need to ask what purpose the incentive serves. Is it really altering behaviors or encouraging incremental efforts? Are the key messages regarding organizational goals and initiatives being delivered? And at senior executive levels, are the target incentive payouts and equity award levels enough to ensure real alignment with shareholder outcomes?

Figure 2: Typical incentive plan payout ranges
Threshold
payout
Target
payout
Maximum
payout
  Annual  incentive plans  

  Europe
  

  0%
  

  100%
  

  200%
  

  U.S.
  

  50%
  

  100%
  

  200%
  

  Asia
  

  75%
  

  100%
  

  130%
  
  Long-term  incentive plans (LTIPs)  

  Europe
  

  50%
  

  100%
  

  200%
  

  U.S.
  

  50%
  

  100%
  

  200%
  

  Asia
  

  50%
  

  100%
  

  150%
  

Beyond target award levels, strong performance alignment requires a consideration of payouts for below- and above-target performance. Compared to Western companies, Asian companies tend to have much lower payouts for above-target performance for both annual and LTIP (Figure 2). The resulting lack of “flex” in the plan can significantly reduce performance-based pay plans’ ability to incentivize, creating the perception that it is quasi-fixed pay.

Plan mechanics can also reduce the sensitivity of payouts to performance and limit their differentiation. In a recent Willis Towers Watson study of more than 500 Asian companies, we found that 35% of companies pay incentives to employees who do not meet expectations. This practice reduces low performers’ incentive to perform better and diverts money from high performers. Asian companies typically pay top performers only 23% more incentive pay than average performers. And when performance is below target, 80% of Asian companies reduce the payouts of high performers by at least as much as they do other employees.

Simple ways to improve the alignment of pay and performance are to ensure payouts are appropriate at all levels of performance and confirm that incentive payouts truly differentiate among individual performers.

Define appropriate performance metrics

Several years ago we were engaged by a food company to review its incentive plans, and we found that it had used a volume-shipped performance metric in its annual incentive plan for many years. When asked why this metric was used, the client responded that the research analysts covering the company tracked it closely and reported it prominently in their research. We then asked the analysts why they tracked this metric. Their response was that the client reported it religiously, so they assumed the client thought it was important.

Clearly, choosing appropriate metrics can be very confusing and difficult. Many Western companies are realizing that like many Asian peers they need to take a more holistic view of performance. They’re expanding the number of metrics in their annual and LTIP to consider both income statement and balance sheet metrics, and to include broader indicators of corporate health and productivity. These indicators can include customer satisfaction, sustainability, employee engagement, and environmental, social and governance factors.

Many Asian companies, however, are reducing the number of performance metrics to better communicate priorities and emphasize critical performance outcomes.

The choice of these key metrics requires analysis and not just a “gut feel” about what investors want. For instance, computing the correlation between various internal performance metrics and measures of shareholder value such as total shareholder return and P/E ratios can reveal surprising linkages. We helped this food company shift to sales margin and revenue in place of the volume-shipped metric. Before doing the analysis, it was assumed that gross margin was not an important metric, but it actually had one of the highest correlations with shareholder value for the company and its industry peers.

Set appropriate performance goals at all payout levels

Once the performance metrics are identified, companies and remuneration committees need to carefully consider how to ensure potential payouts are well-aligned with the challenges associated with all levels of corporate and business unit performance from threshold to maximum.

Traditionally, board-approved performance budgets have been the first stop for setting performance goals. But for too many companies this is also the last stop. The financial budgeting process is not designed to develop realistic and appropriate performance goals, and it should not be used for that purpose — at least not by itself. Financial budgeting is already too complicated — and too important — to be weighed down by unit managers trying to ensure their budgets are easily achievable so that they get a good bonus. In many instances, removing the link between budgeting and bonus payouts can make the budgeting process much easier and more relevant.

Appropriate performance goals should not only reflect management’s input, but also the company’s past performance, current and historical peer performance, analyst and shareholder expectations of future performance and an analysis of the probability of achieving different performance levels. These inputs should be used when setting threshold, maximum and target performance goals.

For instance, looking at 10 years of revenue and sales growth for a company and 10 of its competitors yields 110 observations. With these observations, it is often relatively easy to compute 25th percentile, median, average and 75th percentile annual growth rates. Such a simple exercise often yields information that is useful for setting performance goals. For instance, in many industries the range of revenue growth rates is much narrower than for profit — indicating that the performance range between threshold and maximum performance goals for profit should be wider than for revenue. But many companies use the same 85%-100%-120% performance range for all performance metrics.

Backward test the plan

It’s vitally important for companies to test their performance goals and payout schedules before implementation, but few companies do it rigorously. And even fewer take even a cursory look back over past payouts to identify opportunities for improvement or practices that worked well. We have worked with a number of average or even poorly-performing companies that think that their goal setting process is adequate, but average a higher-than-target payout rate over time — and don’t understand why their payroll costs are higher than peers. Other companies have a history of strong performance, but their incentive plans pay out at below target rates, creating employee retention challenges. Simply tracking plan payouts against absolute and relative company performance can reveal a lot of opportunities for improvement.

Simple steps make a difference

Leading Western companies are benefiting from Asian management ideas, including longer-term mindsets, the consideration of stakeholders beyond financial investors and a broader view of performance. And many traditional Asian companies could benefit from the adoption of some characteristics of Western management, including the adoption of a more rigorous performance culture.

Many Asian companies may find supporting a high-performing culture — let along building one — a difficult undertaking. Building strong linkages between pay and performance at all levels of the organization, and especially among senior executives, is critical to such efforts and doesn’t always require complex or completely new incentive plans. Western companies’ experiences suggest that often it just takes a careful rethinking of payout opportunities, analysis of performance metrics, vigilant goal-setting approaches and thorough testing of both projected and past plan results.

The benefits of the relatively simple efforts we’ve described can include a better employee understanding of key corporate goals, lower fixed payroll costs, better alignment between corporate performance and incentive plan costs, higher retention and motivation of key talents and executives, and, of course, better company performance.