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Article | Beyond Data

Incentive design survey reveals current practices, new challenges

Compensation Strategy & Design
Beyond Data

By Tom Kelly | November 12, 2020

Competitive data can help inform critical incentive design decisions in an uncertain and difficult business environment.

Establishing and managing appropriate executive annual incentive plans can be challenging at any time, but is especially so in today’s pandemic-affected economy. An essential starting point is market information on how other companies design their bonus plans. The Willis Towers Watson 2020 Annual Incentive Design Survey provides companies with a solid foundation from which to evaluate their own program’s design features, and to consider how they might adjust the program to better reflect the current environment.

The survey is based on 280 US participants across a variety of industries, and includes both publicly-traded and private companies, as well as not-for-profit organizations. A similar survey was conducted in 2019 and while the participant group changed from year-to-year, the primary findings remained consistent.

We recently had the opportunity to present key findings of this year’s survey on a webcast attended by about 750 company representatives – an indication of the great interest there is in this topic. In light of the pandemic's  impact on business results this year, we discussed possible mid-year adjustments to the 2020 plan, potential end-of-year discretion overrides and the implications for 2021 bonus plan design. To give you a flavor of the survey findings and our webcast dialogue, here we focus on the annual incentive design features that we believe companies may want to review and possibly change in response to the Covid-19 economy.

Financial Performance Metrics

A critical aspect of bonus plan design is identifying the appropriate performance metrics. Our survey found that profit and margin measures were clearly the most common. The next most prevalent were strategic sales/revenues measures, followed by revenue-based metric.

Figure 1: A critical aspect of bonus plan design is identifying the appropriate performance metrics, and our survey found that profit and margin measures were clearly the most common (80%), followed by strategic business measures (60%) and revenue-based metric (40%).
Figure 1: A critical aspect of bonus plan design is identifying the appropriate performance metrics.

The survey also found that companies typically use more than one metric. The most common approach, used by about 80% of companies, is what we call “additive.” With this approach, each measure is assigned a weighting, with performance results calculated independently for each measure, and the overall results are then aggregated based on their relative weightings.

We have seen many companies incorporate some kind of top-line or revenue metric over the last several years, and according to our survey, revenues were the third most prevalent metric. While profit metrics are still more common and often more heavily weighted as compared to revenue measures, many companies now want management to focus on revenue growth as well and not just rely on cost cutting and expense reduction initiatives to earn their bonus.

Looking forward to next year, profit-based metrics and revenues are likely to remain highly prevalent. However, we expect that some companies will want to modify their plan to put more emphasis on areas where management can most influence performance results, particularly if financial projections reflect significantly higher uncertainty. In a challenging economic environment, we may companies add new measures, including non-financial metrics as well as financial metrics (such as cash flow and working capital management) that are of particular importance.

Non-financial Metrics

Our survey found that the prevalence of strategic metrics, including non-financial measures, is increasing. The theme here is that bonus programs are no longer simply a function of “how much money” the company makes in a given year, but also “how did we get there” in other important areas. We are seeing more companies incorporate ESG (environmental, social and governance) measures into their executive bonus plans. However, there are many different ways ESG is being taken on board. Some metrics, like safety performance, might be readily added to the plan as a weighted metric. But others, like employee satisfaction levels or progress towards achieving certain ESG objectives, are probably better used as a modifier or an individual participant objective. And many ESG initiatives may not really be appropriate to evaluate using annual measurement periods – we know some companies are exploring the incorporation of ESG performance into their long-term incentive plans, to reflect a more appropriate time horizon for the measures used. Beyond ESG, we anticipate that many companies in 2021 will consider adding non-financial goals tied to successfully managing the business in challenging economic conditions.

Weightings by Organization

Another key decision when setting incentives is the organization level at which performance is measured – that is, what combination of corporate, business unit and individual types of measures. Many companies consider whether participants who work in business units or divisions should have at least a portion of their bonus based on overall corporate results, and if so, how much weighting should be assigned to corporate performance.

As the chart below highlights, division participants do indeed usually have at least part of their incentive determined by corporate results. Note business unit prevalence is somewhat understated in these statistics, as some companies classified business performance goals under “individual metrics”. In terms of weighting, the “middle range” of survey responses indicated that a 40% corporate/60% business unit or individual mix is most common for those executives of business units within a larger corporation.

Figure 2: Division participants usually have at least part of their incentive determined by corporate results, as follows - CEOs and corporate executives: 90%, corporate staff: 88%; BU executive 88%; and BU staff: 74%.
Figure 2: Division participants usually have at least part of their incentive determined by corporate results.

When corporate performance is under stress, as it has been for many companies in the past year, it can be challenging to reward business units or individuals who are performing well. For 2021, we expect companies to emphasize a “one company” philosophy, and to maintain if not increase the weighting on overall corporate performance for business unit executives.

Goal-Setting

When setting goals, the survey found that nearly all companies (95%) establish performance standards based on budgeted performance, though the majority are subject to management/Board adjustments if deemed appropriate. Another common method (reported by approximately 20% of organizations) is to factor in year-over-year improvement or other standard expected to apply each year (i.e., 10% growth in earnings or 15% return on capital).

Companies tell us that they consider a variety of factors in developing financial goals, and we expect certain factors may become even more important in light of overall economic uncertainty. The table below shows the most common considerations:

Considerations for establishing financial goals

Table caption: Common considerations when developing financial goals.
Number of Responses
Guidance provided to investors on expected performance results 27%
Advance financial modelling and scenario-based analyses 45%
Performance compared to external benchmark 27%
Achievement of strategic milestones (e.g., new product launch) 32%
Other (specify) 4%

Given the economic downturn in 2020, and the difficulties in predicting likely future performance, many companies may be setting financial goals that are below the goals from the previous year (but possibly above actual performance results achieved). While this approach may be consistent with a philosophy of having a realistic or 50%-60% likelihood of a target payout, there is also greater risk that companies will set themselves up windfall payouts if economic conditions significantly improve. Careful analyses are required to set financial goals appropriately in an uncertain environment. Finally, given the difficulties of setting absolute performance goals, we may see some companies measure performance relative to peers, a measurement standard usually limited to the long-term incentive. However, when considering relative performance, be aware of “lags” in how and when data are reported by other companies. Also note that your definition of a measure may differ, particularly for any adjusted or non-GAAP financial metrics.

The Range of Performance and Payouts

Many companies give substantially less attention to the full range of goals for financial and other quantifiable measures, particularly if the target goal reflects the organization’s budget. Since actual results rarely come in precisely “at budget,” how threshold and stretch performance goals are set is a critical but often overlooked design feature. The survey includes data on how threshold and maximum performance levels compare to the target goals for the most common financial performance measures. For example, it found that the median performance range for Earnings Per Share is a threshold set at 90% of the goal, and a maximum set at 110% of the goal. Generally, the survey finds that the performance range varies by metric, while the payout at threshold (at 50% of target bonus) and at maximum (at 200% of target bonus) is consistent for each metric used.

Figure 3: Performance range varies by metric, while the payout at threshold (at 50% of target bonus) and at maximum (at 200% of target bonus) is consistent for each metric used. For future incentive metrics, higher uncertainty warrants a wider target range while more certainty allows for a narrower target range.
Figure 3: Companies may consider wider performance ranges in a period of higher uncertainty concerning financial results.

As a best practice, we recommend that companies seek to customize their ranges – for the metrics, as well of for the specific business conditions they face. The “best” approach to setting threshold and maximum goals depends on various factors – what is being measured, how it is being expressed, the size of the organization and business unit, the expected variability in the key drivers of financial metrics, the likelihood of achievement, among others.

This is especially important in today’s environment. For 2021, our advice is: don’t fall back on your historical performance ranges nor rely too much on the approach used by other companies, including industry peers. That applies whether thresholds are currently set at 80% or 90% of target, or whether maximums are set at 110% or 120% of target.

Increased uncertainty suggests companies should set a wider range around financial targets in their incentive plans. Uncertainty can come from many sources: from macro factors like business cycles, from sector dynamics, and from company-specific issues. Historically, we observe that range widths vary by performance measure, with top line measures having more narrow ranges, and ranges widening moving down the income statement and across to the balance sheet and cash flow statement. Such variation is likely to remain advisable, but ranges for all metrics may need to be expanded relative to last year’s spans.

For 2021, companies may want to reduce the likelihood that payouts will be low or zero, or that they will be inadvertently high. Appropriate goal and range-setting is the way to address this challenge. Some techniques to consider include: flatter payout curves and wider performance zones; reduced payouts (as a percentage of target) at prior thresholds and maximums; and defining the target as a modest range (for example, 98%-102%) rather than a single point.

Getting Risk Right for 2021 Annual Incentive Design

Many of the design considerations are really about managing risk with the bonus program design, and risk works both ways. One aim is to reduce the risk that the bonus program funds at zero or really low. But an equally important aim is to reduce the risk that the bonus program funds at or near the maximum level when company performance results turn out to be (with benefit of hindsight) not all that strong. We saw this occur at some companies back in 2009 – the financial crisis and recession led many companies to set financial performance goals that turned out to be easily achieved and exceeded as the economy recovered more quickly than anticipated.

All companies should at least take some time to evaluate whether historical practices on the bonus program should continue to apply to next year’s plan given all the uncertainty. This is especially the case if any funding or payouts in 2020 will be largely determined by Board discretion. Well-considered design changes for next year can reduce the probability that such discretion is required two years in a row.

As we know from our client assignments, creative thinking about bonus design for 2021 has already started. It will be interesting to see the findings from next year’s Annual Incentive Design Survey, which will reflect the design changes that are in the works now.

Authors

Senior Director, Executive Compensation (Charlotte)

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