Compensation committees sometimes feel challenged by the task of setting targets for annual goals. Not only do they have to address the upside potential and downside risk in the company’s business plan, but also other factors that include external headwinds and tailwinds associated with macroeconomic factors, competitive opportunities and threats, technological disruptions, and regulatory changes. That said, the task of setting annual targets can become quite complex.
The greater challenge may be setting the range of payouts around target, especially payouts at threshold and maximum levels. The threshold defines what level of performance warrants any payout at all while the maximum defines what level of performance is exceptional. Neither level is easy to set by using a formula, yet they are arguably even more important than the target. This raises the question: What is the best way to set those numbers?
Compensation committees are often tempted to follow conventional wisdom and follow how other companies, especially peers, have traditionally structured their payouts, using either a symmetric payout curve, or a payout curve with equal ranges above and below target. Two practices are common: using 90 percent of target for threshold and 110 percent of target for maximum or using 80 percent of target for threshold and 120 percent of target for maximum. Executives then usually get 50 percent of their target bonuses if they achieve the lower level and 150 or 200 percent if they achieve the higher one. A cap of 200 percent helps compensation committees avoid encouraging unacceptable risk-taking and paying too much for windfalls.
Because thresholds and maximum payout levels need to take into account many factors, particularly the relative predictability and volatility of performance outcomes as well as investor expectations, compensation committees need to move beyond conventional practices. They should instead use analyses that are tailored to their company.
For example, consider the case of a branded food company with stable revenues. This company has launched several high-growth, albeit unproven, initiatives to develop innovative products in new categories in addition to expanding geographically. For years, executives have delivered predictable results which were rewarded by payouts fitting a narrow symmetric payout curve, one with a 95 percent threshold and 105 percent maximum. (See Figure 1.) As a result, the compensation committee considers whether, and how, to adjust the range in light of the shift to a strategy with less predictable outcomes.
To arrive at an answer, the compensation committee can ask two sets of questions. The first set focuses on the top-down questions on how the company needs to perform overall.
What do Wall Street analysts expect? The answer can vary from most bullish to most bearish.
What performance levels have their peers delivered in the last three to five years? To find this answer, the branded food company looks at peer performance at the 25th, median, and 75th percentile performance levels.
What has been the company’s own historical performance? Recent performance serves as a yardstick for defining the minimum acceptable performance levels while historic highs are a reference for outstanding performance levels.
Do the growth initiatives yield returns that exceed the company’s return-on- investment requirements? The answer indicates whether the anticipated initiatives have adequate payback.
Does the range of payouts result in a fair sharing of gains between executives and shareholders? This defines what is equitable to shareholders.
The second set of questions focus on what managers in each business unit believe they can deliver. Managers’ answers depend on budgets that take into account a range of possible scenarios from the most optimistic to the most pessimistic, reflecting the managers’ own actions as well as the external headwinds and tailwinds that buffet their businesses. The compensation committee can use can use internal (e.g., the best the unit has done in the past) or external (e.g., best-in-class among peers or industry in general)
In the case of the branded food company, executives and directors are able to glean four things from their analyses:
The opportunities for growth are higher, but the risks of failure are greater.
The company’s targets pass the litmus tests of exceeding historical and competitor levels, and also satisfy the range of expectations of Wall Street analysts.
The growth initiatives yield a range of potential upside outcomes that exceed historical highs, while downside risks, though greater than the past, are acceptable.
The target level of growth surpasses the return-on-investment hurdles for new investment.
Based on the above, the company’s compensation committee chooses to widen the performance range. It tentatively resets the threshold payout to 90 percent and maximum payout to115 percent. (See Figure 2.) This change is in keeping with the intention to pursue a more aggressive growth strategy, one that has much more upside yet poses increased uncertainty. The committee’s choice assures that the company delivers on analyst expectations, remains competitive with peers, fits the realistic performance of the business units, and ensures the 90 percent threshold figure exceeds the previous year’s results.
As a final check, directors test payouts to ensure that executives and shareholders equitably share in gains as performance improves. The committee looks at the ratio of the aggregate bonus payouts to the company’s pre-tax, pre-bonus profit. It also checks the incremental bonus spend to each incremental dollar of pre-tax, pre-bonus profit. It finds the average spend of profit is 5 percent to 8 percent, the incremental spend, 20 percent to 30 percent. Both are reasonable based on competitive data.
Other companies might come to very different conclusions by conducting their own analyses in setting threshold and maximum levels. For example, those businesses facing more turbulent business environments, those with unsophisticated planning processes, and those with less predictable results because they are highly susceptible to external factors, or are less mature, would probably have wider ranges. In any case, through a detailed analysis that asks both the top-down and bottom-up questions, boards can gain the confidence to move beyond conventional wisdom to reasoned alternatives they can explain to both executives and inquisitive investors.
The more volatile the economic and business background, the more likely a board will set a wider range for threshold and maximum percentages. Even so, the “average” company in an “average” year will set percentages using certain guidelines.
Guidelines for Threshold Payouts
Set at the lower end of a company’s peer-performance range (25th percentile)
Set at the lower end of analyst expectations.
Set above the previous year’s results.
Set high enough to create some modest value for shareholders.
Set at a point on the performance curve where executives have a 90-percent chance of triggering the minimum payout.
Guidelines for Maximum Payouts
Set at the top end of peer performance (75th percentile).
Set at the top end of analyst expectations.
Set in line with record-level company performance as is appropriate.
Set at a level that will create significant value for shareholders compared to peer and historical performance.
Set at a point where executives have only a 10 percent chance of hitting the maximum.
An executive compensation consultant since 1991, Blair Jones currently serves as a managing director of Semler Brossy Consulting Group. She has worked extensively across a variety of industries and has particular depth of expertise working with companies in transitional stages. She may be contacted at firstname.lastname@example.org. Seymour Burchman is a managing director of Semler Brossy Compensation Group and has been an executive compensation consultant for over 20 years. His work focuses on reinforcing key strategies and leading to improved shareholder value through the identification of performance measures and goal setting processes. He may be contacted at email@example.com.
Using total shareholder return (TSR) as a compensation program metric emerged as a hot topic for both panelists and attendees during the third annual Leading Minds of Compensation event last week at the Grand Hyatt in New York City. Discussing the day’s most pressing compensation issues in a panel selected by NACD Directorship magazine Publisher Christopher Y. Clark and Editor-in-Chief Judy Warner were: Steven Hall, managing director of Steven Hall & Partners; Dayna Harris, vice president of Farient Advisors; Jeff Joyce, partner of Pay Governance; Rose Marie Orens, senior partner at Compensation Advisory Partners; Jannice Koors, managing director of Pearl Meyer & Partners; and Barry Sullivan, managing director of Semler Brossy.
Jannice Koors noted that, while not a practice used by the majority of public companies, TSR is a popular metric. “It has some benefits: it clearly is the most directly aligned metric between shareholders and executives, so it’s an easy story to tell, it rewards results, it’s easy to present to shareholders.” But, according to Koors, the pros of TSR are readily outweighed by the cons. “The purpose of an incentive plan is to incent behaviors, actions, and decision making,” she said. “You don’t have behaviors that create stock price.” Dayna Harris agreed. “TSR doesn’t focus people on things they can control,” she said. “When you go to a one-size-fits-all compensation plan, you are reducing the number of tools in the tool chest that help the board and management to improve overall company performance.”
Koors expressed another major reservation with this metric. “You’re measuring movement over that period of time—it creates some natural spikes. So what goes up must come down. What naturally happens in TSR plans—and what a lot of companies who are coming up on that third and fourth and fifth year of having a TSR plan in place are finding—is that if you’re in the top quartile at the end of your three years, you have vastly improved the likelihood that you are going to be in the bottom quartile at the end of your sixth. So what TSR really rewards is being a steady eddy in the middle of the pack.”
But, during the Q&A portion of the event, one director self-identified as an advocate for TSR as a valid and valuable metric, said it’s the purest way to align shareholders with directors. If companies were to move away from TSR, what data is available to lure away TSR’s most ardent adherents? “I’m not going to try to dispel the notion that it is purely aligned,” Koors said. “I’m just saying it’s a reward, not an incentive—and it depends on what you want your long term incentive plan to do.”
Rose Marie Orens added her thoughts about TSR, saying that there is a time and a place for this metric, particularly in the financial services industry. Though acceptable to use TSR as a portion of an award, and to use it as a reminder that driving stock prices is a priority for executives, Orens didn’t think it should be used as the main metric behind executive compensation. “I would drive either for relative performance on metrics that are important in my industry and I want to demonstrate that I am doing better,” Orens said.
Barry Sullivan directed attendees’ attention to “The Problem with Total Shareholder Return,” a study mounted by his firm in 2012 that gave Koors’ intuition and Orens’ observations a statistical bite. “What do we need to do from a growth and profitability perspective over a long period of time to drive TSR?” Sullivan asked. “When you look at the data, those companies that outgrow at a return above their weighted cost of capital drive superior total shareholder return. Focus on growth, focus on profitability, and TSR will come.”
Jeff Joyce didn’t take issue with TSR in and of itself, but rather, he found fault with its application. He observed that, because TSR is measured over a fixed period of time, a sudden lull in stock price at the end of that period undermines shareholder alignment. “While it does play a role, stock price is captured in other forms of equity,” he said. “It doesn’t have to be explicitly measured in terms of total shareholder return.”
NACD Directorship will host a “Prognosticators of Pay” event on July 17th in Seattle. Directors interested in attending this complimentary program may request an invitation online.
Look for full coverage of NACD’s Leading Minds of Compensation event in the May/June 2015 issue of NACD Directorship magazine.
Directors attending the recent NACD Directorship 2020® event in Denver, Colorado engaged in group discussions about how boards can anticipate and effectively respond to environmental and competitive disruptors in the marketplace.
The half-day symposium at the Ritz-Carlton on July 15 was the second of three NACD Directorship 2020 events this year addressing seven disruptive forces and their implications for the boardroom. Summaries of the Denver speakers’ main points are available here.
Following each speaker, directors developed key takeaways for boards. Those takeaways fell within the parameters of the five elements of effective board leadership defined at last year’s NACD Directorship 2020 forums: strategic board leadership and processes, boardroom dynamics and culture, information and awareness, board composition, and goals and metrics.
Environmental Disruptor Takeaways
Strategic Board Leadership and Processes
Crisis response plan. Ensure that the company has a contingency plan in place that takes into account a potential environmental crisis. The plan should include how the company will respond to disruptions in the supply chain and production cycle, as well as to employees, customers, and investors.
Boardroom Dynamics and Culture
Culture. Boardroom culture should reflect that directors are ready and willing to be held accountable for environmental or climatological issues that arise for the company.
Information and Awareness
Engagement. The company should have an established communications plan to use in response to requests from shareholders and stakeholders regarding environmental matters.
Goals and Metrics
Green metrics. Becoming a sustainability-focused company requires adopting a long-term commitment to the cause. The board can communicate that commitment by establishing environment-related performance metrics that align with the corporate strategy.
Competitive Disruptor Takeaways
Strategic Board Leadership and Processes
Board agenda. Set aside time on the board agenda to discuss forward-looking strategy, so that the board’s focus is not limited to reviewing the company’s past performance.
Boardroom Dynamics and Culture
Culture. Fostering innovation requires risk. The culture throughout the organization should support failure and risk taking within the company’s tolerances. Also invite outside experts—or “white space” teams—to help trigger new, innovative thoughts.
Composition. Board composition should reflect a diversity of thought and experience. Regardless of background, directors should be willing to ask probing questions and stay aware of marketplace trends.
Goals and metrics
Understanding the marketplace. Management should be able to answer who future competitors might be and what trends might gain traction.