One of the most challenging aspects of designing effective long-term incentive plans is selecting meaningful but achievable performance measures that motivate the plan participants and enhance the likelihood of driving value creation for investors.

Factors including the introduction of mandatory equity expensing, investor pressure for more rigorous measures and the desire of remuneration committees to develop stronger links between performance and reward, are creating heightened focus on the performance measures used in executive and employee incentive plans.  The situation will be exacerbated next year as the government is expected to amend regulatory requirements on companies to better show the relationship of executive pay with performance (see HERE). 

This article summarises the issues that need attention when selecting the measures for a performance-based plan.

1. Select performance metrics with good line of sight

To align them with company performance priorities, plan participants must be satisfied that the measures and the way they are calibrated are within their power to influence.

While these requirements are considered absolutely basic to an effective incentive plan, over 60% of ASX 300 companies’ plans fail on these requirements alone.  As we have noted many times in the past, applying a relative TSR requirement against a broad index of listed companies will invariably fail the “influence” test. (see HERE, HERE, and HERE, for example)

2. Calibrate requirements so that they are achievable

The achievability requirement is another issue altogether.  That is, the threshold level before starting to pay an incentive must be reasonable.  Calibrating a threshold that has a low probability of success is not motivating and wastes the board’s time considering it, management’s efforts to understand it and any consulting fees and expenses paid for it.

Many governance commentators will insist on performance pay for “out- performance” only.  This reveals an amazing ignorance of human psychology. 

The question is, what is reasonable from a shareholder perspective and motivating from an executive perspective? This is not difficult.  Simply put, the market has informed the board and the board has informed the market on both already.  It is built into the company’s share price.  Instruct your external advisors to work back from this to determine what minimum is required in the drivers of shareholder value to at least meet shareholder expectations built into the share price and you will have the minimum level for incentive payments to begin. 

3.  Make sure performance measures drive shareholder value

Sometimes the predictability of the measure’s success in translating to value for shareholders (and plan participants) can be gauged by assessing the historic correlation between the company’s share price and the proposed performance measure.  The greater the long term correlation, the more predictable and appropriate it is for use in the incentive plan.

Why “sometimes”?  One of the idiosyncrasies of statistical regression techniques is that more of the variance in the dependent variable (such as total shareholder return – TSR)) can be explained by selecting more and more diverse variables.  So, while measures of cash earnings (e.g. cash EPS growth) could explain much of the variance in TSR, additional cash earnings based factors that co-vary with this measure will not add much to explaining variation in TSR, even when they are internally consistent.  Instead, the technique will probably select another measure that has little to do with cash earnings (such as a profit measure based on international accounting standards!) that, combined with your cash earnings measure will explain more of the variance in TSR.  We suggest take care!  While not incorrect, it may be more worthwhile to select internally consistent drivers of shareholder value, rather than a combination that has a better correlation.

4.  Do not be guided by expense impacts

Since the introduction of accounting standards that require the expensing of employee equity grants, many companies are giving careful consideration to the differences in expensing treatment between market-based measures (relating to share price) and non market-based measures.  Our view is that although these differences should be understood, they should not be the determining factor in the selection of the performance measure.

Encouragingly, some companies are showing a preparedness to adopt measures that are different from their peers and depart from the normative practice expected by the market.  As we have indicated previously (see HERE) we expect to see further diversity in design as companies respond to the need for structures and measures that reflect their specific circumstances and objectives.

5. Select the Most Appropriate Timeframe

The most common performance period for a long-term incentive plan is three years, with performance measured at the end of the period.  While this has a positive impact on longer-term performance focus and retention, a three-year term can present difficulties in identifying longer-term goals and outcomes with a degree of precision.  This can be particularly problematic for small companies, those in a strong growth mode or in the midst of major organisational change.

These companies might feel compelled to adopt shorter-term targets, but address investor concerns by instituting a further vesting and restriction period beyond the performance testing date.

7. Weigh absolute versus relative performance measures

Absolute performance goals are specific targets against which future performance is measured.  They are typically linked to the company’s business strategy and should be relatively easy to measure and communicate.  Shareholders might feel more capable of assessing the degree of difficulty in the targets by being able to gauge how they compare with “typical” outcomes, and plan participants may feel more in control of the results.

However, absolute goals rely heavily on effective planning and forecasting, and may induce management to set lower goals in order to enhance their prospects of a payout.

Investor groups, who expect performance to exceed that of peer companies to justify variable reward payments to executives, generally prefer relative measures.  Relative measures can also retain motivational and retention value in times of economic downturn, when vesting can be achieved despite depressed results, provided performance remains ahead of the comparator companies or index.  However, selection of a relevant and appropriate comparator group is critical if a relative measure is used.

8. Consider overlapping rather than consecutive performance cycles

In a consecutive performance cycle, a new cycle begins at the completion of the previous performance period.  For example, a plan could run from the end of 2004 until the end of 2007, with the subsequent plan commencing in early 2008 and ending in December 2010.

Consecutive cycles allow less flexibility to add new recruits to a plan during the performance period and are more susceptible to the impact of large swings in performance or market aberrations, making it difficult to motivate executives during a significant downturn.  However, this type of plan approach is rare in Australia.

In an overlapping performance cycle, a new offer is made each year, so that multiple tranches are running simultaneously.  This approach allows goals to be adjusted annually at the time of each new offer, new recruits to be included, grant quantums to be adjusted to reflect the current share price (whether it has gone up or down) and, where options are used, the exercise price to also reflect the current share price at the time of the offer.  It also presents the opportunity for receipt of rolling annual rewards, enhancing both motivation and retention effects.

9. Calibrate the performance/reward scale

“All or nothing” outcomes can be appropriate where the performance measure represents a critical achievement, such as the attainment of a key project milestone.  However, in other circumstances they may not adequately recognise strong performance that falls marginally short of the goal, perhaps as the result of external factors.  In those circumstances, the use of a vesting scale may be more appropriate, to provide rewards that increase in line with the level of results achieved above a threshold performance level.

The latter approach allows reward to move in line with performance, and retains motivational impact even when the maximum payout might not be achievable. 

10.  Consider the extent that risk management is built in

There are many ways to incorporate risk management.  The most common is to have overlapping performance periods.  In effect, any risky approach that results in an incentive gain in one period may result in no payouts in following periods if the risk does not pay off.

Another method is a careful consideration of the reward vehicle.  Payment in shares that are required to be held (as a result of a trading lock or an executive shareholding requirement) encourages executives to consider risk more carefully, given that they have significant wealth tied up in company stock.

Another method is to defer payment of part of the incentive in to a bonus “bank”.  The measures that calibrate the amount of reward to be paid can be configured to result in a negative reward.  That is, amounts are deducted from the bonus bank accrued from prior good years.  This is another method to sharpen executives’ focus on risk management.

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