September 1, 2020
September 1, 2020
Annual incentive plans are an important tool that companies use to tie compensation outcomes to company performance. Setting the right goals with the right degree of difficulty or “stretch” is the key to ensuring that payouts are appropriate relative to performance.
In early 2020, most companies set goals for their annual incentive plans in the context of a relatively stable macroeconomic backdrop. The COVID-19 pandemic and its impact on the global economy made these goals unattainable for many businesses shortly after they were set. As organizations consider how to grapple with the impact, it can be helpful to consider how these plans have rewarded employees during more stable economic cycles relative to performance.
Compensation Advisory Partners (CAP) conducted research on annual incentive programs at 120 companies in 10 industries with median revenue of $34 billion. This research covered annual incentive plan design and payout history over the last ten years, from 2010 to 2019, to get a sense of how these programs have worked and how we expect that 2020 may be different.
The majority of the companies (87 percent) in CAP’s study have goal-attainment plans that fund formulaically based on performance relative to pre-established threshold, target, and maximum goals. These plans most commonly pay 50 percent of the target annual incentive for threshold performance and 200 percent of the target for maximum performance.
Among the companies in our study, 28 percent use two financial metrics, 35 percent use three metrics, and 29 percent use four or more metrics to determine bonus funding. Financial metrics are common in annual incentive plans; the two most prevalent metrics used are income and revenue. One-third of the companies in our study also use strategic or nonfinancial metrics that incentivize behaviors that contribute to longer-term company priorities. Arguably, the more that companies use strategic and nonfinancial performance goals, the more important it is to ensure that plans and payouts are appropriate and affordable from a cost perspective.
CAP reviewed 10 years of annual incentive payouts from 2010 to 2019 for the 120 companies included in the study. Based on our analysis of payouts over this period, the degree of “stretch” embedded in annual performance goals translated to a 95 percent chance of achieving the threshold performance goal, a 70 percent chance of achieving the target performance goal, and a 10 percent chance of achieving the maximum performance goal.
This shows that participants are “getting in the game” 95 percent of the time by achieving threshold performance goals, and receiving maximum payouts 10 percent of the time, or once in every 10 years on average, by achieving superior results. These findings also reinforce the importance of performance metric selection and performance goal setting, given that companies are spending annual incentive monies equal to at least the amount of their overall target pool 70 percent of the time.
Our study found that select industries have payout distributions that fall outside the norms of the broader group. Companies in the pharmaceutical and insurance industries achieved target performance goals more often than the broader group and paid at or above target 90 percent and 85 percent of the time, respectively, versus 70 percent for the full sample. Conversely, companies in the consumer goods and retail industries, where revenue growth has lagged that of other industries, achieved target performance just 60 percent of the time. Several factors may contribute to differences in payout distributions by industry, including metric selection, goal setting, and performance results. However, median total shareholder return over the period from 2010 to 2019 for the pharmaceutical and insurance companies was higher than that of the consumer goods and retail companies, showing that payouts were ultimately tied to the shareholder experience.
Annual incentive payouts tended to be higher between 2010 and 2014 than in the 2015-2019 period. From 2010 to 2014, companies achieved target and maximum performance goals 80 percent and 15 percent of the time, respectively. From 2015 to 2019, companies achieved target and maximum performance goals 70 percent and 5 percent of the time, respectively. By comparison, during the recessionary years of 2008 and 2009, companies achieved target performance goals just 55 percent of the time. This may indicate that following 2008 and 2009, companies were hesitant to set overly challenging goals or had subsequent growth and performance that exceeded their own expectations.
We also reviewed annual revenue and operating income growth between 2010 and 2019 and found that overall payouts and directional payout trends aligned with revenue and operating income growth trends.
Compensation committees and management teams can use these historical payout trends to guide decisions around the degree of stretch in future incentive performance goals and help evaluate if plans are rewarding employees appropriately.
Given the impact of COVID-19 on financial results, 2020 will be a very different year. Payouts will likely be more erratic by industry and by company for 2020 performance. The expectation is that most companies will pay near or below target. Companies in select industries (such as pharmaceuticals) may pay higher bonuses and struggling companies may pay none. Companies will likely use discretionary assessments of performance and, in some cases, use discretion to fund bonus pools altogether to recognize the challenges of the year. Overall, however, payouts will likely be below historic norms, reflecting a significant departure from the last ten years during which companies paid at or above target 70 percent of the time.
The new year will also present challenges and uncertainties; 2021 is likely to be a challenging year in terms of planning and goal setting, and if COVID-19 and its impact still linger, businesses will be affected operationally and financially. This suggests that payouts could again be lower in 2021 for many companies. Alternatively, companies may use more discretion in overall plan funding, or carve out a greater portion of funding for strategic, nonfinancial, or individual goals. In this case, payouts could be somewhat higher than what would be expected based on pure financials and the degree of economic stability.
While the typical payout patterns may look different for 2020 and 2021 (not unlike 2008 and 2009), this 10-year lookback provides a pattern and distinct guidelines that companies can use to assess their actual payouts and established goals over the longer-term.
Melissa Burek is a founding partner and Mike Bonner is a consultant at Compensation Advisory Partners in New York.
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