The Five Pillars of Incentive Design

Board members bring a wealth of talent and experience to the companies they serve, but often have no practical exposure to the basic building blocks of effective remuneration design. While recruited to a board because of their industry experience and/or technical knowledge, few directors have the knowledge and experience to wrest remuneration matters away from management. It is a case of management expertise versus boards attempting to manage conflicts of interest.

Before committee members jump into aligning incentives with company strategy, discussing best practices, or considering accounting and tax implications, it can be very beneficial to review the concepts typically used in incentive design.

In our experience over the past 30 years, we have seen countless successes and failures of incentive arrangements. As our experiences accumulated, we found that a distinct pattern emerged that we have long since distilled into the five pillars shared below.

We have found the most successful incentive plans strike a balance between these five pillars that are the foundation of the entire incentive design. Incentive plans work when participants:

1 . Know what is expected of them

2 . Believe it is achievable

3 . Can track progress through the performance measurement cycle

4  Can earn a meaningful amount for achieving the goal

5 . Are aware of potential negative as well as positive outcomes

1 . Knowing what is expected of them

If the performance metrics are not a “household word,” do not tie pay to them.

Companies and boards often get excited about new concepts and measurements that drive organisational value, but if those measures are not part of the 24/7 fabric of the participant’s work life, the plan is not likely to work. This means transitioning to new concepts requires training and retraining until the concepts sink in, before tying pay to the measures.

As we develop and select new measures to better reflect execution of company strategy, the trick is to ensure that each measure is understood and embraced, much like the overall strategy.

2. Believing it is achievable

Oftentimes companies place unrealistic targets in front of participants (e.g. $2.00 EPS when $1.50 is the budget forecast). This is founded in the mistaken belief that incentive targets must be “stretch” to qualify for a reward. This belief is shared widely among proxy advisers and institutional investors. However, in practical and behavioural terms, it will not work.

There has to be a degree of buy-in to the goals – otherwise, the plan will be ignored or, at the very least, be ineffective. If you want to reward executives for a 14% ROIC, and the enterprise is currently only generating 10%, a road map showing how the goal can be achieved is a ‘must’.

3 . Tracking progress during the performance measurement cycle

Participants need to see the goal line regularly.

Tracking performance (monthly or more frequently for an annual goal) is crucial to plan effectiveness during the performance measurement period.

Behavioural research indicates that frequent feedback has as much, or more influence, on behaviour as the actual reward. Modern enterprise data solutions make this issue fairly moot in most cases. However, newer goal concepts at many companies have resulted in performance-tracking lag times that render plans ineffective. For example, not seeing the results of Q1’s goal until the end of Q2 is not highly motivational for participants in an annual plan.

Remember, if the metric is important enough to be rewarded, it is important enough to be part of timely, transparent communication.

4. Earning a meaningful amount for achieving the goal

In most executive pay plans, this is also a moot issue as long as competitive target incentive opportunities are set regularly. However, some companies do not set such targets. Also, the incentive plans often roll down to lower levels in the company in certain industries.

Experience has taught us that at least one month of pay (e.g., 8% of fixed pay) is the minimum target opportunity for the lowest level. At executive levels, we seldom see targets below 30% of annual fixed pay. Participants are motivated by pay amounts that can make a difference in their lives. Working hard, or having the discipline to disregard distractions, to achieve goals should yield a reward that is meaningful to the recipient.

5. The negative can be as effective as the positive to get the right results

Since the GFC, the countless research, government enquiries and regulatory reviews have found that the way outcomes are achieved matters.

Boards should set the targets, measure the outcomes, make an award, but then defer a meaningful proportion of it to make sure the award was not at the expense of the company or its customers.

Similarly, certain metrics might be used as ‘modifiers’ rather than the primary measure against which the award is made. For example, rather than having risk in the scorecard with a weighting of 10% (not really meaningful, is it?), participants’ awards may be modified up or down based on their risk behaviour.

The Take-away

Remuneration committees are responsible for bringing the company’s strategy into focus through the use of incentives. Members are advised to keep in mind these five simple pillars. This should ensure the resulting incentive design is effective.

© Guerdon Associates 2024
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