As more uncertainties about the economic outlook for 2012 emerge for those in the slow lane of the 2-speed economy, many companies appear to be edging towards “softer” performance targets in pay plans. But take a hard look before making decisions on executive pay plans. Differentiate between the genuine, the greedy and the incompetent.

The prospect of declining incentive plan payouts in a slackening economy may lead some companies to consider setting lower vesting targets for future awards. We expect there will be several cases where the bonus opportunities for executives will remain unchanged (or in some cases will be increased), but potential rewards for shareholders, measured by dividends paid and share prices, may reduce.

Investors may question whether this represents a proper alignment of interests.

However, a counter argument is that lower targets during economic downturns may be just as challenging as higher hurdles during benign market conditions. New arrangements may be a better reflection of lower growth rates expected by shareholders amid less robust economic conditions.

The proof of this will be in the company’s share price – this is a clear signal that the market expects lower future earnings. But a lower share price is not necessarily a signal that performance targets should be adjusted to suit as well. Boards need to exercise judgment on the extent to which a reduced share price is a function of general market sentiment (i.e. the beta component of share price), or management competence (i.e. the alpha of share price movements).

In regard to the latter, we have seen bonus plans with targets re-based on the dismal performance management achieved in the prior year, allowing for the payment of a bonus for relatively mediocre results in the following year. The same can be said for LTI plans. Are lower EPS growth LTI requirements being considered because management failed to develop and implement robust strategies in the past?

In Australia the expectation is that some market sectors will hold up well (e.g. mining), while others suffer from poor consumer confidence (e.g. the banking and consumer discretionary sectors). Therefore, boards should consider the validity of their overall sector’s outlook and relevant ASX index performance before sharing thoughts on amended performance targets with investors.

Investors need to be realistic about what is achievable. In some cases, performance targets that might have previously been realistic no longer make sense. You can expect these to change. There is no point in having an incentive scheme that does not motivate executives. But that does not mean that targets should be soft or that investors will always sanction amendments to targets. Investors have become hawkish about rewards for lacklustre performance.

Given the pressures, boards may want to consider the following checklist:

1. Is there a justification for assessing a change to performance targets based on management’s financial outlook?
2. Is the revised outlook validated by external measures of customer demand and share market sentiment for peer companies?
3. If the revised outlook is valid, and not a function of management’s relative competence, are incentive targets still appropriate?
4. Do revised targets, if achieved, at least meet and preferably exceed market expectations, reflected in the company’s current share price?
5. On achievement of the revised targets, is the quantum of reward fair, given what is known of competitor pay and performance levels?
6. What is the extent of knowledge (or ignorance) of the investor community on the way you measure your own performance? Do they consider it valid? Can they be educated?
7. What would be the reaction of the proxy advisory firms?
8. Is there enough time to consult with the proxy firms and investor community?
9. What fall back positions are there to retain management if there is a negative reaction to the proposed revisions?
10. In the end, what is in the best long term, fiduciary interests of shareholders for ensuring management are adequately incentivised and rewarded for valuable outcomes?

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