Solving Incentive Formula ConflictsZoom inDownload PDF
Over the next month or so, thousands of companies will review 2012 performance and make annual incentive payouts for the year. For many boards, this will involve a fairly straightforward set of discussions and decisions — significant payouts linked to strong performance for some, and low or no payouts linked to weaker performance for others.
However, there will be other companies where the discussion is not so straightforward — where 2012 performance was a mix of highs, lows, and some “in-betweens,” where incentive formulas indicate one payout, and prevailing views among directors indicate something different. This is where the board’s discretion to adjust incentive payouts comes into play, right? Right, but…
Board discretion is often more easily talked about than it is practiced. Discretionary adjustments from “the formula” can be misconstrued by employees and shareholders alike, leading to hard feelings internally and skepticism externally. In the bright light of say on pay, some boards shy away from discretion altogether, regrettably but understandably, in favor of defined and defensible incentive formulas.
The reality is that incentive formulas will work only some of the time. Even the “best,” most sophisticated formula will get it wrong one or two years out of 10. It is in these situations — where the formula result is simply wrong in the broader context of performance — that the four steps below can help boards and management teams navigate the path from wrong result to right, from formula to something else.
What is the board to do when the incentive formula indicates one thing, but directors think another?
Step 1: Raise the Issue Early
Boards should raise the issue with management as soon as possible to allow as much time as possible for review and discussion. It is essential to bring forward and clarify perspectives of directors and management so that differences, if any, are known. As a point of process going forward, regular updates throughout the performance year can avoid year-end surprises. These discussions — to surface and define disconnects, if any — then become the common starting point for the board and management, setting the stage for open dialogue going forward and, ultimately, constructive outcomes.
Step 2: Build an Information Base
A strong information base is essential to building a consensus view, or, where consensus is out of reach, a credible, defensible position. It is important to both quantify and qualify the difference between the incentive formula result and the Board’s view of performance. By how much is the incentive formula off, and for what reasons? Typically, answers tie back to two related topics: performance measurement and goal-setting.
- Performance measurement: Is the incentive formula measuring the wrong things? Or, not enough things? For example, the incentive formula is based on the earnings result, but doesn’t address the path. So, the incentive result may become disconnected from a fuller view of performance for the company that made its 2012 earnings number by focusing on existing higher-margin customer segments, and ignoring emerging, high-potential segments. In this case, the incentive formula indicates a payout higher than the prevailing board view.
- Goal-setting: Were performance goals too soft when judged in hindsight? Too hard? Goals set with the best of intentions at the beginning of the year can be close to meaningless by year-end. This was a hard lesson for many companies during the recent downturn, where expectations missed both ways — high relative to a 2009 low, and low relative to a 2010 bounce.Of course, there are other factors or events that can lead to a “wrong” result from the incentive formula: a significant product misstep, a big customer win, a downgrade in the company’s debt rating, or a major legal settlement. Few incentive formulas will capture these sorts of events directly in the current year, but some are simply too significant to ignore when determining annual incentives.Finally, it is important to understand available precedent — when have adjustments from formula been made in the past, and why? Pay is best managed over time, and the historical record is important context for today’s decisions.
Step 3: Make This Year’s Decision: Whether, and by How Much, to Adjust Payouts
In some cases, the board’s view may not be so different from the formula after all. If the board’s view and the formula are fairly aligned — say within plus or minus 15 percent — an adjustment may not be worth it in the end. These more minor differences have a way of averaging out over time. However, even these more minor differences can carry significant meaning when around target or threshold performance and payout. An adjustment from formula around these key “anchor points” can mean the difference between an above-target year and a below-target year, or the difference between no payout and some payout.
Where the board decides to make an adjustment from formula, whether minor or significant, the decision now becomes: to whom shall the adjustment apply — all eligible employees, or select executives only? Is it a shared fate for all, or a more focused message to principal stewards? The facts and circumstances of the adjustment and precipitating performance will drive this decision, as well as organizational culture and historical precedent. And with any adjustment, communication is important — the board and management must work together to help ensure intended messages are received by employees and shareholders.
Step 4: Think Ahead to Next Year: What Did We Learn?
Whether or not the board made an adjustment from formula, there are lessons to be learned from the exercise itself. The board and management now have a better sense for what factors or events will warrant consideration in years to come, what conversations need to take place and when, and what information is needed to make informed decisions. And it can be helpful to capture principles for applying discretion to guide future considerations; for example:
- Adjustments from formula should not occur with regular frequency, but only on an as-needed basis for significant performance and/or events beyond the scope of the incentive formula;
- Further, the board’s ability to make adjustments from the formula should not diminish the thoughtfulness and rigor required in defining the incentive formula and setting performance goals; and
- Finally, adjustments from formula will move up and down from the formula result, as the case may be in a given period.
Going forward, expectations will be for an improved, “tighter” process by which to consider potential adjustments from the formula.
Beyond process and principles, some companies will want to change or add performance measures going forward. And for most, goal-setting will continue to be an annual pressure point. Still others may want to build into the incentive approach a more explicit role for discretion, as an overlay or ride-along to the incentive formula itself. This is entirely workable, but must be approached carefully so as not to injure the credibility of the incentive formula itself.
Again, even the best incentive formulas will break down sometimes. When this happens, the way forward is fairly intuitive: ask the right questions, collect the needed information, and make credible, defensible decisions. However, more often than not, there is little time and no clear structure, and considerations become more of an in-the-moment negotiation, with clear sides taken and optimal outcomes out of reach. The four steps above can help. By advancing the discussion, anticipating information needs, and making known overall principles for adjustments, companies can set a clearer path to more constructive outcomes for 2012 and going forward.
This article by Barry Sullivan originally appeared in NACD Directorship.