Performance targets in a high inflation environment

High inflation has multiple impacts on executive remuneration, not just on pay levels, but also the nature and structure of incentives (see HERE and HERE)

The Reserve Bank of Australia’s (RBA’s) decision on 3 May to increase the cash target rate for the first time in over a decade came after annual CPI increased to 5.1% in March with underlying inflation at 3.7%.

The RBA expects a further increase in the inflation rate, with underlying inflation to decline to the top of the target band 2-3% not until 2024.

Increased uncertainty from high inflation in the medium term presents a challenge for boards trying to set appropriate targets for management incentive plans. The following principles are a starting point for calibration of vesting scales in STI and LTI plans:

  • Threshold: lower limit of acceptable performance. No incentive is awarded below this level.
  • Target: represents the expectation of robust outcomes. The incentive awarded at this level of performance is often communicated as the expected payment, or the average outcome from the incentive plan over time.
  • Stretch: delivery of exceptional outcomes above expectations. The maximum incentive opportunity is awarded at this level of performance.

How can the board ensure that performance measures remain appropriately challenging but not impossible for management to achieve in a high-inflation environment? Financial measures such as EPS growth will be particularly challenging to calibrate for LTIs to be granted this year in some industries.

Removing the impact from inflation on actual earnings growth for performance measurement purposes is a possibility – if earnings growth is measured on the underlying “real growth”  basis, management will not be punished for factors that may be largely outside of their control.

This may be difficult to do in practice, as each line item in the income statement would have to be deflated to arrive at the real earnings growth number. The challenge would be compounded for companies with overseas sales as different currencies would have different inflation over the performance period. The calculation is also unlikely to be transparent to investors and proxy advisers who prefer financial measures to be based on reported numbers.

Alternatives that may be easier to achieve investor support include:

Increased vesting range

With higher expected volatility in earnings, extending the range between threshold and stretch performance in the vesting scale can ensure that incentive outcomes are not “all or nothing”, and can accommodate more uncertainty.

Replace growth measures with a measure of capital efficiency

Return measures such as ROIC or ROE are typically calculated as an average annual return achieved over the LTI performance period. Outcomes are typically much less volatile than growth measures such as EPS CAGR and vesting scales less challenging to calibrate.

Replace growth measures with relative TSR

The main benefit of having TSR compared to a peer group or a broad market index as a performance measure is that the board does not have to set targets for vesting. LTI market practice is for vesting to start at median performance, with full vesting at upper quartile performance. While relative TSR is unlikely to be motivating for management it is supported by investors and some proxy advisers as a performance measure and could be considered as an interim solution until inflation abates and financial performance becomes easier to forecast.

Replace performance contingent LTI with restricted shares

While not suitable to all companies, restricted shares that vest subject to time or service can be considered in lieu of some of all of an LTI, perhaps on a temporary basis. See if they can be right for your company HERE.

© Guerdon Associates 2024
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