October 20, 2023 Executive Compensation ESG & Human Capital Management Articles

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From Overwhelming to Opportunity Incentive Goals in Uncertain Environments

As companies look ahead to 2024, goal setting may prove to be a tough challenge. Supply chain uncertainty, higher interest rates, increased labor costs, and changes in consumer preferences all contribute to the issue. Setting achievable but aspirational goals is crucial for focusing leaders and steering their efforts in the right direction.

Avoiding outcomes that result in a sustained pattern of no payouts is key. Unfortunately, setting incentive goals can be difficult with so many unknowns making future performance hard to predict. Some companies anticipate year-over-year performance declines, with significant strategic and operational issues to address. Others have strong tailwinds, but it’s unclear how quickly they can be capitalized upon and how long they will last.

At the same time, institutional investors and proxy advisors have high standards. They expect goals to increase year over year, payouts only if commensurate shareholder value is created, and maximum payouts only in extraordinary years. They are increasingly focused on goal rigor to ensure fair and appropriate payouts. The companies that succeed will strike the right balance between motivating leaders with incentive plan goals and ensuring fairness amid growing investor scrutiny.

The right strategy for goal setting will depend on the circumstances a given company faces. Below, we examine four common challenges and potential strategies to address them.

Effectively reimagine goals considering uncontrollable supply chain or end customer challenges.

This situation calls for focusing on what can be controlled, often through an operational or strategic scorecard. Many companies implemented scorecards when uncertainty was high coming out of the pandemic through 2021 and into 2022. Interest in including environmental, social, and governance metrics in incentive programs also increased the prevalence of scorecards.

Scorecards can provide stability in the program and allow compensation committees to apply some discretion. Investors can be more skeptical of goals with less financial focus, so in these cases, it’s important to demonstrate how the goals help the company better prepare for the future and show that the goals are not “gimmes.” For example, one industrial company focused on restructuring processes to lower costs, expanding nontraditional channel sales, and hitting milestones related to a turnaround. In addition, it may be important to reserve maximum payouts for these goals for truly extraordinary achievements.

Tailor strategies when setting lower year-over-year financial targets due to macro headwinds.

Companies in transition or facing external headwinds often need to set lower financial goals year over year to align with the company’s budget or realistic performance expectations. However, setting lower goals year over year can also be a hot button issue for proxy advisors and some investors. Balancing these considerations requires a thoughtful approach. In one such circumstance, a company reduced the performance goal for target payout but modified the payout curve so that missing the target resulted in a larger reduction in pay. In addition, the maximum performance level was adjusted so that performance had to exceed the prior year by a fair margin.

In another situation, exceeding the prior year’s performance was not realistic. In order to provide some opportunity for management, the maximum payout level was reduced from 200 percent to 125 percent. This reduction took into consideration the maximum performance level compared to historical performance levels at the company. It also avoided providing a windfall to management if the goals turned out to be set too conservatively.

Regardless of the construction, companies in this circumstance will want to make sure they clearly convey to investors the rationale for lower year-over-year goals and a trajectory for continuing improvement in future years.

Adjust payout curves to ensure absolute performance and perceived performance against incentive goals aren’t disconnected.

Setting absolute performance goals is difficult for many companies today given the macro environment. Goals can be viewed as too easy or too much of a stretch if the macro environment differs materially from the assumptions used to set them. Relative goals have been a typical go-to solution to help mitigate these outcomes. Relative total shareholder return (TSR) is the most common go-to metric. Some companies have also used relative earnings per share, relative gross margin, and market share.

Adjusting the payout curves can be important if the macro environment challenges play out over multiple years. For example, one company set incentive goals that in retrospect were too challenging. For the next cycle, the company set a lower threshold cut-in (with corresponding adjustments to the threshold payout level) to help ensure the program was not entirely out of money while still maintaining stretch goals at target. Conversely, in another example, the payouts consistently tracked well above target at a level the board did not find reflected the company’s full potential. In this case, the company modified its goal-setting approach from symmetric performance ranges above and below target to instead include a higher performance level to achieve maximum. This change helped to focus the team on striving for what was truly possible in the business.

Avoid undermining a performance cycle by setting multiple annual goals for multiyear long-term incentives.

In periods of economic uncertainty, long-term goal setting can be particularly challenging. If it’s clear after the first year that goals in the cycle will not be achieved, participants may lose motivation. However, a strategy that has been applied in the past, setting shorter-term goals (e.g., one-year goals) that pay over a longer period, can be criticized for paying for the same performance twice.

Another approach to avoid all-or-nothing outcomes is to set goals at the beginning of the period for all three years, but measure performance after each year and “bank” that year’s performance, modifying the aggregate outcome by three-year relative TSR. This approach establishes a long-term trajectory but prevents any one year from undermining a performance cycle in its entirety. The three-year relative TSR maintains the shareholder perspective.

In all these cases, a thoughtful approach to goal-setting and incentive design can help turn what may initially seem overwhelming into an opportunity to use incentive plans as the effective motivational tool they are intended to be.

View the full article as it was originally published or download a PDF version of it.

Greg Arnold

Blair Jones

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